Using Indicators to Read the Markets Psychological State


Introduction

We cannot easily reduce human behavior to a mathematical equation that can be plotted on a graph. That said, much current research in the social sciences is attempting to bring psychology more in line with mathematics for the precision that it gives to experimental methods.

Hindsight is 20/20. When looking into the past, we can easily tell what the market did and why it happened. But if you are looking to discover the trends of the market today, where do you look?  Many technical indicators gauge market strength and Module 3 recognises some of these.  Volume and oscillators both calculate the market consensus and when used properly their value cannot be overstated.

The principles of market psychology underlie each and every technical indicator, so a good understanding of crowd behavior is crucial to your understanding of the fundamentals of particular technical indicators. Module 3 has gone through technical indicators, so we'll only touch on how market psychology derives from a few of these individual tools.

Reading Market Psychology with Volume & Price

Reading the psychology of markets is a core trading skill. Markets, like people, behave in patterns. Those patterns shift over time, with changes in direction and changes in volatility.

You must be able to read volume. Volume tells us *who* is in the marketplace. Volume also correlates highly with volatility. When volume jumps, it tells us that institutional participants have become more active. When volume dries up, it tells us that the market is dominated by market makers: the liquidity providers. Does price move to a new significant level? Volume will typically provide us with an answer. Increasing volume confirms traders & investors have increasingly demand at these prices - "volume confirms price".

So, just as important as high volume is relative volume: the degree to which current volume diverges from recent volume. If we want to know if today's volume is high or low, we should compare it to the most recent median volume. Because relative volume is so closely connected to volatility, reading volume and its shifts provides important clues as to how far markets can go for or against us. That is useful information in setting stop loss points and profit targets.

Equally important, the astute trader wants to see the total volume that transacts at each price over the course of a trading day or week. The price range at which the lion's share of volume has transacted defines a market's value area. Higher or lower prices cannot attract volume - a range, or the market will accept higher or lower prices confirmed by volume - a trending market. In a range, traders make money by fading strength and weakness; in a trend, they make money by going with market direction.

The astute trader can also read the psychology of markets by seeing whether volume is dominantly transacted at the market's bid price (suggesting that sellers are willing to take lower prices to get out of their trades) or at the market's offer (suggesting that buyers are willing to pay up for higher prices to get into trades). This measure of sentiment, can be tracked over time to see if buyers or sellers are becoming more or less aggressive. 

We can also track market sentiment to see if more transactions across the broad stock market are occurring on upticks vs. downticks. When buyers are more aggressive, we will see more transactions occurring on upticks; when sellers are more aggressive, we will see more transactions occurring on downticks. This measure of sentiment can be tracked over time to reveal whether sentiment in the market is waxing or waning.

When we read these shifts in sentiment over time and combine them with a reading of shifts in relative volume, we can determine whether the largest market participants are becoming more or less bullish. That will tell us if volatility (volume) is expanding with direction (sentiment) and whether moves to new price levels are likely to result in market trends. 

Much of the skill of reading these shifts is placing market dynamics at a shorter time frame within the context of the longer time frame. What is a trending market at the short time frame may be a movement within a range at the longer time frame. A breakout at the short time frame may be trend continuation at the longer time frame. Context rules. A great deal of developing a feel for markets is a recognition of the patterns that occur as market participation (volume) and market sentiment (direction) shift, with longer time frames exercising impact over shorter ones.

<<<<<<< HEAD By Brett Steenbarger Author of The Psychology of Trading (Wiley, 2003), Enhancing Trader Performance (Wiley, 2006), and The Daily Trading Coach (Wiley, 2009)
Oscillators

Oscillators like MACD, RSI, Williams %R and Stochastics, measure the markets psychological state.  Using mathematics they produce overbought and oversold signals, measuring and indicating the interaction between bulls and bears over a specific period of time and how consensus has shifted in that time frame.

Volume

The volume of shares traded is an excellent way in which to ascertain the psychology of the market. Volume is actually a measure of the traders emotional state.  A burst of volume will cause sudden pain in losers and immediate elation in winners, low volume will likely not result in a significant emotional response.

The longest lasting trends generally occur where emotion is the lowest. When volume is moderate and both shorts and longs do not experience the roller coaster ride of emotion, the trend can reasonably be expected to continue until the emotion of the market changes. In a longer-term trend such as this, small price changes either up or down do not precipitate much emotion, and even a series of small changes occurring day-after-day (enough to create a major, gradual trend) will generally not generate severe emotional reactions. This is a classic example of how traders are lulled into a feeling of complacency - small losses (even a series of small daily or weekly losses) do not feel particularly devastating; but the series of small losses will, in a few weeks or months, aggregate into one very large loss.

As we have discovered in Module 3, volume can be interpreted to predict trend reversal.  While moderate and steady volume point to a sustained gradual trend due to the lack of emotion in the market, falling volume may indicate that losers have finally thrown in the towel and that the trend is near its top or bottom. Exceptionally high volume may demonstrate that a great many losers have given up and are selling at any cost. This is true collective psychology at work: amateur traders and investors who are holding losing positions typically reach their breaking point at roughly the same time. A huge burst of volume in a declining market may indicate that even the most patient stalwarts have raised the white flag, which is a classic signal that the bottom is nigh.

In the case of short selling, a market rally may serve to flush out those individuals holding short positions, causing them to cover and subsequently push the market higher. The same principle holds true on the flip side: when the longs give up and bail out, the decline pulls more losers with it (even the most resilient loser reaches his breaking point). At the most fundamental level of market volume, both short and long losers who collectively exit their positions are the primary drivers behind significant volume trends.


To Sum up

These are only a handful of examples of how market psychology is measured by technical indicators.  The main lesson is how to use these indicators as part of your trading strategy and for this you must understand each indicator and how it relates to trader psychology.  As ever, Technical Analysis is not an exact science and as we've seen above when dealing with "the crowd", how can it be?

======= By Brett Steenbarger Author of The Psychology of Trading (Wiley, 2003), Enhancing Trader Performance (Wiley, 2006), and The Daily Trading Coach (Wiley, 2009)