All traders are human beings (remember that there is still no robot that can consistently provide positive results in trading). Human psychology, therefore, plays an important role in any financial market, be it stocks, bonds, currencies or commodities.
Economic cycles, that correspond to the periods of higher and lower prices, vary in nature. Some of them can be attributed to market psychology. Here is how they work. When an ever-increasing number of people enter a particular market with a long position, be it Bitcoin in 2017 or the IT industry in the late 90s, the price can be expected to demonstrate a steady growth with little to no retracement. As a result, an illusion of never-ending growth is created. What follows next is a full-blown hysteria. In the 90s, a lot of well-known investment experts dubbed IT as “the only industry that still deserves your money”. The same happened to Bitcoin back in 2017. When the price of a particular asset demonstrates triple digit gains, in the eyes of certain experts it suddenly becomes the Holy Grail of trading. Yet, in reality it is just the opposite. The faster the growth, the higher the probability of a sudden crash. Bitcoin and the dot-com bubble are not exceptions. It is, therefore, wise to consider a diversified portfolio.
When the asset price (be it equity, commodity, cryptocurrency or anything else) gets blown too far away from its intrinsic — in other words, real — value, the countdown begins. Sooner or later, the market will demonstrate that there is no growth potential left, and the wise will start pulling their money out of the asset.
The same applies to the periods of economic downfall. The general public (that is mostly responsible for the market psychology phenomenon) is too eager to sell when the asset price begins to plummet. What constitutes a lucrative opportunity to buy low for a professional, becomes a bloodbath for unprepared traders.
It is hard to avoid the temptation of keeping that profitable position just a little bit longer, and of course you do not have to close long-term positions all at once. Yet, it is important to estimate future growth prospects. By estimating the target price, support and resistance levels, you can get a better understanding of how much steam is still left in the asset you are trading. In other words, you don’t have to believe in a particular asset, you have to thoroughly and calmly evaluate its real potential.
The same logic applies to shorter timeframes, as most technical analysis indicators take principles of mass psychology into account. What rises should fall, and what falls should rise again. By predicting the market sentiment, you would be able to predict the behavior of other traders and, consequently, the price of the asset. It may sound cheesy but in order to trade successfully, you have to think like other people and predict their actions. And this is where market psychology comes into play…
