The principles of market psychology underlie every technical indicator, so a good understanding of crowd behavior is crucial to your comprehension of the fundamentals of certain technical indicators. The psychology of the market is hard to predict, but several trusted indicators make it easier for traders and investors to better estimate directional changes based on shifting sentiment.

Here, we look at several technical indicators that are driven by the psychology of the market.

MACD

The moving average convergence divergence (MACD) is simply a tool that measures shifts in consensus from bullishness to bearishness, and vice versa. Extending the basic MACD to a deeper level, we find the MACD-histogram, which is actually a tool for determining the difference between long-term and short-term consensus of value. The measure tracks the difference between the fast MACD line (short-term consensus) and the slow signal line (longer-term consensus).

The Directional System

The directional system was developed by J. Welles Wilder, Jr., as a means of identifying trends that are strong enough to be valid and useful indicators for traders. Directional lines are constructed to determine whether trends are bullish or bearish: When a positive directional line is above the negative line, bullish traders possess greater strength (and a bullish signal is given). The opposite situation indicates bearishness. More telling is the average directional indicator (ADX), which rises when the spread between the positive and negative lines increases. When the ADX rises, profitable investments are getting ever stronger, and losers are getting weaker; furthermore, the trend is likely to continue.

Momentum and Rate of Change (RoC)

Momentum indicators measure changes in mass optimism or pessimism by comparing today’s consensus of value (price) to an earlier consensus of value. Momentum and RoC are specific measures against which actual prices are compared: When prices rise but momentum or rate of change falls, a top is likely near. If prices reach a new high but momentum or RoC reach a lower top, a sell signal is realized. These rules also apply in the opposite situation, when prices fall or new lows are reached.

Smoothed Rate of Change

The smoothed rate of change compares today’s exponential moving average (average consensus) to the average consensus of some point in the past. The smoothed rate of change is simply an enhanced version of the RoC momentum indicator—it is intended to alleviate the RoC’s potential for errors in determining the market’s attitude of bullishness or bearishness.

Williams %R (Wm%R)

Wm%R, a measure focusing on closing prices, compares each day’s closing price with a recent consensus range of value (range of closing prices). If on a particular day, bulls are able to push the market to the top of its recent range, Wm%R issues a bullish signal, and a bearish signal is issued if bears can push the market to the bottom of its range.

Stochastics

Similar to Wm%R, stochastics measure closing prices against a range. If bulls push prices up during the day but cannot achieve a close near the top of the range, stochastic turns down, and a sell signal is issued. The same also holds true if bears push prices down but cannot achieve a close near the low, in which case a buy signal is issued.

Relative Strength Index (RSI)

RSI also measures market psychology in a fundamentally similar way to that of Wm%R. RSI is almost always measured with a computer, typically over a seven- or nine-day range, producing a numerical result between 0 and 100 that points to oversold or overbought situations; the RSI, therefore, gives a bullish or bearish signal, respectively.

Volume

The total volume of shares traded is an excellent way in which to ascertain the psychology of the market. Volume is actually a measure of investors’ emotional state: While a burst of volume will cause sudden pain to poorly-timed investments and immediate elation for those who made wise investments, low volume will likely not result in a significant emotional response.

The longest-lasting trends generally occur when emotion is the lowest. When volume is moderate and both shorts and longs do not experience the roller coaster ride of emotion, the trend can reasonably be expected to continue until the emotion of the market changes. In a longer-term trend such as this, small price changes either up or down do not precipitate much emotion, and even a series of small changes occurring day after day (enough to create a major, gradual trend) will generally not generate severe emotional reactions.

In the case of short selling, a market rally may serve to flush out those individuals holding short positions, causing them to cover and subsequently push the market higher. The same principle holds true on the flip side: when the longs give up and bailout, the decline pulls more poorly timed investments with it. At the most fundamental level of market volume, both short and long investors who lose money, who collectively exit their positions, are the primary drivers behind significant volume trends.

Frequently Asked Questions

How do technical indicators and market psychology fit together?

Technical analysis looks at price charts to find patterns that indicate trends and reversals. Technicians believe that these patterns are the result of market psychology. A price chart, then, can be thought of as a graphical representation of emotions such as fear, greed, optimism and pessimism, and human behavior, such as herd instinct. Price charts illustrate how market participants react to future expectations.  

What do the MACD and ADX reveal about market sentiment?

The moving average convergence divergence (MACD) demonstrates the shift in consensus between bullishness and bearishness. The directional system uses directional lines to indicate whether trends are bullish or bearish, including the average directional indicator (ADX).

What do RoC and Williams %R reveal about market sentiment?

Momentum and the Rate of Change (RoC) demonstrate sentiment and the likelihood of tops or bottoms forming by looking at current price levels versus an earlier consensus of price. The smoothed rate of change looks at the current average consensus versus the consensus of a previous point.

Williams %R assesses closing prices versus a recent range of closing prices; stochastics look at closing prices versus a range; the relative strength index (RSI) looks at prices over a seven- or nine-day range.

How can volume indicators uncover trader psychology?

The total volume of shares speaks to the so-called conviction and emotional state of traders, with moderate volume often correlated to less volatility and higher volume often tied to greater volatility. Volume also helps confirm the legitimacy of a trend and identify support and resistance levels. For instance, if a price has fallen to a resistance level and volume increases without much price movement, it can indicate consolidation, often interpreted as market indecisiveness. 

Technical analysis is a useful tool that allows a trader to anticipate certain market activity before it occurs. These anticipations are drawn from previous chart patterns, probabilities of certain trade setups and a trader’s previous experience. Over time, anticipation can eliminate the need for over-analyzing market direction as well as identifying clear, objective areas of significance. It isn’t as hard as it sounds. Read on to find out how to anticipate the direction of a market trend and follow it through to a profit.

Anticipation vs. Prediction

Technical analysis is often referred to as some sort of black magic used to time the market. However, what many outside of the financial world don’t realize is that traders don’t try to predict the future. Instead, they create strategies that have a high probability of succeeding—situations where a trend or market movement can be anticipated.

Let’s face it: if traders could pick tops and bottoms on a consistent basis, they would be spending more time out in a Ferrari F430 convertible enjoying a nice stretch of highway than they would hunched over their computer screen. Many of you have probably tried picking tops and bottoms in the past and are through with the game. Perhaps you’re already following in the footsteps of many professional traders who attempt to find situations where they can anticipate a move and then take a portion of that move when the setups occur.

The Power of Anticipation

When deciding on whether or not to make a trade, you likely have your own strategies for entering and exiting the market. (If you don’t, you should decide on them before clicking the buy/sell button.) Technical traders use certain tools such as the moving average convergence divergence (MACD), the relative strength index (RSI), stochastic, or the commodity channel index (CCI), along with recognizable chart patterns that have occurred in the past with a certain measured result.

Experienced traders will probably have a good idea of what the outcome of a trade will be as it plays out. If the trade is going against them as soon as they enter and it doesn’t turn around within the next few bars, odds are that they weren’t correct on their analysis. However, if the trade does go in their favor within the next few bars, then they can begin to look at moving the stops up to lock in gains as the position plays out. (“Bars” are used as a generic term here, as some of you may use candlesticks or line charts for trading.)

The figure below is an example of a trade taken on the British pound/U.S. dollar (GBP/USD) currency pair. It uses an exponential moving average (EMA) crossover to determine when to be long and when to be short. The blue line is a 10-period EMA, and the red is a 20-period EMA. When the blue line is over the red, you are long, and vice versa for shorts. In a trending market, this is a powerful setup to take because it allows you to participate in the large move that often follows this signal. The first arrow shows a false signal, while the second shows a very profitable signal.

This is where the power of anticipation comes into play. The active trader typically monitors open positions as they play out to see if any adjustments need to be made. Once you had gone long at the first arrow, within three bars, you would already be down more than 100 pips. By placing your stop at the longer-term trend moving average, you will probably want to be out of that trade anyway, as a potential reversal might be signaled.

On the second arrow, once you were long, it would only take a few days before this trade went in your favor. The trade management comes into play by trailing your stop up to your personal trading style. In this case, you could have used a close under the blue line as your stop, or waited for a close underneath the red line (longer-term moving average). By being active in position management—by following the market with your stops and accepting them when they are hit—you are far more likely to have greater returns in the long run than you would be if you removed the stop right before the market blasted through it.

The above figure illustrates the difference between anticipation and prediction. In this case, we are anticipating that this trade will have a similar result based on the results of previous trades. After all, this pattern was nearly identical to the one that worked before, and all other things remaining equal, it should have a decent enough chance to work in our favor.

So did we make a prediction about what would happen in this case? Absolutely not. If we had, we wouldn’t have put our stop-loss in place at the same time the trade was sent. Unlike anticipation, which uses past results to determine the probability of future ones, making an accurate prediction often involves a combination of luck and conjecture, making the results much less, well, predictable.

Limited Emotion

By monitoring the trade(s) in real-time and adjusting accordingly, we ensure that emotions aren’t able to get the better of us and cause a deviation from the original plan. Our plan originated before the position was taken (and thus had no conflict of interest), so we use this to look back on when the trade is active.

Since we already have a plan that involves no emotion, we are able to do as much as possible to stick to that plan during the heat of battle. Make a point of minimizing emotion, but not completely removing it. You’re only human, after all, and trading like a robot is nearly impossible for most traders, no matter how successful they are. We know what the market will look like if our anticipation both does and does not occur.

Therefore, by using the chart above, you can see where the signals clearly did and did not work as they were happening based on the price action of each bar and its relation to the moving averages. The key is to take ownership of your trades and act based on your trading plan time and time again.

The Bottom Line

Objectivity is essential to trading survival. Technical analysis provides many views of anticipation in a clear and concise manner, but as with everything else in life, it doesn’t provide a guarantee of success. However, by sticking to a trading plan day in and day out, our emotions are minimized and we can greatly increase the probability of making a winning trade. With time and experience, you can learn to anticipate the direction of your trades and improve your chances of achieving better returns.