Market sentiment is the notion that the market will fluctuate according to or be influenced by the emotional state of the participants in the field. This is one of the main topics of behavioral economics - an interdisciplinary field that studies the various factors that precede economic decisions.
1. What is market psychology?
In fact, many believe that emotions are the main driving force behind financial market volatility, and that the overall volatility of investor sentiment is what creates psychological market cycles.
In short, market sentiment is the general feeling investors and traders have about the price action of an asset. When market sentiment is positive and prices increase continuously, the market will have an upward trend (or bull market). On the contrary, when prices continuously decrease, it is called a bear market.
Therefore, market sentiment is made up of the personal views and emotions of all traders and investors in the financial markets. Or in other words, it is the average of the feelings of market participants.
However, as with any group, no one opinion can completely dominate. Based on market psychology theories, the price of an asset tends to change continuously in response to general market sentiment - this sentiment will always change; otherwise, it will be difficult to make a successful transaction.
In fact, when the market goes up, it is likely because traders' attitudes and beliefs have improved. Positive market sentiment causes demand to increase and supply to decrease. In turn, increased demand can create a stronger signal. Likewise, when the market drops sharply, it leads to negative sentiment, reducing demand and increasing available supply.
2. How does sentiment change during the market cycle?
2.1 Uptrend
All markets go through cycles of expansion and then contraction. When a market is in an expansion phase (bull market), the whole market will be very optimistic, confident and greedy. Often, it is these positive emotions that lead to a surge in purchases.
Cyclical effects are quite common in market cycles. Suppose market sentiment becomes more positive as prices rise, then as prices rise, sentiment will become increasingly positive and push the market higher.
In some cases, the market will move sideways for a period of time as assets are gradually sold. This is also known as the distribution phase. However, some cycles do not have a clear distribution phase and a downward trend begins shortly after the peak is reached.
2.2 Downtrend
When the market begins to turn, euphoria can quickly turn to quiet satisfaction, as many traders refuse to believe that the uptrend is over. As prices continued to fall, market sentiment quickly turned negative, and was filled with feelings of anxiety, denial and panic.
As prices fall further, the selling wave becomes stronger. At this point, fear and panic often lead to what is known as market abandonment (when investors give up and sell their assets at levels close to the local bottom).
Ultimately, the downtrend will stop when volatility decreases and the market stabilizes. Typically, markets experience sideways movements before feelings of hope and optimism begin to reappear. Such a sideways period is also called an accumulation period.
3. How do investors use market psychology?
If the theory of market psychology is valid, understanding this theory can help traders enter and exit the market at more favorable times. The general psychology of the market has an undesirable effect: the time of greatest financial opportunity (for buyers) often comes when most people are hopeless, and the market is very weak. On the contrary, the time of highest financial risk often appears when the majority of market participants appear eager and overconfident.
So, some traders and investors try to read the psychology of the market to detect the different phases of its psychological cycle. Ideally, use this information to buy when there is panic (lower prices) and sell when there is increased demand. However, it is not easy to realize these optimal points in practice.
4. Technical analysis and market psychology
When looking back at the market cycle, anyone can completely recognize how general psychology has changed. Analyzing previous data can allow you to clearly see which actions and decisions could have been most profitable.
However, it is more difficult to understand how the market is changing at the moment, and it is even more difficult to predict what trends will occur.
The MACD is also an example of an indicator that can be used to detect different psychological phases of the market cycle.
5. Market psychology and Bitcoin
The 2017 Bitcoin market is a clear example of how market psychology affects prices and vice versa. From January to December, Bitcoin rose from around $900 to an all-time high of $20,000. At that time, market sentiment became increasingly positive. Thousands of new investors have entered the market, having been caught up in the excitement of the bull market.
Trend reversals began to take place in late 2017 and early 2018. The market reversal caused many late entrants to suffer significant losses. Even when the downtrend was established, confidence and complacency caused many to insist on holding.
A few months later, market sentiment turned very negative as investor confidence reached an all-time low. FUD and panic caused many people to buy near the top and sell near the bottom, suffering huge losses.
6. Conclusion
Most traders and investors agree that sentiment has an impact on prices and market cycles. Although the theory of psychological market cycles is very popular, it is not always easy to handle. From the Dutch Tulip craze of the 1600s to the dotcom bubble of the 90s, even skilled traders struggle to separate their own emotions from the general sentiment of the market. Investors have also been faced with the incredibly difficult task of understanding not only market sentiment but also their own sentiment, as well as how that affects the decision-making process. their.
