2 Core Components of Market Psychology

09/28/2011 1:30 am EST

Focus: STRATEGIES

Alexander Elder

Author, The New Trading for a Living

Successful traders not only understand their own psychology, but also the psychology driving the markets, explains Dr. Alexander Elder, imparting advice for getting a handle on both.

As a trader, you probably hear about learning the “psychology” of the market, but what does that really mean?

Our guest today is Dr. Alexander Elder to talk about that. So, Dr. Elder, when anybody says “learn the psychology of the market,” what do they really mean?

I think market psychology is divided really into two huge areas: individual psychology of the trader and mass psychology of the markets.

In terms of individual psychology of traders, I think all of us come to the markets with a wonderful goal—to make more money than we can get from a Treasury bill—but along the way, most of us lose focus and we start trading for entertainment.

I think the financial markets are the most entertaining places on the face of this earth. It’s like a horserace, card game, chess game, all rolled up in one, and it goes 24/7; you can always find action.

So, people who are bored escape into trading, and they’re immensely entertained by it, but they don’t make money. When you want to be entertained, you have to pay. You cannot make money.

Successful trading is a little bit boring. That’s why my best advice for somebody who wants to become a cool, calm, disciplined, successful trader is to keep recent records. I hate keeping records; I’m bored by it, but that’s what makes me a serious trader.

I’ve heard you say something like “Buy happy markets and sell depressed markets.” Did I get that right?

You got it. When markets are happy, that’s when they top out. That’s when they go down. When markets are depressed, that’s when sellers come out of the woodwork and everybody sells the markets.

Eventually, there’s no more loose shares to be sold. So, depressed markets bottom out. We have indicators which help us identify happy markets and sad, depressed markets.

When the market blows out of its channel, when a market creates a bearish divergence, when I hear happy news of IPOs, well, that’s a happy market. That’s when I start looking for short opportunities.

When the market is depressed, when it falls out below it’s lower channel line as the stock market has done recently, when the news is gloomy, that’s when I become interested in creating a shopping list.

What about the sentiment indicators, put/call ratios, and Commitment of Traders, that sort of thing?

Put/call ratios, Commitment of Traders, also not to be forgotten is the Volatility Index (VIX). I don’t think it was Shakespeare who wrote this poem, “When VIX is low, go slow. When VIX is high, it’s safe to buy.”

VIX is a fear index, so when VIX is high, fear is rampant. That’s a safe time for buying.

When VIX is low, the crowd is complacent, so that’s a dangerous time.

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