When technical tools are used judiciously, their value cannot be overstated. And every time you apply a tool of technical analysis, you are calculating a consensus of bullishness or bearishness among all market participants.

Tutorial: Technical Analysis

For example, the moving average convergence-divergence (MACD) is simply a tool that measures shifts in consensus from bullishness to bearishness, and vice versa. Extending the basic MACD to a deeper level, we find the MACD-histogram, which is actually a tool for determining the difference between long-term and short-term consensus of value. The measure tracks the difference between the fast MACD line (short-term consensus) and the slow signal line (longer-term consensus).

The principles of market psychology underlie each and every technical indicator, so a good understanding of crowd behavior is crucial to your understanding of the fundamentals of particular technical indicators. Assuming that most readers will already possess some knowledge of interpreting the more common technical indicators, we will specifically describe how market psychology drives these individual tools. (To read more on behavioral finance, see Taking A Chance On Behavioral Finance, Understanding Investor Behavior and Mad Money ... Mad Market?)

The Directional System
The directional system was developed by J. Welles Wilder, Jr., as a means of identifying trends that are strong enough to be valid and useful indicators for traders. Directional lines are constructed to determine whether trends are bullish or bearish: when a positive directional line is above the negative line, bullish traders possess greater strength (and a bullish signal is given). The opposite situation indicates bearishness. More telling is the average directional indicator (ADX), which rises when the spread between the positive and negative lines increases. When the ADX rises, winners are getting ever stronger, and losers are getting weaker; furthermore, the trend is likely to continue. (Learn more in our article on Directional Movement.)

Momentum and Rate of Change (RoC)
Momentum indicators measure changes in mass optimism or pessimism by comparing today's consensus of value (price) to an earlier consensus of value. Momentum and RoC are specific measures against which actual prices are compared: when prices rise but momentum or rate of change falls, a top is likely near. If prices reach a new high but momentum or RoC reach a lower top, a sell signal is realized. These rules also apply in the opposite situation, when prices fall or new lows are reached. (Learn more in Measure Momentum Change With ROC.)

Smoothed Rate of Change
The smoothed rate of change compares today's exponential moving average (average consensus) to the average consensus of some point in the past. The smoothed rate of change is simply an enhanced version of the RoC momentum indicator - it is intended to alleviate the RoC's potential for errors in determining the market's attitude of bullishness or bearishness.

Williams %R (Wm%R)
Wm%R, a measure focusing on closing prices, compares each day's closing price to a recent consensus range of value (range of closing prices). If, on a particular day, bulls are able to push the market to the top of its recent range, Wm%R issues a bullish signal; and a bearish signal is issued if bears are able to push the market to the bottom of its range.

Similar to Wm%R, stochastics measure closing prices against a range. If bulls push prices up during the day but cannot achieve a close near the top of the range, stochastic turns down and a sell signal is issued. The same also holds true if bears push prices down but cannot achieve a close near the low, in which case a buy signal is issued. (Learn more about stochastics in Stochastics: An Accurate Buy And Sell Indicator.)

Relative Strength Index (RSI)
RSI also measures market psychology in a fundamentally similar way to that of Wm%R. RSI is almost always measured with a computer, typically over a seven- or nine-day range, producing a numerical result between 0 and 100 that points to oversold or overbought situations; the RSI therefore gives a bullish or bearish signal, respectively.

The total volume of shares traded is also an excellent way in which to ascertain the psychology of the market. Volume is actually a measure of investors' emotional state: while a burst of volume will cause sudden pain in losers and immediate elation in winners, low volume will likely not result in a significant emotional response.

The longest lasting trends generally occur where emotion is the lowest. When volume is moderate and both shorts and longs do not experience the roller coaster ride of emotion, the trend can reasonably be expected to continue until the emotion of the market changes. In a longer-term trend such as this, small price changes either up or down do not precipitate much emotion, and even a series of small changes occurring day-after-day (enough to create a major, gradual trend) will generally not generate severe emotional reactions. This is a classic example of how traders are lulled into a feeling of complacency - small losses (even a series of small daily or weekly losses) do not feel particularly devastating; but the series of small losses will, in a few weeks or months, aggregate into one very large loss.

Volume can be interpreted to predict trend reversals. While moderate and steady volume point to a sustained gradual trend due to the lack of emotion in the market, falling volume may indicate that losers have finally thrown in the towel and that the trend is near its top or bottom. Exceptionally high volume may demonstrate that a great many losers have given up and are selling at any cost. This is true collective psychology at work: amateur traders and investors who are holding losing positions typically reach their breaking point at roughly the same time. A huge burst of volume in a declining market may indicate that even the most patient stalwarts have raised the white flag, which is a classic signal that the bottom is nigh.

In the case of short selling, a market rally may serve to flush out those individuals holding short positions, causing them to cover and subsequently push the market higher. The same principle holds true on the flip side: when the longs give up and bail out, the decline pulls more losers with it (even the most resilient loser reaches his breaking point). At the most fundamental level of market volume, both short and long losers who collectively exit their positions are the primary drivers behind significant volume trends.

Bottom Line
Believe it or not, the preceding indicators are only a few basic examples of how market psychology is measured. There are a great number of additional indicators used in trading rooms everywhere, not to mention a near-infinite selection of variations and refinements of those that have already been mentioned.

For more about technical analysis, check out 3 Technical Tools To Improve Your Trading.

Related Articles
  1. Chart Advisor

    These Oil & Gas Stocks Have Reversed

    It's been a long downtrend for oil stock owners, but there's hope. These four oil and gas stocks have reversed and may keep trending to the upside.
  2. Professionals

    Top Stocks to Short, Go Long On to Beat the Market

    A long/short portfolio can help weather a variety of market scenarios. Here's how to put one together.
  3. Chart Advisor

    4 European Stocks to Consider Buying

    European companies, listed on US exchanges, that are providing buying opportunities right now.
  4. Investing Basics

    3 Key Signs Of A Market Top

    When stocks rise or fall, the financial fate of investors change, as well. There are certain signs that can reveal a stock’s course, and investors don’t need to be experts to spot them.
  5. Chart Advisor

    ChartAdvisor for October 2 2015

    Weekly technical summary of the major U.S. indexes.
  6. Investing Basics

    Tops Tips for Trading ETFs

    A look at two different trading strategies for ETFs - one for investors and the other for active traders.
  7. Investing

    How Diversifying Can Help You Manage Market Mayhem

    The recent market volatility, while not unexpected, has certainly been hard for any investor to digest.
  8. Technical Indicators

    Why MACD Divergence Is an Unreliable Signal

    MACD divergence is a popular method for predicting reversals, but unfortunately it isn't very accurate. Learn the weaknesses of indicator divergence.
  9. Investing News

    6 Signs You Are Addicted To Investing

    An addiction to trading can ruin your life and relationships. Not to mention the monetary costs. There are telltale signs that you've gone too far.
  10. Chart Advisor

    Weakness In Biotech Will Likely Continue

    You can breathe easy with your biotech holdings--assuming you aren't counting on them to make you rich.
  1. How do technical analysts predict bull markets?

    Technical analysis studies past data and trends to predict future market movements. The underlying concept inherent in technical ... Read Full Answer >>
  2. How do mutual funds split?

    Mutual funds split in the same way that individual stocks split, but less often. Like a stock split, mutual fund splits do ... Read Full Answer >>
  3. What are some of the most common technical indicators that back up Doji patterns?

    The doji candlestick is important enough that Steve Nison devotes an entire chapter to it in his definitive work on candlestick ... Read Full Answer >>
  4. Tame Panic Selling with the Exhausted Selling Model

    The exhausted selling model is a pricing strategy used to identify and trade based off of the price floor of a security. ... Read Full Answer >>
  5. Point and Figure Charting Using Count Analysis

    Count analysis is a means of interpreting point and figure charts to measure vertical price movements. Technical analysts ... Read Full Answer >>
  6. What assumptions are made when conducting a t-test?

    The common assumptions made when doing a t-test include those regarding the scale of measurement, random sampling, normality ... Read Full Answer >>

You May Also Like

Hot Definitions
  1. Section 1231 Property

    A tax term relating to depreciable business property that has been held for over a year. Section 1231 property includes buildings, ...
  2. Term Deposit

    A deposit held at a financial institution that has a fixed term, and guarantees return of principal.
  3. Zero-Sum Game

    A situation in which one person’s gain is equivalent to another’s loss, so that the net change in wealth or benefit is zero. ...
  4. Capitalization Rate

    The rate of return on a real estate investment property based on the income that the property is expected to generate.
  5. Gross Profit

    A company's total revenue (equivalent to total sales) minus the cost of goods sold. Gross profit is the profit a company ...
  6. Revenue

    The amount of money that a company actually receives during a specific period, including discounts and deductions for returned ...
Trading Center
You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!