Trading financial markets will often invoke a wide range of emotions. It is crucial for traders to never act on these emotions to avoid harming one’s portfolio. The psychological aspect of market cycles and trends cannot be underestimated.
Table of contents
- The Psychological Nature Of Trading
- The Impact Of Emotions
- Different Market Cycle Stages
- Using Psychology To Your Advantage
- The Power Of Technical Analysis
- Don’t Get Biased
The Psychological Nature Of Trading
To the average neophyte, trading in financial markets may seem like a simple numbers game. Time trades correctly, pocket a profit, and look for the next opportunity. If that were all there is to becoming a successful trader, everyone would be doing it today. The reality is very different, as one cannot underestimate the psychological aspect of engaging with financial markets.
Additionally, there is also a thing called “market psychology”. On the surface, it is often challenging – if not impossible – to determine why a market is moving in a specific direction at that time. Finding an explanation isn’t always required either, as it can often be a matter of figuring out the current market psychology.
Whether one wants to believe it or not, the movement of a market is influenced by market participants’ psychological state. The human psyche often works in mysterious ways. If enough market participants share the same emotion at the right time, they can make a market move in a specific direction. Breaking that combined momentum will often be a futile effort.
This combined psychological state will often catalyze a bullish or bearish market trend. The overall market sentiment is merely a collection of how investors feel about the market at the time. Positive sentiment is often more challenging to achieve than a negative one. Once a particular belief takes hold, other traders are likely to keep compounding the current trend for a while.
As is the case with any human emotion, things can turn around on a dime. Maintaining a dominant position in a market is impossible for extended periods. Market sentiment will always be dynamic, and the balance of power shifts around regularly.
The Impact Of Emotions
The human brain will respond differently to market sentiment depending on which trend is unfolding. Keeping these emotions in check will always be challenging, yet traders can’t always act on them.
The Bull Market
During a bull market, the primary emotion is euphoria, optimism, and sometimes even relief. When an uptrend starts, most traders remain a bit hesitant to enter new positions and often monitor the sidelines’ situation. Once an uptrend is confirmed, the emotions will shift from “unsure” to ‘excited” very quickly. This snowball effect can turn a small uptrend into a genuine bull market for days, if not weeks.
Such growing optimism becomes outspoken when the uptrend continues to gain traction. Prices that go up will make traders more willing to take risks, creating a dangerous situation.
Greed is a very negative emotion when trading financial markets. It is crucial for traders to never give in to greed, as it is one of the main reasons why neophyte traders will often lose money during an uptrend.
In the worst-case scenario, compounding levels of greed will trigger a market bubble. When a bubble phase occurs, the market in question will become incredibly volatile. Some traders will become irrational, putting their entire wealth on the line as greed clouds their judgment.
Overextension of the price is the logical outcome, and the market will shift to a bear market very quickly. Being aware of this turning point is crucial if one wants to maintain a healthy trading portfolio.
The Bear Market
One may be inclined to think the psychological state of traders is very different during a bear market. That is true for the first wave of emotions – complacency, anxiety, and panic. However, bear markets often incur emotions like greed as well.
When investors see a market drop in value very quickly, they will often wonder what is going on exactly. Initially, they may see it as a “pullback to resume the uptrend”, but that only happens every so often. Being unable to accept the bear market is far from an ideal psychological state.
If the bear market keeps pushing prices lower, investor sentiment can shift to extreme greed. They will try to keep moving prices even lower by opening short positions for that market.
When this stage occurs – also known as capitulation – the market is often near the bull market’s bottom level. When the bottom is reached, and the market moves up again, those with open short positions will lose even more money as they lose track of the bigger picture.
Different Market Cycle Stages
As is the case with anything related to psychology, financial cycles can go through different sets of emotions quickly. Four stages can occur across both bullish and bearish market cycles.
Optimism, Thrill, Euphoria
Regardless of whether the market is bullish or bearish, there will always be a positive attitude at first. Traders expect their investments to pay off quickly, which will often happen. Going with the market trend is always the easier option, and tends to lead to bigger success. As more investors’ expectations are met, excitement becomes a thrill as traders seek out higher returns.
Ultimately, this stage of the market cycle will peak, which is when euphoria occurs. This is a crucial stage, as most investors may think things will keep going their way. Unfortunately, no market can keep rising in value, and beating the market is a lot more challenging than one may think.
Arrogance, Denial, Fear
As soon as the market stops meeting investors’ expectations, there will be arrogance among traders.The feeling of “this is wrong and I will prove it” can take hold very quickly. Remaining complacent about the market resuming its uptrend will eventually result in denial, even though the writing is clearly on the wall.
However, as the market keeps rebuking investor sentiment, traders will often grow anxious and eventually fearful. During such a time, it is crucial to remain rational and not give in to panic-infused decisions. That is often much easier said than done.
Panic, Panic, PANIC!!!!!!
The leap from fear to panic is often a rather small one. There is a lot to be fearful about when exploring financial markets. When things go south, panicking will not help anyone. Desperate investors often lose tremendou amounts of money, whereas rational traders can tough it out. Markets will recover EVENTUALLY, but it may take a while.
Caution Remains Advised
Once the market starts bottoming out, the panic phase will eventually transition into caution. New investors may not contribute big chunks of money to the asset you are trading. As an existing trader, it may be best to rebalance a portfolio to hedge against more instability.
Sooner or later, the market price will start moving up again. No big moves occur, and the trading volume remains relatively low. It is a tough phase, but one that will often bring us back to Optimism and Thrill.
Using Psychology To Your Advantage
In the end, the psychological state of a market and its traders is another tool to leverage. Understanding the human psyche’s inner workings during these market cycles can help traders make a lot of good money. During a bull market or bear market, it is crucial to enter positions at a good time.
Similar to how the human mind can go through five psychological stages of grief, so do market cycles. Associating the correct state of mind with the current market trend’s state can make traders pick the best opportunities to enter or exit a market.
All of this may sound easy on paper, but things are very different in the real world. There are no guarantees when trading financial markets, and the above concept will not always apply either.
The Power Of Technical Analysis
For those willing to project the five psychological states on a market’s chart, it is crucial to perform technical analysis simultaneously. Looking back at market cycles and recognizing their “shape” is only possible when looking closer at what triggered this momentum. With that knowledge, traders can determine when to take action or to ignore the impulse to participate.
An extra benefit of technical analysis is how it can help determine when the next psychological state will occur. This can lead to further uptrends, downtrends, sideways trading, or swing trading points.
One crucial tool for any technical analysis is the Relative Strength Index or RSI. It depicts when markets are either overbought or oversold, although it does not automatically signal a potential market reversal.
Another tool to pay attention to is the MACD. It is a great way to analyze whether buying or selling pressure is weakening all of a sudden. Such shifts in pressure can trigger a temporary or complete trend reversal.
Don’t Get Biased
Whenever psychology enters the picture, it is a matter of time until bias starts taking hold. Falling into common thinking patterns is a crucial pitfall to avoid as a trader. Incorrectly handling bias can impact individual traders but also hamper the market as a whole.
- Overvaluing your portfolio: Just because you own a specific asset doesn’t mean it’s worth more than what the market dictates.
- Fear Losses: Many traders are risk-averse, making them fear losses more than achieving potential gains. These traders often endure physical pain when a loss occurs and hardly feel anything when their portfolio gains value. For traders who value good market opportunities, the “fear of loss” is a bias to avoid.
- Confirmation Bias: overstating the importance of something confirming your personal beliefs. This bias often leads to traders dismissing contrary information, such as negative news, valid concerns, or worrisome developments.
The psychological state of an individual trader or an entire financial market isn’t that different from the next one, yet they may analyze markets differently and make dissimilar decisions. Psychology will always have an impact on the market price and associated trading behavior.
The human brain works in mysterious ways, and there is little one can do to avoid it. Trying to keep emotions in check is all one can do, but that won’t always be sufficient.
Many external factors influence your decision-making process. Knowing what to expect and turning it into an advantage can make the difference between being a mediocre trader and excelling in what you do.