What is market psychology and how can it benefit businesses?
By Indeed Editorial Team
Published 11 November 2022
The Indeed Editorial Team comprises a diverse and talented team of writers, researchers and subject matter experts equipped with Indeed's data and insights to deliver useful tips to help guide your career journey.
Having foresight of the stock market is vital for traders, analysts and business owners. Psychology is one factor that investors can consider, looking at the current and past sentiment in the market to determine how it may change. As a study of behaviour, market sentiment helps to predict periods of growth and slower times in the market alongside other indicators. In this article, we answer the question, 'What is market psychology?, provide key indicators and offer advantages of using sentiment for businesses.
What is market psychology?
The answer to, 'What is market psychology?, is a valuable insight that covers a broad overview of trends. This includes various behaviours and sentiments happening amongst people, companies and prices within the market. Financial and media analysts often use psychology to explain a market movement that isn't explainable through other physical metrics, such as fundamental analysis, which compares company financials within an industry. As market sentiment doesn't use solid facts and numbers, it's harder to use than fundamental analysis to identify changes in the market.
In this kind of psychology, a financial professional or trader looks at the aggregate of market participants to understand the overall sentiment within that market. The current psychology of investors in the market can significantly impact the economy's health and indexes. For instance, if investors lose confidence in how healthy the economy is, or there is a large amount of fear in the market, this may directly affect market prices. Keeping track of market sentiment is critical to keep on top of those changes and prevent losing money.
Technical indicators for market psychology
Technical indicators are numbers or other figures that analysts use to look at trends in the market. By examining the flow of these numbers, you can gauge the current market sentiment and gain insight into potential future behaviour. Examples of technical indicators for market sentiment include:
On-balance volume, or OBV, is a running total single figure that rises and falls each day based on the prices of the previous day. As a leading indicator, OBV provides insight into whether the market is likely to rise and fall before the actual prices.
A high figure suggests a bull market where prices increase, the economy is more stable, while a low number indicates a bear market with more volatility and declining values. If the OBV total looks different from actual prices on the market, this suggests that the emotion of the market, the value, isn't consistent with the exact prices, resulting in a potential shift.
Accumulation/distribution, or A/D, is a leading indicator that looks at volume alongside the closing and opening prices on the market. Positive A/D indicates higher prices at closing than opening, while negative A/D suggests the opposite. A/D indicators provide insight into the behaviour of more amateur traders alongside professional traders, giving a better overview of the market with amateurs trading first time while professionals trade later on. This process provides insight into psychology for both groups of people, helping to make decisions about the state of the market.
Open interest looks at the futures market, adding the total of long and short contracts within the market on that day and corresponding that information with the absolute value of open interest. Open interest reflects the psychology of the market when it deviates outside of its norm, providing valuable information about how confident bulls and bears are in the market. This information is helpful for businesses to identify where behaviours are within a trend, with falling open interest suggesting the end of a trend with the loss of a contract.
The volatility index
The volatility index (VIX), also known as the fear index, determines the market's state. A rise in the VIX suggests an increase in levels of fear, with a steeper increase when portfolios are close to market bottoms. This measure provides insight into the desires of investors, which helps determine market sentiment and understanding of when the market is likely to change. High levels of fear or overconfidence can indicate whether a market is unsustainable, which offers clues into whether it's worth investing in.
Why is market psychology important?
Market psychology is an essential consideration for analysts and traders. It provides valuable information about the patterns within a market and can help individuals or businesses decide on the ideal course of action using their forecasts. As most market participants are human, as opposed to AI or automation, it's possible to look at crowd behaviour to identify the evolution and direction of trends. For instance, examining how markets have changed with behaviour and attitudes in the past may help identify changes that may happen in the future.
While sentiment psychology isn't an exact science, it works alongside other indicators to provide insight into whether demand or supply is more significant. This basic information helps to know whether prices rise or fall, allowing businesses or individuals to buy at low prices and sell when the value is higher. Many traders follow other established analysts or professionals in trading actions. This can lead to trends accelerating and breakouts occurring that result in a bandwagon effect. Understanding how and why this happens is valuable to anticipating patterns and preventing losses.
How can businesses take advantage of market sentiment?
Market sentiment is valuable for businesses looking to invest or companies that make investments on behalf of their clients within the finance industry. For instance, sentiment psychology provides information about the market's current state and helps investors narrowly predict changes and make quick decisions to buy or sell. Some ways businesses can take advantage of market sentiment psychology include:
Deciding when to invest
Companies that invest in the market can utilise information from market sentiment indicators to decide when the ideal time is to spend money. Alongside fundamental indicators, looking at general market sentiment and how that is likely to change helps identify when you can make the most potential profit. Knowing when to invest successfully is vital for profiting from the money you put into the market, allowing you to make continual investments at the correct times.
Businesses that support clients in investing can learn about market psychology and use that insight to provide important information about the market to people that would like to invest. For instance, a financial advisor may examine psychology on behalf of a client, providing them with a report on what the market is likely to look like in upcoming days and weeks. Accurate guidance helps build trust in the business and encourages clients to return for more advice.
Identifying upcoming trends
Identifying upcoming trends is valuable for businesses to know when to sell their shares within the market before experiencing losses. For instance, if psychology suggests that there is likely to be a steep decline in value shortly, this helps to identify that trend early and get out before the market changes. Identifying trends is also helpful for planning future investments by looking at patterns that have occurred frequently within the market to determine what month or period would be ideal for buying and selling investments.
Understanding the typical process of the market
Market psychology is vital in understanding how the market works, particularly the human element of trading that is less of a consideration in practical techniques or fundamental indicators. By understanding typical market processes, inclines and declines, companies are ready to invest using existing knowledge instead of figuring out the process as they go.
Spotting unsustainable growth
A strong understanding of psychology can make it easier to spot unsustainable growth in the market, which is vital to understand when to invest and when to avoid joining in with other traders. For instance, learning psychology can help identify where the market value is likely to fall, providing businesses with the foresight to know when it's too late to invest without significant risk. Knowing what a bandwagon effect looks like in market sentiment can be beneficial for avoiding amateur mistakes, such as making long-term investments in trends that are likely to be short-term before failing.
Offering expert analysis as a subject specialist
The ability to read the markets properly and understand the behaviour of traders can help businesses position themselves as brand experts within their particular niche. For example, a company that provides financial advice to potential investors may dedicate time to researching psychology, allowing them to create tutorials, blog posts and social media content that reflect their expertise. This knowledge and insight are valuable for brand positioning, encouraging potential customers to connect with the business and seek help from industry professionals.
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