Each price is the momentary consensus of value of all market participants. It shows their latest vote on the value of a trading vehicle. Any trader can “put in his two cents’ worth” by giving an order to buy or to sell, or by refusing to trade at the current level.
Each bar on a chart reflects the battle between bulls and bears. When bulls feel strongly bullish, they buy more eagerly and push markets up. When bears feel strongly bearish, they sell more actively and push markets down. Each price reflects action or lack of action by all traders in the market.
Charts are a window into mass psychology. When you analyze charts, you analyze the behavior of traders. Technical indicators help make this analysis more objective.
Technical analysis is applied social psychology. It aims to recognize trends and changes in crowd behavior in order to make intelligent trading decisions.
Strong Feelings
Ask most traders why prices went up, and you are likely to get a stock answer-more buyers than sellers. This is not true. The number of trading
instruments, such as stocks or futures, bought and sold in any market is always equal. If you want to buy a contract of Swiss Francs, someone has to sell it to
you.
If you want to sell short a contract of the S&P 500, someone has to buy it from you. The number of stocks bought and sold is equal in the stock market. Furthermore, the number of long and short positions in the futures markets is always equal. Prices move up or down because of changes in the
intensity of greed and fear among buyers or sellers.
When the trend is up, bulls feel optimistic and do not mind paying a little extra. They buy high because they expect prices to rise even higher. Bears
feel tense in an uptrend, and they agree to sell only at a higher price. When greedy and optimistic bulls meet fearful and defensive bears, the market rallies. The stronger their feelings, the sharper the rally. The rally ends only when many bulls lose their enthusiasm. When prices slide, bears feel optimistic and do not quibble about selling
short at lower prices. Bulls are fearful and agree to buy only at a discount.
As long as bears feel like winners, they continue to sell at lower prices, and the downtrend continues. It ends when bears start feeling cautious and refuse to sell at lower prices.
Rallies and Declines
Few traders act as purely rational human beings. There is a great deal of emotional activity in the markets. Most market participants act on he principle of “monkey see, monkey do.” The waves of fear and greed sweep up bulls and bears.
Markets rise because of greed among buyers and fear among short sellers. Bulls normally like to buy on the cheap. When they turn very bullish, they become more concerned with not missing the rally than with getting a cheap price. A rally continues as long as bulls are greedy enough to meet sellers’ demands.
The sharpness of a rally depends on how traders feel. If buyers feel just a little stronger than sellers, the market rises slowly. When they feel much stronger than sellers, the market rises fast. It is the job of a technical analyst to find when buyers are strong and when they start running out of steam. Short sellers feel trapped by rising markets, as their profits melt and turn into losses. When short sellers rush to cover, a rally becomes nearly vertical.
Fear is a stronger emotion than greed, and rallies driven by short covering are especially sharp. Markets fall because of greed among bears and fear among bulls. Normally bears prefer to sell short on rallies, but if they expect to make a lot of money on a decline, they don’t mind shorting on the way down. Fearful buyers agree to buy only below the market. As long as short sellers are willing to meet those demands and sell at a bid, the decline continues.
As bulls’ profits melt and turn into losses, they panic and sell at almost
any price. They are so eager to get out that they hit the bids under the market. Markets can fall very fast when hit by panic selling.
Trend Leaders
Loyalty is the glue that holds groups together. Freud showed that group
members relate to their leader the way children relate to a father. Group members expect leaders to inspire and reward them when they are good but to punish them when they are bad.
Who leads market trends? When individuals try to control a market, they usually end up badly. For example, the bull market in silver in the 1980s was led by the Hunt brothers of Texas and their Arab associates. The Hunts ended up in a bankruptcy court. They had no money left even for a limousine and had to ride the subwy to the courthouse. Market gurus sometimes lead trends, but they never last beyond one market cycle .
Tony Plummer, a British trader, has presented a revolutionary idea in his book, Forecasting Financial Markets – The Truth Behind Technical Analysis. He showed that price itself functions as the leader of the market crowd! Most traders focus their attention on price.
Winners feel rewarded when price moves in their favor, and losers feel
punished when price moves against them. Crowd members remain blissfully unaware that when they focus on price they create their own leader. Traders who feel mesmerized by price swings create their own idols.
When the trend is up, bulls feel rewarded by a bountiful parent. The longer an uptrend lasts, the more confident they feel. When a child’s behavior is rewarded, he continues to do what he did. When bulls make money, they add to long positions and new bulls enter the market. Bears feel they are being punished for selling short. Many of them cover shorts, go long, and join the bulls.
Buying by happy bulls and covering by fearful bears pushes uptrends higher. Buyers feel rewarded while sellers feel punished. Both feel emotionally involved, but few traders realize that they are creating the uptrend, creating their own leader.
Eventually a price shock occurs-a major sale hits the market, and there are not enough buyers to absorb it. The uptrend takes a dive. Bulls feel mistreated, like children whose father hit them with a strap during a meal, but bears feel encouraged.
A price shock plants the seeds of an uptrend’s reversal. Even if the market recovers and reaches a new high, bulls feel more skittish and bears become
bolder. This lack of cohesion in the dominant group and optimism among its opponents makes the uptrend ready to reverse. Several technical indicators
identify tops by tracing a pattern called bearish divergence . It occurs when prices reach a new high but the indicator reaches a lower high than it did on a previous rally. Bearish divergences mark the best shorting opportunities.
When the trend is down, bears feel like good children, praised and rewarded for being smart. They feel increasingly confident, add to their positions, and the downtrend continues. New bears come into the market. Most people admire winners, and the financial media keep interviewing bears in bear markets.
Bulls lose money in downtrends, and that makes them feel bad. Bulls dump their positions, and many switch sides to join bears. Their selling pushes markets lower.
After a while, bears grow confident and bulls feel demoralized. Suddenly, a price shock occurs. A cluster of buy orders soaks up all available sell orders and lifts the market. Now bears feel like children whose father has lashed out at them in the midst of a happy meal.
A price shock plants the seeds of a downtrend’s eventual reversal because bears become more fearful and bulls grow bolder. When a child begins to doubt that Santa Claus exists, he seldom believes in Santa again. Even if bears recover and prices fall to a new low, several technical indicators identify their weakness by tracing a pattern called a bullish divergence. It occurs
when prices fall to a new low but an indicator traces a more shallow bottom than during the previous decline. Bullish divergences identify the best buying opportunities.
Social Psychology
An individual has a free will and his behavior is hard to predict. Group behavior is more primitive and easier to follow. When you analyze markets, you analyze group behavior. You need to identify the direction in which groups run and their changes.
Groups suck us in and cloud our judgment. The problem for most analysts is that they get caught in the mentality of the groups they analyze. The longer a rally continues, the more technicians get caught up in bullish sentiment, ignore the danger signs, and miss the reversal. The longer a decline goes on, the more technicians get caught up in bearish gloom and ignore bullish signs. This is why it helps to have a written plan for analyzing the markets. We have to decide in advance what indicators we will watch
and how we will interpret them.
Floor traders use several tools for tracking the quality and intensity of a crowd’s feelings. They watch the crowd’s ability to break through recent support and resistance levels. They keep an eye on the flow of “paper” – customer orders that come to the floor in response to price changes. Floor traders listen to the changes in pitch and volume of the roar on the exchange floor. If you trade away from the floor, you need other tools for analyzing crowd behavior. Your charts and indicators reflect mass psychology in action. A technical analyst is an applied social psychologist, often armed with a computer.