What is market psychology?
Market psychology is the idea that the movements of a market reflect (or are influenced by) the emotional state of its participants. It is one of the main topics of behavioral economics - an interdisciplinary field that investigates the various factors that precede economic decisions.
Many believe that emotions are the main driving force behind the shifts of financial markets. And that the overall fluctuating investor sentiment is what creates the so-called psychological market cycles.
So, the sentiment is made up of the individual views and feelings of all traders and investors within a financial market. Another way to look at it is as an average of the overall feeling of the market participants.
But, just as with any group, no single opinion is completely dominant. Based on market psychology theories, an asset's price tends to change constantly in response to the overall market sentiment - which is also dynamic. Otherwise, it would be much harder to make a successful trade.
In practice, when the market goes up, it is likely due to an improving attitude and confidence among the traders. A positive market sentiment causes demand to increase and supply to decrease. In turn, the increased demand may cause an even stronger attitude. Similarly, a strong downtrend tends to create a negative sentiment that reduces demand and increases the available supply.
How do emotions change during market cycles?
All markets go through cycles of expansion and contraction. When a market is in an expansion phase (a bull market), there is a climate of optimism, belief, and greed. Typically, these are the main emotions that lead to a strong buying activity.
It's quite common to see a sort of cyclical or retroactive effect during market cycles. For example, the sentiment gets more positive as the prices go up, which then causes the sentiment to get even more positive, driving the market even higher.
Sometimes, a strong sense of greed and belief overtakes the market in such a way that a financial bubble can form. In such a scenario, many investors become irrational, losing sight of the actual value and buying an asset only because they believe the market will continue to rise.
They get greedy and overhyped by the market momentum, hoping to make profits. As the price gets overextended to the upside, the local top is created. In general, this is deemed as the point of maximum financial risk.
In some cases, the market will experience a sideways movement for a while as the assets are gradually sold. This is also known as the distribution stage. However, some cycles don't present a clear distribution stage, and the downtrend starts soon after the top is reached.
When the market starts to turn the other way, the euphoric mood can quickly turn into complacency, as many traders refuse to believe that the uptrend is over. As prices continue to decline, the market sentiment quickly moves to the negative side. It often includes feelings of anxiety, denial, and panic.
In this context, we may describe anxiety as the moment when investors start to question why the price is dropping, which soon leads to the denial stage. The denial period is marked by a sense of unacceptance. Many investors insist on holding their losing positions, either because "it's too late to sell" or because they want to believe "the market will come back soon."
How do investors use market psychology?
Assuming that the theory of market psychology is valid, understanding it may help a trader to enter and exit positions at more favorable times. The general attitude of the market is counterproductive: the moment of highest financial opportunity (for a buyer) usually comes when most people are hopeless, and the market is very low. In contrast, the moment of highest financial risk often arises when the majority of the market participants are euphoric and overconfident.
Technical analysis and market psychology
It is easy to look back at market cycles and recognize how the overall psychology changed. Analyzing previous data makes it obvious what actions and decisions would have been the most profitable.
Bitcoin and market psychology
Cognitive biases are common thinking patterns that often cause humans to make irrational decisions. These patterns can affect both individual traders and the market as a whole. A few common examples are:
- Confirmation bias: the tendency to overvalue information that confirms our own beliefs, while ignoring or dismissing information that runs contrary to them. For example, investors in a bull market may put a stronger focus on positive news, while ignoring bad news or signs that the market trend is about to reverse.
- Loss aversion: the common tendency of humans to fear losses more than they enjoy gains, even if the gain is similar or greater. In other words, the pain of a loss is usually more painful than the joy of a gain. This may cause traders to miss good opportunities or to panic sell during periods of market capitulation.
- Endowment effect: This is the tendency for people to overvalue things that they own, simply because they own it. For example, an investor that owns a bag of cryptocurrency is more likely to believe it has value than a no-coiner.