Mass Psychology of Trading

Psychology in trading encompasses that of the trader him/herself & the crowd

Disclaimer: content is summarised from Part 2 (Chapter 11 - 16) of 'The New Trading for a Living: Psychology, Discipline, Trading Tools and Systems, Risk Control, Trade Management' by Alexander Elder

The 4 Types of Animals on Wall Street

A bull is a buyer: it fights by striking up with its horns. A bear is a seller: it fights by striking down with its paws. Hogs are greedy traders that overpay/overstay their trading positions. Sheep are passive & fearful. When the market is open, bulls are buying, bears are selling, while hogs & sheep get trampled underfoot.

Buyers either wait til prices come down / pay what sellers demand. Sellers either wait til prices rise / accept a lower offer from buyers. Trades occur when there is a momentary meeting of these 2 minds. The presence of undecided traders pressures bulls & bears to move fast before deal is snatched.

Consensus of Value & Behavioural Patterns

Each price is a momentary consensus of value of all market participants, expressed in action. Patterns of prices & volume reflects mass psychology of the market.

Prices move in small increments during quiet times. When a crowd becomes spooked / elated, prices begin to jump. An astute trader aims to enter the market during quiet times & take profits during wild times. Each trading session is a battle between bulls, who make money when prices rise, and bears, who profit when they fall. Technical analysts discover the balance of power between bulls & bears to bet on the winning group. Technical analysis combines science & art: Scientific via usage of statistical methods and computers; artistic via personal judgment & experience to interpret findings.

The Market & the Crowd

Traders try to take money from each other by outguessing them on the probable direction of the market. It is a uniquely harsh environment as everyone is against you & you are against everyone. Think independently. Though crowds are powerful enough to create trends, you do not have to run with the crowd—but you shouldn't run against it. Respect the strength of the crowd—but do not fear it. Though powerful, crowds are primitive, their behaviour is simple & repetitive.

Source of Money & Insider Info

Money is in the markets as other traders have put it there. The money you want to make belongs to others who have no intention of giving it to you. Corporate insiders consistently make profits in the stock market & are thus stealing our money. Technical analysis can help in detecting insider buying & selling, whilst allowing you to follow them to the bank.

The Trading Scene

Since trading takes time, money & hard work to learn, few rise to level of professionals.

Institutional Traders (pros) pay low commissions. They enjoy informational advantage with the best researchers, traders & intelligence networks at their disposal. They have a psychological advantage as employees of firms are more relaxed knowing that their own money is not at risk. However, 1 advantage individual traders have over them, is the autonomy to choose when to trade. Institutional traders are pressured to trade regardless of conditions. Capitalise on this by trading only when the best opportunities are available.

"Sword Makers" provide trading tools. Trading software includes:

1. Toolbox: displays data, draws charts, plots indicators, changes parameters, and tests your trading systems

2. Blackbox: when fed data, it tells you what & when to buy & sell. Not an advisable tool to use due to an ever-changing market

3. Gray boxes: straddle the fence between toolboxes and black boxes

The Market Crowd & You

Traders bet on the future opinion & mood of the crowd. The value of your position rises & falls via buying & selling actions of strangers.

People become impulsive, react to emotions rather than their intellect & anxiously search for a leader / group to join for safety. Successful traders are independent thinkers as they catch trends like members of the crowd, but leave before reversals kill them. Note however, that if the trade goes against you—cut your losses & run. Never argue with the crowd. Price is the leader of the market crowd. Though most of us think we are independent of the crowd, few of us realise how much we focus on the behaviour of price.

Most members of a group constantly influence each other, causing shared feelings & actions. In a useful group members make independent decisions without knowing what others do, whilst benefiting from the combination of knowledge & expertise of each other.

Decisions on stock selection & direction is made in solitude, results are released & voted on, then the group taps on the collective wisdom of all members.

Psychology of Trends

Each price bar / candle reflects a battle between bulls & bears. Technical analysis is for-profit social psychology. For stocks, number of shares bought & sold is equal. For futures, number of long & short positions are always equal.

Prices change with intensity of greed & fear among buyers & sellers. In an uptrend, bulls feel optimistic & don't mind paying up since they expect prices to rise even higher while bears feel afraid & agree to sell only at a higher price. When greedy & optimistic bulls meet fearful & defensive bears, the market rallies (stronger feelings = sharper rally). Rally ends when bulls start losing their enthusiasm.

Technical analysts must find when buyers are strong & when they run out of steam. Markets rise with greed among bulls & fear among bears, markets fall with fear among bulls & greed among bears. Note that fear is a much stronger emotion than greed.

As an uptrend develops, eventually a price shock occurs—a major sale occurs with shortage of buyers to absorb it. As such, a reversal occurs. Even if the market recovers and reaches a new high, bulls still remember what happened & feel more skittish while bears become bolder. Bearish divergence is a pattern wherein prices reach a new high but indicator reaches a lower high than the previous rally. This marks the end of the uptrend & provides one of the best shorting opportunities.

As downtrend develops, price shock occurs. A cluster of buy orders soaks up all available sell orders, lifting the market. Bullish Divergence occurs when prices fall to a new low but an indicator traces a shallower bottom than during the previous decline. This identifies some of the best buying opportunities

Managing vs Forecasting

Fundamental analysis is the study of actions of the Federal Reserve, following earnings reports, examining crop reports, etc. Technical analysts believe that prices reflect everything known about the market, including fundamental factors. Be neither a bull nor a bear, but only seek the truth. One trick to detect your bias: If you want to buy, turn your chart upside down and see whether it looks like a sell. Be a Doctor: manage problems as they emerge rather than forecasting.

After a man falls down a few steps, he may dust himself off & run up again. But if he falls out of a second-story window, he's not going to run anytime soon; he needs time to recover. Similarly, when indicators give you a buy signal in 2 markets, buy the one that has fallen the least.

Successful trading stands on 3 pillars. You need to analyse the balance of power between bulls & bears. You need to practice good money management. You need personal discipline to follow your trading plan & avoid getting high / depressed in the markets.