Market Psychology and Technical Analysis

The goal for any investor or trader is to buy when price is low and sell when price is high, but as anyone who has ever traded will know, consistently executing trades in this manner is a difficult task. The majority of traditional investors concentrate on fundamental analysis to make their trading decisions (analyzing financial reports, economic data etc...), and while this manner of analysis can do well during extended bull markets, during bear markets or times of high volatility (i.e. 2008-2009) this type of analysis often leads to poor results. The reason why fundamental trading methods often fail during markets like those experienced in 2008 and 2009 is because these are times where high levels of emotion are involved in the markets, and fear and greed often drive the price of financial instruments (stocks, futures, exchange-traded funds etc...) far beyond the levels which fundamental analysis would suggest. To be successful during these types of markets, or really any type for that matter, one needs to understand the psychology of market participants, or more specifically the times when market psychology is shifting. Market (or trader) psychology is extremely important to pay attention to as it encompasses all the beliefs, predictions, information, and emotions which traders have in regard to the markets and specific financial instruments, and is ultimately what drives the movement of price. When one comes to understand that it is the collective psychology of all market participants that determines the price of a financial instrument it becomes quite obvious how beneficial it is for traders to be able to detect changes in market psychology, or more specifically times when the psychology is changing from bullish to bearish, or vice versa.

The best way for a trader to study market psychology is through technical analysis. Technical analysis is the study of changes in the price and volume of a financial instrument over time, in an attempt to discern information about where price will move next. Technical analysts use price charts for this study, these charts are composed of individual bars which represent the change in price over a specified time period, which could be a month, a week, a day, 15 minutes, 1 minute, etc... Each of these individual bars show the opening price of the period, the closing price, as well as the high and low prices for the period. While technical analysis has been used successfully by investors to make investment decisions for hundreds of years, the majority of investors still rely more on methods such as fundamental or quantitative analysis, with some even going as far as to consider technical analysis a pseudoscience. However, the reason that technical analysis has remained on the fringe is likely due to the large degree of misunderstanding surrounding it. Many people look at technical analysis and think how can one gain any valuable information, or even dare make a trading decision just by looking at a chart of past price movements. These opponents are also often of the mind frame that one must gain tangible information about a company, such as future growth opportunities, economic conditions that will effect the company, earnings prediction etc... for one to be able to make a wise investment decision and thus how can one gain any of this information just by studying the movement of price over time. However, these views only represent the ignorance that many have towards technical analysis, as a price chart can provide an investor with the most relevant, timely, and important information that is needed for one to execute profitable trades, and that information is the dynamic psychology of market participants.

The price of a financial instrument, like any other freely traded good, is determined by the interaction of supply and demand. The supply of an equity will increase when the number of people who wish to sell their contracts increases, while demand rises when the number of people who want to buy the contract increases. When demand increases faster than supply, price will rise, while when supply outpaces demand, prices will fall. Supply and demand of an equity are directly determined by the psychology of market participants. Investors will normally make the decision to purchase an equity (increasing demand), when they have a feeling (produced by a piece of information, emotion, recommendation from a colleague, etc...) that leads them to believe that price will rise in the future. Conversely, one decides to sell an equity (increasing supply), because they have a feeling that leads them to believe that price will soon fall. So all these feelings whether they are correct, well thought-out, or even logical, determine the supply and demand, and reflect the collective psychology that all market participants have towards financial instruments.

While an investor using fundamental analysis may concentrate on something such as an earnings report to make an investment decision, this is only one element that will effect the market psychology in regards to a specific equity. While earnings may be a dominant element at certain times, at others, such as times when emotions such as fear and greed are rampant the effect of earnings may be quite limited on overall market psychology. This is the reason that it is so difficult for traditional investment methods to maintain consistent levels of profit when market conditions experience a dramatic shift. While certain pieces of information which fundamental analysts concentrate on may drive price changes for certain periods of time, such as the extended bull market experienced up until late-2007, when conditions change and shift to a bear market with high levels of volatility, these same pieces of information may become a lot less significant and instead the primary driver of price may become investors' emotions. Thus, for one to maintain consistent returns over extended periods of time, and throughout different market conditions, it is essential for a trader not to limit their analysis to specific elements which they believe will drive price, but instead to study all the elements which are driving the price of a financial instrument, or in other words overall market psychology. The only practical way an investor can study changes in market psychology is by analyzing price charts, or in other words using technical analysis, as changes in price over time reflect the collective beliefs, views, and emotions that all market participants have towards a certain financial instrument.

When a trader decides to use technical analysis it is essential that they realize that it will not provide them with the power to predict the future, and thus cannot enable one to consistently pick market tops and bottoms (more on this here). Furthermore, while over the years a huge number of indicators have been developed by technical analysts, unfortunately none of these indicators are able to consistently predict turning points in the market. The vast majority of these indicators are derived from price and volume data, and while some of these indicators if understood and observed correctly, can be helpful to a trader, often relying too heavily on indicators can just create confusion and the production of false entry and exit signals. Therefore, instead of relying on indicators to signal entry and exit levels, a trader should study the movement of price in an attempt to determine when trader psychology has turned bullish (to enter a long position or cover a short position), turned bearish (to enter a short position or close a long position), or when trader psychology is neutral or full of conflicting views and during these times it is often optimal to stay on the sidelines. While obtaining the skill of detecting changes in market psychology requires a lot of hard work and dedicated study of price charts, there are three simple and common aspects of price movement which traders new to technical analysis should particularly pay attention to as they relate directly to trader psychology, and they are; the relationship of highs and lows (the underlying price trend), levels of support and resistance, and chart patterns.

The first element, the relationship of highs and lows on a price chart, or in other words the prevailing price trend is quite easy to observe and can reveal a lot about current market psychology. There are basically three different types of trends which one should become familiar with, an uptrend, a downtrend, and a consolidation (sideways trend). On a price chart an uptrend can be identified by a series of higher highs and higher lows, and a downtrend by a series of lower lows and lower highs. A consolidation on the other hand, is identified by neither a series of higher highs nor lower lows, but instead price sees extended sideways movement, usually bounded in a range by an upper level of resistance and a lower level of support. While identifying a trend may seem quite simple, the importance of trading in the direction of a trend should not be overlooked, as like an object in motion, a trend is more likely to continue then reverse. Furthermore, a trend is directly related to and caused by the psychology of market participants, and therefore, by identifying the trend one can determine the prevailing market psychology and trade in unison with it.

The effect of market psychology on trends can be seen through the following example examining how and why an uptrend forms (downtrend occurs with basically the opposite psychology). An uptrend first begins with the demand for a stock (could be any other financial instrument) increasing as more traders' feelings turn bullish (which could be caused by any number of reasons) and this increase in demand drives price up. Eventually price moves up to a level where certain traders want to get out with the profit they have earned, as they are fearful that this might be the highest price will go and this leads to an increase in supply. The increase in supply causes price to fall, supply is further increased as some investors become scared when price starts moving down and thus try to sell their contracts as well. However, in an uptrend the increase in supply does not bring price down as far the previous low, as when it comes close to the previous low investors overall become bullish again and increase the demand. This second rise in demand usually brings more on board to a bullish mentality, or in other words crowd behaviour plays its role and this drives price up to a higher level then the previous peak (high). This pattern continues as each subsequent higher high leads to more buying (increasing demand) until ultimately price reaches a level where so many traders become fearful, believing that price cannot continue upward that supply increases so much that price is pushed down below the most recent low, ending the uptrend. It is important to realize that while the start of an uptrend or a downtrend can be initiated by a single piece of news, it can only continue if there is a significant change in trader psychology which allows successive highs to be made in an uptrend or successive lows in a downtrend.

While uptrends and downtrends are driven by similar market psychology patterns, with the difference being that in the uptrend the psychology is bullish and in the downtrend it is bearish, a consolidation reflects a different type of psychology, that of primarily indecision and uncertainty. This indecision and uncertainty prevents price from trending up or down, instead when price reaches a certain upper level in a consolidation sellers rush in increasing supply as they are afraid that this is the highest price will go. Conversely, when price reaches a lower level in a consolidation buyers rush in increasing demand believing that price will not go much lower. Periods of consolidation are often seen during market bottoms, which are times where emotion plays a very significant role in traders actions and therefore, the movement of price. During a bottom traders are usually divided between those who believe that price cannot go any lower and therefore see it as a great time to go long, and those who think that the worst is yet to come and therefore will sell on any upward move in the market. While consolidations are often difficult to trade, they can quite easily be observed on price charts and allow for investors to take appropriate action, either by not trading during these times or applying methods which work well during sideways movement.

Along with determining the underlying trend, identifying support and resistance levels also reveals a lot about trader psychology and as such can be beneficial for making trading decisions. Levels of support and resistance are price levels which the market has historically had a difficult time moving above for what is considered a resistance level, or below for a support level. These levels are caused by the psychology of market participants and are particularly useful to traders as levels to monitor when entering or exiting positions. For example, if price is just below a significant level of resistance it may not be wise to enter a long position until price has broke through that level, on the other hand if price is just above a support level it is usually beneficial to wait for that level to be broken before going short.

Levels of support and resistance emerge as a result of traders' emotions and examining why these levels form allows one to understand just how beneficial it is to understand the psychology of market participants. As was mentioned earlier a level of support is a price level which a financial instrument has struggled to trade below in the past. A support level is revealed on a price chart as a level which price has moved down to at multiple times but never been able to fall any further to lower levels. Each time that price has reached this support level sellers have been unable to increase supply enough to move it down any further and instead price has reacted upwards as more traders act on bullish feelings making demand more prominent. The important thing to realize regarding the formation of support levels is that the first time that price reacts down to the level, not everyone anticipates the shift to a bullish psychology and many traders are therefore caught off guard, either missing an opportunity to go long or missing the chance to cover an open short position. It is the action of these people which leads to the creation of the level of support as when price reacts back to the support level in the future, these traders who believe that they missed out on an opportunity the first time increase demand and this rise in demand leads price upwards again. If the price level is truly an area of support this market psychology will repeat itself when price comes down to this level a third, fourth, and fifth time etc... Without going into a lengthy description, a level of resistance is formed in the opposite manner of a support level, with price first moving upward to a specific price level and then seeing sentiment turn from bullish to bearish and price subsequently reacting downward. When a trader sees a price which they think may be a meaningful support or resistance level it is beneficial for them to alter their trading strategy accordingly.

The third element important for the detection of shifts in market psychology, are chart patterns. Relationships among groups of price bars form patterns which can provide a lot of information about the psychology of market participants allowing a trader to obtain information about whether a trend is likely to continue (continuation patterns) or reverse (reversal patterns). These price patterns result from the dynamic interaction between the supply and demand of a financial instrument and can reveal to a trader whether demand is becoming more dominant and therefore an upward move is likely, or supply is becoming more dominant likely leading to a downward move. There are many chart patterns that are used by technical analysts (information about them can be found here or here) and by examining the formation of a specific pattern one can see the relationship of chart patterns to market psychology and as such their usefulness. For any trader who decides to use chart patterns in their trading strategy it is crucial that they do not just memorize the appearance of the pattern, but also understand the psychology of market participants which is behind the formation of the pattern.

The pattern that will be examined as an example is the head and shoulders pattern, which is a commonly used topping pattern. The head and shoulder pattern is formed by three consecutive peaks, with the second (middle) peak reaching the highest price level, while the other two peaks reach about the same price level (slightly lower than the middle peak), making the pattern resemble a head (the middle peak) and two shoulders (the left and right peaks). The psychology, or dynamics of supply and demand which lead to the creation of this pattern can be explained in the following manner: The pattern begins with price in an uptrend, experiencing higher highs and higher lows and as such the left shoulder is formed as just one of the peaks in an uptrend. The head of the pattern is formed right after the first shoulder and again appears on the chart as a continuation of the uptrend, or in other words the most recent higher high. However, it is important to note that in many cases the participation during the formation of the head is much lower than during the formation of the first (left) shoulder. This can be observed by the decrease in volume as price moves to the new highs. This decrease in volume is important as it signifies that while prices are sill rising the participation or level of demand at these higher prices has declined and as such fewer contracts are exchanging hands. The move down from the high of the head usually leads prices to around the same price level as the previous low (located between the left shoulder and head) and this level is known as the neckline. From here enough people become bullish again causing demand to increase and price to move up again. However, during the formation of the right shoulder there is not enough demand to push prices to the highs of the head. As more and more market participants realize that price is not going to reach the previous high, the level of supply begins to accelerate as fear sets in causing price to fall below the neckline which is the signal that confirms the head and shoulders pattern. The break of price below the neckline often signals the end of an uptrend as it shows that there was more supply at the neckline prices then demand. Furthermore, this decline in price below the neckline points to a shift towards a more bearish overall market psychology as buyers were unable to maintain the sequence of higher highs and higher lows.

While the head and shoulders pattern is quite popular among technical analysts it is important to remember that this pattern, or any other chart patterns for that matter, are not reliable predictors of future price movement as often they do not lead price in the direction that one would expect. In other words chart patterns are nowhere near 100% reliable. Instead one needs to look at chart patterns as signs or pieces of evidence that signify a possible shift in market psychology. Fortunately, the more one studies price charts the better they will become at identifying significant patterns, and by being able to better determine the significance of a chart pattern a trader will greatly increase their profitability.

Studying price charts and using technical analysis to observe the prevailing trend, levels of support and resistance, and chart patterns allows a trader to gain a significant amount of information regarding the psychology of market participants. This information is extremely valuable as it can be used by traders to make informed decisions about when to enter and exit trading positions based on possible shifts in overall market sentiment. While the analysis of market psychology is unlikely to result in a trader executing one hundred percent profitable trades, it will drastically help a trader increase the probability of executing a higher number of profitable trades. Furthermore, the greatest benefit that technical analysis has over any other method of investment analysis, is that technical analysis studies the foundation of what causes price to move, or in other words it examines the dynamic interaction of supply and demand. This interaction, which is caused by the psychology of market participants, drives the change in price of all financial instruments, at all times, throughout all the different types of market conditions, thus allowing a trader the opportunity to be consistently profitable over extended periods of time. To conclude, one must realize that while analyzing price movement does present the opportunity for impressive profits, to be successful, one must spend a lot of time studying the movement of price in order to gain a deep knowledge and understanding of market psychology as well as how changes in psychology are revealed on a price chart.