How to Read Market Psychology

During times of high volume, traders that have been unsuccessful in their positions and have been losing money definitely take a hit. The natural reaction to this is for said traders to try and close their positions as swiftly as possible; accepting the losses they have already received. When losing traders exit the market, there are two likely trends- a trend based on a considerate volume can continue for a very long time, as smaller losses can build up over time. Trends based on more significant volumes more than likely will not last very long at all. Trends that last the longest are most likely based on markets that are changing slightly, not changing at all or moving in every direction each day forming a trend slowly but surely. But all of this is only evident when viewed in hindsight.

That is not all there is to volume as it relates to market psychology, though. There is a plethora of trading indicators that you can measure the condition of the market psychologically. It would take a number of articles on the market’s psychological state in order to fully examine this topic. This specific article covers the work done by Dr. Alexander Elder, who contributed ideas and standards for traders in a brief, clear-cut and comprehensible manner; for that, we thank Dr. Elder. If you are interested in more information on the subsequently mentioned topics, you may reference the following books by Dr. Elder: “Come into My Trading Room: A Complete Guide to Trading” and “Trading for a Living: Psychology, Trading Tactics, Money Management.”

A/D (Accumulation and Distribution)

Accumulation/Distribution is one of the main indicators when it comes to volume and it takes both opening and closing prices of the market into consideration. Having a positive Accumulation and Distribution means that prices when the markets closed were higher than when they opened and a negative Accumulation and Distribution signifies the exact opposite.

There are two types of investors that can be credited from each day’s volume- a “bull” investor and a “bear” investor. A bull, known to be a more optimistic investor, tries to make a profit off of an increasing market and a bear investor, known to be more pessimistic, tries to make a profit off of a declining market. But both the bull and the bear will only receive a portion of the daily volume and this portion depends on the difference and range between the opening and closing price. It goes without saying that a large range between the opening and closing prices creates a more solid A/D, but it is the pattern of A/D highs and lows that is extremely important. For instance, if the market opens high and closes lower than the opening price, it will cause the A/D to decrease making the upward-trending market less successful than it seemed in the first place.

The true importance of A/D is in its awareness of the different professional groups and beginner traders and their many activities. Beginner traders, as a whole, will have an impact on the market’s opening price because these traders tend to make their first trades based on both financial news and corporate news that they have read and/or seen. What the beginner traders may not know is that the bullish behavior of veteran traders can drive the prices higher during the trading day and therefore essentially determine the day’s end results. On the other hand, if veteran traders disagree with the beginner traders being bullish when the market opens, they can drive prices lower during the trading day. What veteran traders do during the trading day is, for the most part, more relevant that what beginner traders do as their behavior can be a sign for future trends.

OBV (On-Balance Volume)

Created by Joseph Granville, On-Balance volume is a continuous total that increases or decreases every trading day depending on the day’s closing price and whether it is higher or lower than the prior day. On-Balance volume is one of the premier indicators and therefore it will increase or decrease before the actual prices do. A new low On-Balance volume means that bears were more powerful, bulls weaker and therefore a decrease in prices may occur. A new high On-Balance volume means that bulls were more powerful, bears weaker and therefore a rise in prices may occur. If, at any point the On-Balance volume signifies a variance from the actual prices, this means that the volume, which is the emotion of the market, is different from the consensus of value, or the actual prices. At this point, we know that a change in price is likely to occur, which would help to relieve this imbalance.

Open Interest

We are now moving away from talking about volume to discussing open interest, which is the next big signal of crowd psychology. Open interest relates to the futures market and references a reading of options or future contracts that may be ending sometime in the future. Open interest combines the amount of long and short contracts in the market on any day. Also, the absolute value of open interest relates to a total long or short position. Open interest will only increase or decrease when a new contract is either made or ended- exactly one long and one short seller have to come into the market in order for open interest to increase, conversely one long and one short seller have to exit the market in order for open interest to decrease.

Open interest is only important when it goes against the standard. An absolute value is not very interesting. Open interest displays the psychology of the market through the market’s basic discord between bulls and bears. In order for open interest indicators to move up or down, the bulls and bears have to be on the same playing field in regards to their feelings of whether their long or short position is right or wrong. An increasing open interest shows that bulls are bold enough to begin contracts with bears, who are just as bold to enter the position. It goes without saying that someone will eventually lose, whether it be bulls or bears, but if said possible losers continue to enter into contracts, the increase or decrease of open interest will go on. There is, though, more to open interest than it initially seems.

How to Read Open interest Signals

An increasing open interest means that there will be an increase of possible losers, thus, pushing the trend forward. Open interest that goes up when there is an upward trend means that there are a handful of bears that feel the market is exceptionally high. If the uptrend continues to increase, the bulls’ short positions will be pressured and their successive purchasing will push the market even higher. Conversely, open interest that stays the same when the market is in an uptrend means that the number of losers has not grown any further as the possible contenders to begin a contract are people have previously purchased and are looking to gain a profit from their position. If this is the case, the uptrend will probably be coming to an end soon.

When the market is experiencing a downtrend, shorts become determined to sell, but the only people buying at the time are bottom pickers. Value investors also leave their positions when the prices drop too far, meaning that the prices will decrease even more. If, in a declining market open interest increases, the downtrend will probably remain. If, in a declining market open interest remains the same, there will be little-to-no bottom pickers leaving only bears that were shorted earlier and are now hoping to cover and exit the market. If bears exit the market with a profit, this will create a flat open interest during a declining market, which means that any and all of the best gains from the market have more than likely already been had.

Decreasing Open Interest

A decrease in open interest tells us that losers are closing out their positions while the winners are gaining a profit. It also tells us that there are no more losers to replace those that have simply given up. The decreasing open interest is also a sure sign that winners are taking their profits and exiting while losers, on the other hand, have simply given up. Having a declining open interest and a loss of a contract means that more than likely a trend will be ending soon.

Final Thoughts

Sometimes, reading the market trends and market psychology by using certain metrics can be as effective as trying to find a needle in a haystack. Sometimes, though, if you are meticulous when choosing the indicators, comprehending their limitations and using them together, you will be in a better position to notice the market’s mood and make a change based on what effect that mood will have on your positions.

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