Psychology is the often overlooked intangible aspect of trading, because it is unquantifiable and generally misunderstood by most traders and investors. Unlike the precise mathematical formulas used in technical analysis, we cannot easily reduce human behavior to a mathematical equation that can be plotted on a graph as a trendline or as a series of variables that we can examine in detail, throughout history. (To learn more, see How To Read The Market's Psychological State.)
TUTORIAL: Technical Analysis
That said, much of the current research in social sciences is attempting to bring psychology more in line with mathematics for the precision that it gives to experimental methods. Mathematical methods are applied to behavioral science for the purpose of observing and comparing human behavior, according to a set of strict numerical criteria, the only stable benchmarks that allow comparison of behavior from person to person and from time to time. (To read more on behavioral finance, see An Introduction To Behavioral Finance, Understanding Investor Behavior and Mad Money ... Mad Market?)
In relation to trading and investing, we can consider two very different approaches to psychology in the markets: individual psychology and group psychology. Individual psychology obviously only looks at the behaviors of the single individual trader. Attempting to draw conclusions based on the actions of the herd, mass psychology (or group psychology or crowd behavior) examines how behavior of all investors exerts an effect on a stock price (or option price or currency value). (You can read more about this in The Importance Of Trading Psychology And Discipline.)
Go Against the Grain
The foundations of how crowd behavior relates to investing are rooted in distant history, all the way back to the famous Dutch tulip mania of investing folklore. Interestingly, the behavior of crowds is a paradoxical indicator when applied to stock markets. When most investors are in consensus and are driving the market in a particular direction, one naturally thinks that the consensus will continue ad infinitum and that the best trading decision is to follow the crowd. (For further reading, see How The Power Of The Masses Drives The Market.)
However, history has proven exactly the opposite. When driven strongly by consensus, crowd behavior is actually a contrary indicator. When the consensus of the majority of investors or traders is strongest, the individual trader should do exactly the opposite of what the crowd is doing. The astute trader can profit by doing quite the opposite of what, at first glance, seems logical. When the market is strongly bullish, the astute trader is ready to short the market. When the market is bearish, he or she gets ready to buy.
When and How?
You would not be faulted if you were to question this strategy of trading. How do you know that the contrary trade is not going to be exactly the wrong action? Mass psychology may continue to drive the trend for a longer period of time. How can you expect to identify that exact magic moment, the single day or week, when the consensus indicator is strongest, the absolute best time that you should make your contrary move?
To answer these questions, traders must realize that a consensus indicator is not meant to be an absolutely precise indicator. Market consensus should be used as a clue that a trading opportunity is afoot. It indicates that it is a good time to apply more detailed analysis into particular stocks or currencies. It is important to find out if the trading opportunity is supported by technical analysis or momentum indicators.
The second question that I raised is the more interesting one. How do you identify when the consensus is strongest? Several tools are used to help investors roughly identify the consensus of the market. Most of these tools tabulate a numerical consensus indicator on the basis of advisory opinions, signals from the press or signals from advertisers.
The advisors of which I speak are ubiquitous newsletter writers who service their subscribers week-by-week or month-by-month by giving opinions on the future direction of markets or individual stocks. Sources such as Consensus and Market Vane poll these newsletters to track the bullishness or bearishness of the market. Even if the individual letter writers are blindly regurgitating whatever they hear in the media, these polling services, because they have developed special numerical figures to analyze these newsletters, can assign either a bullish or bearish value to each of the opinion letters. These services then tabulate the overall bullishness or bearishness of their entire universe of advisors. When this numerical value crosses a certain threshold, either a buy or a sell signal is issued. The signal is issued contrary to the balance of advisory opinion.
By their very nature, financial journalists are fence sitters. Financial newspapers and magazines do not ever want to be wrong in their opinions, so they present reportage within their pages that is as innocuous and non-committal as is humanly possible. Journalists' fence sitting only disappears at the end of a long trend, when the balance of opinion amongst analysts, investors and the press has reached a strong consensus.
At this time, the press will jump firmly onto one side of the fence or the other, presenting strong opinions concerning the state of the market and its likely short-term direction. When journalists have jumped to one particular side of the fence, astute traders climb over the fence and position themselves on exactly the opposite side. Standing huddled as a group, the journalists look at the lone trader through the rungs of the fence with smug expressions on their faces. In a very short period of time, however, the trader will be the only one with reason to exhibit any smugness once the markets change direction to his or her advantage and in exactly the opposite direction to the predictions of journalists.
Take a look at a major business newspaper one day and see how many ads you can find for certain individual investment opportunities, such as real estate, commodities or certain types of equities. Chances are you will find several ads touting the investment potential of one particular investment or another. When you notice, for example, a large number of ads for the potential for appreciation in the price of gold, the price of gold is likely to be near its top. When the advertisers get together to scream 'buy,' the astute trader walks very quickly to his or her terminal in order to hit the sell button.
The Bottom Line
Trading contrary to opinion is deadly effective because of the often-misunderstood axiom that much of living is based on the power of paradox. At the surface, many aspects of life and of investing, like the power of consensus trends, appear to be true and straightforward. However, as we have seen, the herd is almost always wrong, or at least late in jumping on the bandwagon. As we see time and again, both in the markets and in life in general, when the herd finally jumps aboard a trend, that trend has very nearly run its course.
The individual who is able to recognize the inherent paradox in crowd behavior is best able to capitalize on the inevitability of contradictory opportunities. For more on consensus indicators, see Trading Psychology: Consensus Indicators - Part 2.