3/25/2024

How does market psychology work?

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The psychology of trading as such and the psychology of individual traders is inextricably linked with market psychology. Why does this happen and how does market psychology work? This article is dedicated to answering these questions!

Market psychology is the aggregate behavior and sentiment of market participants that is relevant at a given time. This concept is often used by financial analysts and the media to interpret market movements that cannot be explained by other indicators, such as fundamentals.

Market psychology focuses on the overall behavior of the market, which is determined by the combination of emotional and cognitive factors operating within the market system.

Features of market psychology

Market psychology has significant power that can influence stock prices regardless of fundamental factors or events. An example is when indices fall when there is a sudden decline in investor confidence in the health of the economy. As a consequence, this leads to a fall in stock prices, regardless of the financial condition of the companies.

Greed, fear, expectations and euphoria are just some of the factors driving market sentiment. These conditions, in turn, cause boom and bust cycles known as “risk taking” and “risk aversion.”

Market psychology can lead to unpredictable results that cannot be explained by fundamental analysis. This suggests that theories of market psychology contradict the belief that markets are rational.

How to predict market psychology?

There are two main methods used by professionals to select stocks, and only one of them takes into account the influence of market psychology to a significant extent.

Fundamental analysis. This method aims to find promising stocks by examining a company’s financial performance in the context of its industry. Market psychology plays a minor role in this approach.

Technical analysis. This method is based on the study of trends, patterns and other indicators that affect stock prices. Market psychology is one of the key factors taken into account in technical analysis.

Due to the unreliability of fundamental analysis, traders also use quantitative trading strategies. Trend-following strategies used by hedge funds are examples of investment techniques based in part on exploiting shifts in market psychology. The goal of such strategies is to identify and exploit discrepancies between an asset’s fundamentals and market perception of it to generate profit.

What lessons does market psychology teach traders?

Because market participants are human, markets, as a collection of human choices, can exhibit herd behavior and other irrational tendencies. Typical examples of such trends are panic selling and speculative frenzy, leading to the formation of asset price bubbles.

Recognizing the influence of market psychology allows us to conclude that markets are not always efficient and rational.

By doing your own research, you can identify moments when market psychology, such as fear or greed, leads to oversold or overbought assets. This makes it possible to make opposite trades: buy when others are selling, and sell when others are buying.

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