The Psychology of Price Movement

My objective for this chapter is to break down and analyze the dynamics and psychology of price movement, first, at its most fundamental level, that of the individual trader; then I will broaden the explanation by examining the behavior of traders collectively as a group. I want to demonstrate that, if you understand the psychological forces inherent within traders' actions, you can easily determine what they believe about the future by just observing what they do. Once you know what traders believe about the future, it's not that difficult to anticipate what they are likely to do next, under certain circumstances and conditions.

What is really important about this insight is that it will help you to understand the distinctions between wishful thinking and the actual potential that exists for the market to move in any given direction. You will be learning to let the market tell you what to do by understanding the forces behind its behavior and then learning to differentiate between pure, uncontaminated market information and how that information is distorted once it starts doing something to you.

The most fundamental component of the markets is traders. Keep in mind that traders are the only force that can act on prices to make them move. Everything else is secondary. What makes a market? Two traders willing to trade, one wanting to buy and one wanting to sell, who agree on a price and then make a trade.

What does the last posted price represent? The last posted price is what someone was willing to pay and what someone was willing to sell for at the moment the two traders agreed on the trade. It reflects an agreement in present value between those traders acting at that price.

What is the bid? A trader announcing the price at which he is willing to buy. What is the offer? A trader announcing the price at which he is willing to sell. How do traders make money? There are only two ways to play this game to make money. To buy at a price you believe is low relative to where you can sell it back at some future point in time. Or to sell at a price you believe is high relative to where you can buy it back at some future point in time.

Now, let's take a look inside the pit to see what has to happen for prices to move off equilibrium and how this will tell us what traders believe.

98-18 The offer, sellers attempting to sell high.

98-17 Equilibrium, the last price.

98-16 The bid, buyers attempting to buy low.

Since the only object to trading is to make money we can assume that a trader will not knowingly enter into a trade believing he is going to lose. And for a trade to exist requires two traders who agree on a price. However, from the moment two traders agree to the trade, they are both subjecting themselves to market risk. In other words, the next tick is going to make one of them a winner and the other a loser. Since we know that both traders want to win and neither trader wants to lose, we can assume that both traders have completely opposite beliefs about the future value of the contract. So for two traders to agree on a price and make a trade, they have to have diametrically opposing beliefs about the future. The buyer believes he is buying low relative to where he can sell back at some point in the future, and the seller believes he is selling high relative to where he can buy back at some point in the future.

If the next tick is going to make one of them a winner and one a loser, we can assume that neither one of them believes he is going to be that loser. If the seller believed the next tick was going to be up, why wouldn't he have waited to sell it higher? The same is true for the buyer. That is the object of the game and the only way to make money. Basically what we have is a situation where two opposing forces are clashing; both believe they are right about the future, and only one side can profit at the direct expense of the other.

If the last price of a bond future was 99-14, what has to happen for the price to move to 99-15? Very simply, some trader has to be willing to bid and pay higher than the last price. This means that relative to the last posted price, he has to be willing to do the opposite of buying low. Any trader or group of traders willing to buy high or sell low relative to the last posted price is very significant for several reasons.

First, a trader willing to buy high or sell low instead of buy low or sell high has to have a stronger conviction in his belief in the future value, even if his conviction is out of panic. Second, he is making the last price a bottom. Third, he is aggressively taking the initiative and is making losers out of everyone who sold at the last price and deepened the losses of those who sold lower. Fourth, he is creating price movement that can possibly gather momentum if other traders perceive the new price as low relative to the future. This will also be true for the trader who is paying up to liquidate a position. On the other hand, the seller on the other side of his trade is being lured into the market by the attractiveness of the high price at which he can sell. He believes he is getting the edge. He is in fact selling high, but he is not creating movement or much of a possibility for momentum in his direction. He is picking a top and waiting for something to happen, hoping it won't go any higher.

Now, what do the actions of the two traders represent about the market in its collective form? First, this trade tells us that nobody had a strong enough belief in the future value to risk selling it to him at the last price or lower. Second, nobody was aggressive enough to want to enter the market short or liquidate an existing long position by offering to sell it at the last price or lower. A consummated trade at the next higher level creates a new equilibrium. This new equilibrium makes winners out of all the buyers at the last level and losers of all the sellers at the last level.

All of the losers at the last price level or lower would have to maintain a belief in the future value to stay in their position or demonstrate a conviction in this future value by adding on to their positions. This is because each new level the price is bid up makes it that much more attractive to them. If they believed it was high at lower levels, at each higher level, it's even a better trade. However, at the same time, each move the market makes against their position invalidates the sellers' expectation of future value. Each move clearly demonstrates that the sellers are passive, that the buyers are the aggressors, and that the buyers have a greater potential to move the market in their direction.

The fact that buyers are aggressively bidding up the price and paying more and more again tells the observer something. It tells him there aren't enough sellers to meet the buyers' demand for a trade at each new price level. If there is a limited supply of sellers, those traders wanting to buy will have to compete among one another for the limited number of sellers available willing to take the other side of the trade.

]ust observing this price action tells you that at the present moment, the momentum is in favor of the buyers. Prices would not be bid up unless there were fewer sellers in relation to the buyers. If traders continue to pay more and more, the price gets further away from old sellers. Eventually their belief in future value will erode, and one by one the sellers will join the existing pool of buyers competing against one another for the fewer and fewer traders willing to sell. As long as the ratio between buyers and sellers remains as I have just described, there is very little potential for downward price momentum to be established.

Now what will start to tip the balance to cause the market to fall back? For one thing, old buyers will eventually take profits. When they do, they will be joining the existing pool of sellers, thereby increasing the number of traders available to sell. If a move gathers enough steam, it can become similar to a frenzied shark feeding. Eventually, prices will be driven way out of line with some economic factors other traders perceive as relevant compelling them to enter the market in the opposite direction. If these new traders enter with enough force, it will likely cause old buyers to panic adding to the downward momentum.

Maybe you can visualise this back and forth action. When there are more sellers than there are buyers to take the other side of the trade, the balance will be tipped. Sellers will then aggressively offer to sell lower than the last price, responding to what they perceive as a limited number of buyers to take the other side of the trade.

All price movement is a function of group behavior. The market prices flow back and forth like a tug of war between those who believe and expect the market to go up—and consequently buy— and those that believe the market will go lower—and consequently sell.

If there is no balance between the two forces, one side will gain dominance over the other. As prices move farther and farther away from the weak group, the emotional pain of admitting they are wrong will be in direct conflict with their need to avoid losses. Eventually, one by one they will lose faith in their position and liquidate their trade, adding to the momentum of the dominant force.

The prevailing force will continue to dominate until there is a general perception that prices have gone too far and are out of line with other related factors. The members of the dominant force will have to switch sides to liquidate their positions, creating momentum in the opposite direction.

As individuals, if we do not have the strength actually to move prices in the direction we would most benefit from, then the next best thing is to learn to identify and align ourselves with the side that has established dominance until the balance shifts and again align ourselves with the side establishing the strength.

As prices move back and forth in this tug of war, it creates an ebb and flow that is easily identifiable in price charts or point and figure charts. These charts will show us in graphic terms how the forces interact and counteract. They are a visual representation of traders' beliefs in the future and the intensity in which they have been willing to act on those beliefs.

If, for example, a market has been making consistently higher highs and higher lows, to determine what is likely to happen next, ask yourself the following questions:

1. What kind of price action will sustain the buyers' beliefs that they can make more money?

2. When are sellers likely to come into the market in force?

3. Where are old buyers likely to take profits? Where are old sellers likely to lose faith in their positions and bail out?

4. What would have to happen for buyers to lose faith? What would have to happen to draw new buyers into the market?

You can answer all these questions by identifying certain significant reference points where buyers' and or sellers' expectations are likely to be raised and where they are likely to be disappointed if they don't get their way.

Actually, all this works quite nicely in the typical market behavior patterns and price formations with which we are all familiar. So, we are going to look at the psychological makeup of some of these typical patterns. However, before we do, I want to cover a few more definitions,

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