What Is Stock Market Psychology?

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Contributor, Benzinga
October 13, 2023

Every trader wants to experience success in the stock market. But getting to a place of success as a trader requires constant education, learning, humility and self-discipline. Understanding how to navigate the stock market isn’t just about technical formulas and indicating tools. It’s also about recognizing and managing your emotions.

Human emotions influence the state of the stock market more than most other factors. That’s why understanding your emotions and the collective sentiments of traders as a whole is a useful tool that will help you manage your assets and make investing decisions while trading.

This strategy is known as stock market psychology, and it’s what the best traders rely on to keep themselves from making emotional choices when the market rises and falls.

Understanding Stock Market Psychology

Stock market psychology describes how the state of mind, emotions, biases and thought processes of market traders influence their buying and selling decisions.

Because the stock market is shaped by humans — and because emotion is fundamental to the human condition — the stock market is at the mercy of both individual and collective psychological behaviors.

In addition to logistics like earnings and supply chains, the reason for any given trade can typically be credited to three aspects:

  • Market sentiment
  • The mood of investors and fund managers
  • Human emotions like greed and fear

The sum of these factors makes up what is known as stock market psychology, also referred to as trading psychology.

The Importance of Trading Psychology in the Market

Trading psychology has real-world, practical implications in the everyday movement of the stock market. Being mindful of your own psychological behaviors can help you stay away from irrational trading behaviors rooted in greed or fear.

Fear can be a healthy trait because it protects you from threats, but when it comes to trading, you need to be mindful of how your fight-or-flight instincts manifest when reviewing positions.

For example, it’s natural for traders to feel fearful when stocks start moving against them. They often experience the fear of loss, which results in them holding on to failing positions much longer than they ought to. Giving in to this fear is one of the biggest mistakes you can make as a trader.

Fear

Fear can also keep you from trading or investing in a stock in the first place — especially if you’ve experienced a crash before. Fear of a crash keeps many traders from acting when they should. Investing decisions can be heavily influenced by market psychology.

Greed

can also influence your trades if you’re not careful. This emotion tends to arise in traders who take advantage of their winning stocks by investing even more money into the same stock with the hope that it will continue creeping in a favorable direction.

Another way greed can cause financial ruin is when you choose to double down on a losing trade by investing more money into it, hoping more money will resolve the issue.

An example of collective greed happened during the initial rise of cryptocurrency. Investors began throwing money into crypto under the assumption that more money would increase its value. But these investors were negatively impacted by the crypto market crash.

Fear of Missing Out

Fear of missing out is another expression of both human emotion and trading psychology that can harm you in the stock market world if you’re not careful. Stock market psychology plays a crucial role in influencing stock price, investing decisions, and investment strategy.

This fear can cause traders to:

  • Enter into a trade hastily without enough research, planning or thought
  • Close trades early or at the wrong time because that’s what other traders are doing
  • Risk too much of their own capital because of herd mentality

Fast-paced markets and market volatility are some of the leading contributors to the fear of missing out.

Market Psychology Indicating Tools

Now that you have a basic grasp of what trading psychology is and how it manifests in the stock market, you might be wondering how to predict market psychology.

Predicting market psychology is not an easy task nor is it a perfect technique. Humans remain unpredictable no matter how much the mind and emotions are studied.

Some common indicators can help investors and traders anticipate changes in the stock market based on collective shifting sentiment.

1. Moving Average Convergence/Divergence (MACD)

The moving average convergence/divergence (MACD) is a technical tool that analyzes and evaluates shifts in trading consensus from a bear market to a bull market and vice versa. This tool measures both longer-term and short-term consensus, also known respectively as the slow signal line and the fast MACD line.

By following the MACD, you can look at contemporary indicators and historical trends to forecast how traders will react to either bearish or bullish momentum.

2. Directional System

Another technical indicator that can help you forecast trading psychology is the directional system, which helps identify bullish and bearish trends.

When market trends are moving above the negative line, it’s likely that bullish traders will buy more in the underlying market with the hope that they can sell for a profit in the future.

In the opposite situation, bearish traders may engage in practices like short selling or may hastily close their trades out of fear.

3. Rate of Change (ROC)

The rate of change (ROC) is a momentum-indicating tool that can analyze collective pessimism or optimism in the market. ROC tools compare the value of today’s consensus to the value of yesterday’s (or another earlier date) consensus.

The ROC is measured against the actual prices in the market. When these prices rise but the ROC falls, you can expect that the securities in question are peaking and about to enter a downward trend. This is also known as a top.

5 Ways to Manage Market Psychology for Trading Success

If there were no methods to manage market psychology, it’s unlikely most traders would experience success. Thanks to clever analysis by experts, there are ways for you to navigate the ever-capricious psychology of the market.

1. Do Your Own Research

Avoid the herd mentality: Never make decisions based on the decisions of larger groups of investors.

By doing your own research, you can evaluate whether the market is being oversold or overbought.

An oversold asset is one that’s traded in at a lower price while having the potential for the price to bounce in the future. Technical indicators, like the ones listed above, can help assess the levels at which stocks are oversold by identifying the current stock price compared to prior prices.

Oversold is a relative term. What one trader may view as an oversold asset, another may view as an asset that is on a downward trend.

That’s why doing your own research is important. Suppose that technical indicators are all saying that an asset is oversold, so the herd mentality kicks into gear and many investors begin buying the asset.

But if you research the asset using fundamental analysis, you’ll see the reason the asset is being interpreted as oversold is that the company is on a decline. Perhaps rumors are circulating that the company is headed toward bankruptcy or some similar bad news affecting stock price.

Doing your own research will help you avoid herd mentality and could therefore save you from making a bad investment.

You should keep up with information about the company whose assets you’ve purchased. And while you don’t need to be an expert in geopolitical affairs, if the company you’re invested in has operations outside of your own country, you should try to keep an eye on the political and business affairs of those regions, to make informed investing decisions.

2. Create a Trading Plan

A trading plan is designed to help you understand not only which stocks you should buy or sell but also when you should enter and exit a trade.

To create a trading plan, you should take note of:

  • Why you’re trading
  • What your goals are
  • What your risk appetite is
  • How much capital you have available to trade
  • Your own risk-management philosophy and rules
  • What time commitment you’re willing to make
  • Which markets you’d like to trade in
  • What your trading strategies are
  • How you’ll keep records of your trading activities

Your trading plan is distinct from your trading strategies, which clearly define how you intend to enter and exit asset trades. Trading strategies are highly individual, but a brief example would be something like buying a specific crypto asset once it reaches $1,000 and selling it once it reaches $2,500.

Trading plans help you avoid the potential pitfalls rooted in emotion by offering a blueprint for logical investing decisions. This blueprint creates parameters for what defines your ideal personal trade.

Benefits of a solid trading plan include:

  • An easier trading process because you’ve done a lot of the planning legwork up front
  • More logical and objective decision-making
  • Defined parameters for when you’re willing to cut losses or take a profit
  • Better discipline when it comes to trading
  • Increased room to improve your systems
  • A structured procedure for record-keeping
  • The ability to learn from past trading errors

Creating a trading plan can feel like a massive undertaking, but the payoff is exponential.

3. Keep a Journal

A trading journal goes hand in hand with your trading plan. This journal is a medium through which you document your strategies and trades, and it will help you figure out what’s working and what’s not.

While your trading plan should be free of emotion, your journal doesn’t have to be. You can document any emotions you experience during your trades as well as the rationales behind your actions and investing decisions.

You should always try to stick to your trading plan. If you deviate from it, you should document it in your journal. Write about why you did what you did and the outcome of your decisions.

If you tend to be impulsive, journaling before acting can be helpful.

Say you’re experiencing fear of missing out with regard to a specific stock. Even though it isn’t aligned with your trading plan, you want to enter a trade. Taking the time to write about your thoughts, your feelings and the potential consequences of your actions can help calm your emotions and strengthen logic and discipline.

4. Avoid Herd Mentality

As you connect with other investors, you will trade increasing amounts of information and advice.

It’s fine to listen to the people in your network and take stock of their advice. But you should always come back to your trading plan and stick to it with as much discipline as possible. Doing so will help you avoid following the herd and help you manage any fear of missing out.

5. Manage Your Risk Appetite

Everyone’s risk appetite is different, from those who are willing to make high-stakes gambles to those who overthink every step they take.

You should know what type of investor you are based on your trading style.

Four of the most common trading styles include:

Swing Trading

Swing traders are investors who hold onto positions over the course of several days to several weeks to take advantage of any medium-term market moves.

Position Trading

Position trading is when investors hold onto positions for weeks or months — or even several years — hoping they will become profitable in the long term.

Day Trading

Day trading describes traders who enter and exit same-day trades and rarely hold the same positions overnight.

Scalping

Scalping describes traders who enter and exit multiple trades per day, only holding these positions for either a few seconds or a few minutes, with the hope of making numerous small profits that will add up.

Knowing your trading style and incorporating it into your trading plan will help you determine your risk limit. This knowledge is critical because prices in the stock market are constantly changing and fluctuating.

The Key to Trading? Human Emotion

Understanding psychology is critical for identifying how human emotion plays a role in the stock market. The more you study and become acquainted with stock market psychology, the easier it will be for you to navigate the erratic nature of the stock market. Always remember thatsStock market behavior is influenced by human lives and emotions.

Frequently Asked Questions

Q

How much of trading is psychology?

A
Psychology and human emotion play major roles in trading. Although there are technical tools you can use to navigate the market, those tools do not interpret emotion and sentiment from traders, which is why understanding stock market psychology is so important.
Q

What two emotions move the markets?

A

The two major emotions that move the markets are fear and greed.

Q

How do you become a mentally strong trader?

A

Become a mentally strong trader by creating a thorough trading plan, keeping a detailed trading journal and regularly practicing self-discipline.

About Sarah Edwards

Sarah Edwards is a finance writer passionate about helping people learn more about what’s needed to achieve their financial goals. She has nearly a decade of writing experience focused on budgeting, investment strategies, retirement and industry trends. Her work has been published on NerdWallet and FinImpact.