How Market Psychology Drives Technical Indicators

By Jason Van Bergen AAA

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.

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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.

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