Market psychology is one of the main topics of behavioral economics. It is the idea that the volatility of the market reflects the emotional state of its customers.
There are many that believe the main driving force behind the shift in these markets is the emotions of its participants.
In a nutshell, market sentiment is the general attitude that investors and traders have about an asset’s price movement. A bullish trend exists when the market’s attitude is optimistic and prices continue to rise (often referred to as a bull market). When prices continue to fall, this is a bear market. Just with anything, no single opinion is dominant. Based on psychological theories an asset’s price is always changing in response to its market sentiment which is also always changing.
When the market value increases it is due to the improving attitude of its traders. The confidence and positivity they set out leads to a positive market sentiment which then causes demand to increase and supply to decrease. The increased demand can lead to a stronger attitude and vice versa. A strong decrease in value will create negative sentiment which will reduce the demand and in response will increase supply.
How do investors use market psychology?
Assuming the notion of market psychology is correct, knowing it may assist a trader in entering and exiting positions at more profitable moments. The market’s overall attitude is counterproductive: the best financial opportunity (for a buyer) frequently occurs when most people are discouraged and the market is very low. In contrast, the highest point of financial risk often occurs when the market participants are overconfident.
Traders and investors will try to analyze the market to pinpoint the difference between the stages of its psychological cycles. Then using the information to buy when prices are low and sell when prices are high.
Most traders and investors believe that psychology does indeed have an impact on market prices and cycles. These cycles are well known to the public however are not easily dealt with. Investors face the task of understanding the psychology of the markets together with their own psychology and how that affects their decision-making.
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