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 participating users. It is a major topic in behavioral economics - an interdisciplinary field that investigates the various factors that precede economic decisions.
Many believe that emotions are the main driving force behind changes in financial markets. And that the general variation in investor sentiment is what creates so-called psychological market cycles.
In short, market sentiment generally reflects how investors and traders feel about the price action of an asset. When market sentiment is positive and prices are rising steadily, there is an upward trend (often called a bull market). The opposite is called a bear market, when there is a steady decline in prices.
Therefore, this concept of market sentiment is composed of individual opinions and feelings of all traders and investors who are part of the financial market. It can also be seen as an average representation of the general sentiment of market participants.
However, as with any group, no opinion is unanimous. Based on market psychology theories, the price of an asset tends to change constantly in response to the general market sentiment - which is also dynamic. Otherwise, it would be much more difficult to make a successful trade.
In practice, when the market is trending upwards, it is likely due to increased confidence among traders. Positive market sentiment causes demand to increase and supply to decrease. Increased demand can lead to even stronger trading behavior. Similarly, a strong downtrend often creates negative sentiment that reduces demand and increases available supply.
How do emotions change during market cycles?
Uptrend
All markets go through boom and bust cycles. When a market is in a boom (bull market) there is a climate of optimism, belief and greed. These are usually the main emotions that lead to strong buying activity.
It is quite common to see a sort of cyclical or retroactive effect during market cycles. For example, market sentiment becomes more positive as prices rise. As prices continue to rise, sentiment becomes even more positive and drives the market even higher.
Sometimes, a strong sense of greed and belief dominates the market to such an extent that a financial bubble can form. In this scenario, many investors become irrational, losing sight of the real value and buying an asset just because they believe the market will continue to rise.
They get greedy and excited by the market momentum, hoping to make a profit. When the price goes up too much, there is a peak point. This point is generally considered the point of maximum financial risk.
In some cases, the market will move sideways for a while as assets are gradually sold off. This is also known as the distribution stage. However, some cycles do not have a clear distribution stage and the downtrend begins shortly after the top has been reached.
Downtrend
When the market begins to change direction, euphoria can quickly turn to complacency as many traders refuse to believe that the uptrend is over. As prices continue to fall, market sentiment quickly shifts to the downside. At this point, traders often experience feelings of anxiety, denial, and panic.
In this context, we can describe anxiety as the moment when investors begin to question why the price is falling, which soon leads to the denial stage. The denial period is marked by a feeling of non-acceptance. Many investors insist on holding on to their losing positions, either because “it is too late to sell” or because they want to believe “that the market will come back soon.”
However, as prices fall further, the wave of selling becomes stronger. At this point, fear and panic often lead to what is called market capitulation (when traders give up and sell their assets near the lowest value).
Eventually, the downtrend is interrupted as volatility subsides and the market stabilizes. Typically, the market experiences sideways movement before feelings of hope and optimism return. This period of sideways movement is also known as the accumulation stage.
How do investors use market psychology?
Assuming that the theory of market psychology is valid, understanding it can help a trader enter and exit positions at more favorable times. The general market attitude is counterproductive: the moment of greatest financial opportunity (for a buyer) usually comes when most people are hopeless and the market is very low. Conversely, the moment of greatest financial risk usually comes when most people are euphoric and overconfident.
In this way, some traders and investors try to read the sentiment of a market to identify the different stages of its psychological cycles. In an ideal scenario, they would use this information to buy when there is panic (lower prices) and sell when there is greed (higher prices). In practice, however, identifying these points is not an easy task. What may seem like a low point (support) may not hold, leading to even lower values.
Technical analysis and market psychology
It's easy to look at market cycles and recognize how general psychology has changed. Analysis of past data shows very clearly which actions and decisions would have been the most profitable.
However, it is much harder to understand how the market is changing as it progresses - and even harder to predict what will happen next. Many investors use technical analysis (TA) to try to anticipate likely future market movements.
In a way, we can say that TA indicators are tools that can be used to try to measure the psychological state of the market. For example, the Relative Strength Index (RSI) indicator can suggest when an asset is overbought due to strong positive market sentiment (e.g. excessive greed).
The MACD is another example of an indicator that can be used to identify the different psychological stages of a market cycle. In short, the relationship between its lines can indicate when market momentum is changing (e.g., the buying trend is weakening).
Bitcoin and Market Psychology
The 2017 Bitcoin bull market is a prime example of how market psychology affects prices and vice versa. From January to December, Bitcoin rose from around $900 to an all-time high of $20,000. During the bull run, market sentiment became increasingly positive. Thousands of new investors were drawn in, caught up in the excitement of the bull market. FOMO, over-optimism, and greed quickly drove prices higher – until the bear market began to fall.
The trend reversal began to occur in late 2017 and early 2018. The correction left many late entrants with significant losses. Even when the downtrend was already established, false confidence and complacency caused many people to insist on HODLing.
A few months later, market sentiment turned very negative as investor confidence hit an all-time low. FUD and panic caused many of the users who bought near the top to sell near the bottom, resulting in significant losses. Some people became disillusioned with Bitcoin, even though the technology was essentially the same. In fact, its technology is constantly being improved.
Cognitive biases
Cognitive biases are common thought patterns that often lead humans to make irrational decisions. These patterns can affect both individual traders and the market as a whole. Some common examples include:
Confirmation bias: the tendency to overvalue information that confirms our own beliefs while ignoring or discounting information that contradicts them. For example, investors in a bull market may focus more on positive news while ignoring bad news or signs that the market trend is about to change.
Loss aversion: A common human tendency to fear losses more than to celebrate gains, even if the gain is similar or greater. In other words, the pain of a loss is often more intense than the joy of a gain. This can cause traders to miss good opportunities or sell out of panic during periods of market capitulation.
Endowment effect: The tendency for people to overvalue the things they own, simply because they own them. For example, an investor who owns a cryptocurrency exchange is more likely to believe in its value than someone who doesn’t own cryptocurrency.
Final considerations
Most traders and investors agree that psychology affects market prices and cycles. While psychological market cycles are well known, they are not always easy to navigate. From the Dutch Tulip Mania of the 1600s to the dotcom bubble of the 1990s, even skilled traders have struggled to separate their attitudes from the overall market sentiment. Investors face the difficult task of understanding not only market psychology, but also their own psychology and how it affects their decision-making process.