As we discussed in last month’s Advanced Training, there is a tremendous correlation between Psychology and Trading. Since trading is attached to money, many emotions are in play. In particular, emotions such as Greed and Fear are intimately associated with trading. Not only does this affect individual traders, it translates out to the market as a whole. Since traders drive the market, this market psychology drives the patterns of the candles (“footprints of money”.)
As prices rise, they draw attention to themselves. More people notice the rise and want to be a part of that (greed.) They imagine how much money they could be making so they jump right on the train and, in doing so, cause the train to accelerate, drawing more attention and so on. Those who got on the train late, start imagining how far it’s “going” to go.
However, those who were in the move early are starting to think that the ride can’t last much longer and are starting to sell out – to the new people jumping on the train. The risk of entry here is much greater because they are buying at a much higher price – from people who are getting out of the move. Fewer and fewer buyers in the market cause the prices to start to slip. This is the point at which fear starts to guide the market.
When prices start to fall, fear, and it’s extreme companion, panic, take over. Fear, being a primal emotion, typically causes prices to fall much faster than they rise. Those who have been holding a long time for more profit start to realize their profit is eroding. Those who were late getting on the train are rethinking their grand design on making tons of cash. Everyone starts to dump the positions to whomever will take them, but buyers are few and far between. Short sellers enter the market making it more difficult to sell bad positions. Prices drop and drop until the smart buyers start to get interested, but the late adopters take pretty large losses.
These emotions manifest on the charts as support/resistance levels and other chart and candle patterns that we regularly use to identify probable market turns and follows-through.
If a resistance level (above the current price) breaks you can be sure there are more “bulls” in the market (buyers) which suggests more demand and higher pricing. If the level holds and price bounces from the resistance, you can be sure there are more “bears” or sellers and the supply will increase, causing lower prices. Support levels (below the market) work the opposite way.
About a year and a half ago, I wrote an article at Winner’s Edge about the 123 Reversal. I included a few paragraphs from that article about the psychology behind the 123 reversal. If you would like, I think you might find the article interesting as it includes a bit of my story.
The article details the 123 reversal pattern and how to trade it. I’m including the part of the story that discusses the operation of traders’ emotions on the actual 123 reversal pattern.
123 Point 1
The number 1 point occurs at a place where traders who were long in the market decide they need to secure the profits they made during the trend up. That’s why the initial trend is very important. It’s also why you should watch for this point at a place of strong resistance. It’s the place where traders will feel that the market may stall or turn. In other words, they fear they may lose the profits they’ve got in place. The surge in volume is due to the “not so smart” money finally recognizing the trend and jumping on the bandwagon (euphoria – “this trend could last forever, I gotta get me some”.) That surge in volume usually happens when a move has reached exhaustion. The volume is a signal that the smart money is passing on their holdings to the latecomers, leaving them “holding the bag”. This is the number one point.
123 Point 2
Of course, after there are no more traders to buy up the positions the latecomers entered, the price starts to drop. As the price drops, the smart money sees an opportunity to possibly make a little profit on another pop to the number 1 high, but they are less committed because most of the longer term momentum indicators are still giving overbought indications and the market has just made a big up move. Eventually, all the latecomers that bought while the market was at the peak are experiencing fear. As the market continues to drop, they unload those positions to the smart money – who are more willing to buy as the price drops lower. Until there are no more folks wanting to sell. That’s the number 2 point.
123 Point 3
Now that the latecomer sellers are gone, prices will start to move up again. The smart money folks bought from the latecomers, so now as it starts to go up again, the latecomers figure they got out too soon and start buying again, but since they were burned before, they are a little more wary, so fewer of them get involved this time. And of course, the smart money folks are more than willing to take their profits as the market goes up. But since there are fewer willing to buy this time, when the price peaks, it often doesn’t get as high as the number one point before it starts dropping again. This is the number 3 point.
As the market starts to drop from the number 3 point, the more educated, smart money traders recognize that this could be a reversal or the beginning of a trading range, but at the very least, they are willing to sell down to the number 2 point again – which is exactly what we will do. This causes prices to drop back to the number 2 point – often breaching the number 2 point by a few pips.
The “Smart Money” Traders Get It
The “smart money” traders in our story are the ones that “get it”. They are the ones that get in the early momentum of the trade and take profit earlier. They are the ones that have mastered their emotions and don’t chase trades. The “not so smart money” traders are the ones that get excited when they see a big move in progress and jump in too late – just as the momentum is flagging. They’re the ones that end up losing.
The chart patterns that we often discuss in the room are primarily based on trader’s emotions. That makes them fairly consistent, since emotional reactions don’t change. Each pattern is different because each time they occur, the group of traders responsible for them is different. Each group has a different emotional make-up. Some traders experience extreme emotions during trading, others experience less. So each pattern, while still following the general shape, will be somewhat different.
Our Momentum Strategy is designed to take advantage of the emotions of a Support/Resistance level break. We anticipate that a break of that level will cause momentum acceleration of price for a period of time. The reason we avoid the “news effect” (the effect of news and data releases that happen periodically during the month) is that it changes the emotional makeup of price movement for the duration of that effect.