Skillsfirst Level 3 Certificate in Introduction to Financial Trading (RQF) - UNIT 1: Principles of financial trading
Skillsfirst Level 3 Certificate in Introduction to Financial Trading (RQF) - UNIT 2: Principles of Financial Planning and Cash Flow in Financial Trading
Skillsfirst Level 3 Certificate in Introduction to Financial Trading (RQF) - UNIT 3: Understanding financial trading techniques

MARKET PSYCHOLOGY – MARKET SENTIMENT AND CROWD BEHAVIOUR

Some would tell you that trading can be quite simple; you just don’t do what most do … in fact, you basically do the opposite. Like everything else though, the devil is in the details and the assumption should be questioned as well.

With over 90% of market participants losing money overall, some may argue that the key to success in trading is simply to do the opposite of what most people do! But in practice, assessing the overall mood and sentiment of the mood at any particular point in time is a task fraught with difficulties – not least due to the fact that for every single trade that transpires, there must be an equally –matched interaction between equal numbers of buyers and sellers.

So how is market sentiment gauged, and how can that information be used to develop a certain trading strategy or philosophy? To answer these questions, we need to make some basic assumptions regarding the markets. A basic one is that, “For the most part, for a significant amount of trades that occur there is a reasonable balance in supply and demand. By reasonable, we are suggesting that there are not an overwhelming number of buyers and an absence of sellers, nor are there an overwhelming number of sellers and an absence of buyers. Instead, there is a reasonable equilibrium between these two groups.”

However, there are clearly times where this is not true. Sometimes there is clearly a bias to one side or the other and that bias can last for a long time. In fact, long term trends are a reflection of that bias. At the same time, there are times when there are an overwhelming number of buyers and fewer sellers or vice versa. In these more extreme settings, sentiment can become extreme and the concept of crowd psychology comes into play.

Wonderful opportunities await the nimble and cognizant trader in such situations for crowd psychology suggests that most people are more comfortable doing what the crowd does regardless of whether it is wise or not as there is this inherent strength in numbers. It doesn’t mean that the crowd is right, just simply that there are more of them and people tend to be more comfortable in their decision making when they go along with the crowd.

Therefore, it occurs time and time again that in the face of directional movements upwards or downwards, momentum begins to build. There is an innate tendency among market participants to purchase at higher, not lower prices. Conversely, when the market is going down, there is the tendency to sell at lower prices, rather than buy. This is due just as much to fewer traders willing to stand in the face of momentum as more traders wanting to get behind it.

However, this does not imply that the only way to successfully trade is to either go against the market or to go with it. Every market scenario which occurs is a new one, and there will be times when it makes sense to go against the crowd, as well as times when the best course of action is to do the opposite. The secret of trading success however lies in being able to differentiate between the two.

In general, though, this secret can only be obtained by close observation of the most pronounced effects crowd psychology has on general market. The fact that buyers tend to buy higher and sellers sell lower is a result of crowd psychology and the desire to follow the leader rather than to lead. In general, workable trading strategies that take advantage of this observation can be profitable regardless of whether you trade with or against the crowd. Typically, a trader does one or the other, but like any athlete who has truly developed their game, being able to use all tools available to you presents you with significant advantage to those that can’t.