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The Psychology of Trading--The Mind of the Market
What is the
purpose of the foreign exchange market, or any trading market for that matter?
It seems like a simple question. The purpose is to
facilitate exchange, to permit participants to sell and buy commodities,
equities or futures and to trade one currency for another. But that simple
definition disguises a world of complexity.
If two parties wish to
conduct an exchange, of one currency for another or of an equity or bond for a
sum of cash the first question is at what price should the transaction take
place? In the consumer world, in a supermarket or department store, the price
is predetermined by the seller and is rarely changed. The purchaser measures
their need for the item against the price asked and makes the decision to buy or
not. There is little discussion and no bargaining over the price. The consumer
does not say the price will be lower in a few minutes; I will wait until then to
make my purchase. Likewise the seller does not normally remove the item from
sale expecting the price to rise in a few days. This basic function of price
determination or price discovery is essentially different in a trading market. A
market transaction differs from a consumer purchase because both the seller and
the buyer continually adjust their price expectations to information flowing out
from the market to participants and into the market from outside sources.
Market participants, in theory, incorporate all available
information into the prices at which they buy and sell. This is called the
perfect information assumption of efficient markets theory. Each participant
in the market acts as an independent decision maker. Each decision influences
the overall market and price level. The market or to be more precise, the price
level of a market traded item, is, at any time, the amalgamation of all the
price decisions made by all market participants.
On this one topic--
what should the market price be-- the market reflects the decisions of its
participants. In foreign exchange markets the decision makers are the traders,
all of them, from the smallest retail trader to the largest hedge fund. But how
do 1,000 or 10,000 individual decisions, made in ignorance of each other become
a market price? How do we know that the price of this mass decision accurately
reflects the wishes of 10,000 people?
If three market participants want
to buy a commodity at a certain price level and 50 want to sell, the market
price for that commodity will fall. But what actually happens? The three bids
in the market will be filled but that leaves 47 sellers. If no other bids enter
the market the sellers will begin to react to the lack of bids by adjusting
their offering prices down, displaying lower and lower prices until buyers enter
bids and a trade is made at the new lower level. The sellers and the buyers
incorporated the information flowing out of the market, the temporary lack of
bids, into their price expectations producing a new price.
would perhaps say âthe market fell today â. But a market is not an entity. It is
only a method for coordinating the decisions of its participants. What occurred
is that each participant in the market reacted to the information coming to them
from within the market and their combined reaction is the movement in price. It
appears to an observer that the âmarketâ traded lower because the thousands of
individual decisions that comprise the movement are not given separate life.
Only the mass decision, âthe priceâ, is represented.
of the decision making power of markets and of
the âmarketâ a living entity is reflected in the terms we use to describe
the price action. We often sayâ âthe market reacted badly to the newsâ or âthe
market took profit todayâ. We personify the market and its behavior. Of course
we know that there is no âmarketâ somewhere below the pavement on Wall Street
making the decisions for the stock exchange. But the common use of this
âmarketâ shorthand tends to obscure what is the most important psychological
point in understanding market behavior. Namely, that the âmarketâ is a picture
of the thoughts of its participants, the market is a snapshot; it is a mass
We can remove some of the sense of mystery from the term, âthe
marketâ when we remember just who or what âthe marketâ is. The answer is plain enough, to paraphrase the
comic strip character Pogo, âwe have met the market and he is usâ. The logic,
analysis and fear that motivate market behavior have their source within the
mind and psychology of market participants, that is, within each of its
When analyzing market behavior it is instructive to keep this
very simple fact in mind. The market is a mass mind focused on one topic,
price. It represents the momentary culmination all of the external and internal
inputs that bear on the price of the traded commodity as ranked by the traders
in that market. But even if the method by which the market arrives at a
decision is obscure, its ingredients are notâthey exist in the analysis,
outlook, aspirations and psychology of
each individual trader.
Since the market is a reflection of the minds of
its participants and a traders job is to make profits it follows that a traderâs
primary task it to match his decision to that of the mass, to anticipate and
mimic the decision of the market. There should be no mystery in âthe marketâ
even when it thrashes our positions, for the chances are that the operating
logic was known to most traders. Known and rejected by the losing minority of
traders but embraced by the majority.
When our trades lose money,
whatever the logic of the position, we can be sure we were not alone. But we can
equally be sure that we were in the minority. Had we been in the majority the
market would have performed as we had anticipated. The market decision process
is that simple. It is a matter of putting our assumptions in line with the
majority as often as we can. The most effective tool to achieve that is our own
empirically tested market psychology. We are the market, if only we can let the
mass mind of the market and not our individuality rule our decisions.
The market does not reward iconoclasts.
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