Thursday, October 10, 2019

Understanding the Psychology of the Market

It's been a somewhat frustrating recent market for traders holding positions.  We've had good volatility, but not great directional trending.  That can create choppy conditions, where the chop is occasionally violent.  What I've found is that markets that traders call "choppy" (and thus imply that they're not tradeable) are often ones that display cycling behavior.  Another way of saying that is that markets that don't exhibit good momentum can display good mean reversion (value) behavior.  It's all about identifying the market environment and adapting the trading to the behavior of market participants.

Above we can see recent action in the ES futures, with volume traded at the offer price minus volume traded at the bid price captured in the middle panel of bars.  At the bottom is an exponential moving average of the volume distribution, capturing when bulls have been more aggressive (lifting offers) and when bears have taken control (hitting bids).  Note the cyclicality of that behavior; note also the volume traded at each price point (left bars) and how we could not sustain a break below the value area during overnight trade.

All relevant to the psychology of the market.

I'll say something that is a gross generalization, but fits my experience.  Beginning traders struggle with their own psychology; experienced traders struggle with the psychology of the markets.  There are many tools out there that can help us read other players in the market better.  Right now I'm playing with uptick/downtick measures (like NYSE TICK) that are specific to the Dow stocks; the NASDAQ stocks; the S&P 500 stocks; the NYSE shares; and the Russell 2000 stocks.  

When we see significant upticking or downticking in one universe of stocks but not others, that says something about rotation and the perceptions of market players.  When we see all elements of the universe upticking or downticking at the same time, that says something quite different.  The pattern of upticking and downticking across various segments of the market reflects important distinctions between momentum/trending markets and mean-reverting/value ones.

Meanwhile, beginners look at price charts and fret about their own psychology.  Perhaps they're experiencing turmoil because what they're looking at does not adequately capture the psychology of the marketplace.  It's not that they're playing the game poorly; it's that they're playing the wrong game.

Further Reading: