What is market psychology?

Market psychology believes that market trends will reflect (and be affected by) the emotional state of participants. It is one of the main topics of behavioral economics. Behavioral economics is an interdisciplinary field that studies the factors that precede economic decisions.

Many people believe that emotion is the main driving force behind changes in financial markets. Overall swings in investor sentiment create what are known as market psychological cycles.

In short, market sentiment is the overall feeling among investors and traders about the behavior of an asset's price. When market sentiment is positive and prices continue to rise, a bullish trend (often called a bull market) occurs. The opposite situation is called a bear market, where prices continue to fall.

Emotions therefore consist of the personal opinions and feelings of all traders and investors in financial markets. Another way to look at sentiment is as an average of how market participants feel overall.

But as with any group, no one viewpoint is completely dominant. According to market psychology theory, the price of assets tends to continuously change with the overall market sentiment, and the overall market sentiment is also dynamic. Otherwise, it will be much more difficult to make a successful trade.

In fact, when the market rises, it is most likely because traders' attitudes and confidence have improved. Positive market sentiment leads to increased demand and decreased supply. In turn, increased demand may trigger stronger attitudes. Likewise, a strong downtrend tends to create a negative sentiment, reducing demand and increasing available supply.

How does sentiment change during market cycles?

Uptrend

All markets go through cycles of expansion and contraction. When the market is in an expansion phase (a bull market), there is an atmosphere of optimism, belief, and greed. Typically, these are the primary sentiments that lead to strong buying activity.

It is common to see some kind of cyclical or retroactive effect in market cycles. For example, as prices rise, sentiment becomes more positive, which in turn causes sentiment to become more positive, pushing the market further higher.

Sometimes, strong greed and belief can take over the market to the point of forming a financial bubble. In this situation, many investors become irrational, ignore actual value, and buy an asset simply because they believe the market will continue to rise.

They become greedy, get carried away by the market momentum, and only want to make profits. When prices rise excessively, a local top occurs. Generally, this would be considered the point of highest financial risk.

In some cases, the market will experience a period of sideways movement as assets are gradually sold. This is also called the allocation phase. However, some cycles do not have a clear distribution phase and begin a downtrend shortly after reaching the top.

Downtrend

When the market starts to move the other direction, euphoria can quickly turn to complacency as many traders refuse Believe that the uptrend is over. As prices continued to fall, market sentiment quickly turned negative. This often includes feelings of anxiety, denial, and panic.

In this case, we can describe anxiety as the moment when investors begin to question why prices are falling, which can quickly reach the denial stage. Periods of denial are characterized by an unacceptable feeling. Many investors insist on holding on to their losing positions, either because "it's too late to sell now" or because they still believe "the market will recover soon."

But as prices fell further, the selling wave became stronger. At this point, fear and panic often lead to what is known as a market capitulation sell-off (where holders give up and sell assets near the bottom).

Eventually, the downward trend stops as volatility declines and the market stabilizes. Typically, markets go through sideways moves before hope and optimism begin to emerge again. Such sideways fluctuations are also called the accumulation phase.

How do investors use market psychology?

Assuming that market psychology theory is valid, understanding it can help traders enter and exit positions at more advantageous times. The prevailing attitude in the market often works in the opposite direction: the moments of highest financial opportunity for buyers often come when most people are desperate and the market is very depressed. Conversely, the highest financial risks tend to occur when most market participants are elated and overconfident.

As a result, some traders and investors try to decipher market sentiment to discover the different stages of their psychological cycles. Ideally, they would use this information to buy in times of panic (low prices) and sell in times of greed (high prices). But in practice, identifying these sweet spots is not easy. What looks like a local bottom (support) may not hold, resulting in lower lows.

Technical Analysis and Market Psychology

Reviewing the market cycle, And it's easy to spot the changing trends in overall psychology. By analyzing previous data, we can clearly see which actions and decisions were the most profitable.

However, it can be difficult to understand how markets change over time, and even harder to predict what will happen next. Many investors use technical analysis (TA) to predict the likely direction of the market.

In a sense, we can say that the TA indicator is a tool used to measure the psychological state of the market. For example, the Relative Strength Index (RSI) indicator can indicate when an asset is overbought due to strong positive market sentiment (e.g., excessive greed).

Another indicator - MACD can be used to discover different psychological stages of the market cycle. Simply put, the relationship between these two lines may indicate when market dynamics are changing (e.g., buying power is becoming weaker).

Bitcoin and Market Psychology

Bitcoin in 2017 The coin bull market is a clear example of how market psychology affects prices and vice versa. From January to December, Bitcoin rose from approximately $900 to an all-time high of $20,000. Market sentiment has become increasingly positive during this rally. Thousands of new investors jumped in, getting caught up in the excitement of the bull market. FOMO, over-optimism, and greed drive prices higher and higher until they reach their highest point.

This trend began to reverse from the end of 2017 to the beginning of 2018. The ensuing pullback caused heavy losses for many late entrants. Even when a downtrend has taken hold, inappropriate confidence and complacency lead many to hold on to long-term holdings.

A few months later, market sentiment turned very negative as investor confidence hit an all-time low. Fear, hesitation and doubt, and panic caused many people who bought near the top to sell near the bottom, resulting in huge losses. Some people are disillusioned with Bitcoin, even though its technology is not fundamentally different. In fact, it is constantly being improved.

Cognitive bias

Cognitive bias is a common thinking patterns that often lead humans to make irrational decisions. These patterns can affect individual traders and the market as a whole. Some common examples include:

• Confirmation bias: the tendency to overestimate information that confirms our beliefs and ignore or disregard information that contradicts it. For example, in a bull market, investors may focus more on positive news and ignore bad news or signs that the market trend is about to reverse.
• Loss aversion: A common human tendency to fear losses more than enjoy gains, even if the gains are similar to or greater than the losses. In other words, the pain of losses usually outweighs the pleasure of gains. This can lead to traders missing out on opportunities or panic selling during market capitulation sell-offs.
• Endowment Effect: This refers to the tendency of people to overestimate the things they own simply because they have it. For example, an investor who owns a bag of cryptocurrency is more likely to believe it has value than an investor who does not own the cryptocurrency.

Summary

Most traders and investors agree that psychology has an impact on market prices and cycles. Although market psychological cycles are well known, they are not always easy to deal with. From the Dutch Tulip Mania of the 17th century to the dot-com bubble of the 1990s, even sophisticated traders have had a hard time distinguishing their attitudes from the overall market sentiment. Investors face a difficult task: understanding not only the psychology of the market, but also their own psychology and how that affects their decision-making process.