Market Sentiment (Part 2):
- The Bandwagon Effect -
The bandwagon effect is the observation that people often do things because many other people are doing the same things. Also called the herd instinct, it can profoundly affect the behavior of teen-agers. Without examining the merits of a subject, people tend to "follow the crowd."
People enjoy being on the winning side. Some people vote for those candidates or parties who are likely to succeed (or are proclaimed as such by the media), thus increasing their chances of being on the 'winner's side' in the end.
The bandwagon effect also arises when people's preference for a commodity increases as the number of people buying it increases. This interaction potentially disturbs the normal results of the theory of supply and demand, which assumes that price and preference are independent.
The technical analyst can take advantage of the bandwagon effect by A) Entering a position during the crowd produced momentum and B) Closing the position before the effect disipates.
- Mania and Panic -
Manic - An excessively intense enthusiasm, interest, or desire.
Panic - A sudden, overpowering terror, often affecting many people at once. A sudden widespread alarm resulting in a rush to sell.
The market is naturally in a constant state of fluctuation between the two states. Greed and fear, euphoria and depression, mania and panic, happen everyday in the market. The good news for the trader is that technical analysis is the cure for the bi-polar condition of the marketplace. By staying unemotional and simply graphing the swings of the crowd, the technician can maximize trading opportunities.
Two words are guaranteed to get a crowd moving. These two words are Fire! and Free! Either will cause a stampede. It is the inherent nature of people to flee from danger, and to flock to a bargain. Especially if an expert, or someone we esteem as having authority, validates the announcement.
When someone we consider to be knowledgeable or accomplished states that a stock is a "gem", or a states the current price is a "steal", the herd mentality kicks in and folk are caught up in the euphoria of the moment. In the same way, if someone we believe to have insight warns that a dangerous situation at hand, we are ready to take flight.
As a technical trader you want to be sensitive to what the crowd is doing, with becoming emotionally involved in the passion of the crowd itself. There is a vast difference between useful information and incorrect information. Add the possiblilty of disinformation, and intentionally misleading information, and the average trader is likely to be tossed to and fro by the waves of greed and fear.
The technical analyst is practically immune to all of this, as the chart tells us all we need to know. What the news is, where it came from, and how it was disseminated, have little or no bearing on our decisions. The chart will tell us how people are reacting to all of the above, and THAT is what is going to move the PPS (price per share) of a stock.
Let me state that again, as it is extremely important. The chart does NOT tell us whether a piece of news or a PR was good or bad. It tells us whether people perceived it to be good or bad. I cannot tell you the number of times that I have seen a long awaited piece of news hit the streets, only to watch the pps of the stock fall off that day. A quick read of the boards will show that people are perplexed, even the 'leaders' are at a loss when grappling with WHY the expected run never materialized. While all that postulating is going on, the chartist is looking at the MA's, checking the trendlines and support points, and calculating how much longer it will take for the remaining fear and depression to get worked out of the market.
- Accumulation and Distribution -
Most of the time, one or the other is occuring and there are several indicators that will help us to discern which. BUY during accumulation and SELL during distribution. (we'll talk specifically about dips later)
Every trade you make is either an accumulation or distribution of shares. There are four possible actions associated with trading. You and everyone else are either:
1. Entering a position [buy]
2. Adding to a position [buy]
3. Reducing a position [sell]
3. Closing (squaring) a position [sell]
When lots of people have jumped on the bandwagon it becomes too heavy for the horses to pull any further up the hill. When it can no longer move up...it must either park and rest and rebuild its strength, or roll back down the hill. If enough people believe there are better days ahead, the wagon will pull to the side. Some folk will get off, some folk will get on, and some folk will stay on. If people begin to panic at the thought of rolling back down the hill and start jumping off, two things can happen. The wagon can indeed plummet driverlessly back down the hill, or savvy investors can regain control and the lightened load will enable the horses to surge back up the hill, attaining even greater heights.
- 4 reasons position are reduced or squared -
1. People believe that the move is exhausted.
2. People have met a goal or target. [profit or stop loss]
3. People have reached the end of a time period or limit. [week, year, etc]
4. People need the capital to trade another security.
All of this plays into how the t/a uses the indicators to establish buy and sell targets. As we begin our study of indicators the backdrop of 'market sentiment' will play a huge part in our interpretations and calculations. For example, one of the reasons that the use of support/resistance points is effective is because the 'slowing action' of the pps at those points provides a opportunity for people to enter, add, reduce, or square a position.
If you buy a stock at $1 and it runs to $2 then pauses for a few days [for whatever reason] you naturally begin to consider one or more of the four reasons for either reducing or closing your position.