Tuesday, October 7, 2008

Market Tops and Bottoms

The mechanics of the markets are based so much on psychology. Its a fact that the public buys at the top and sells at the bottom. This phenomenon can be traced back even to the Dutch Tulip bubble of the 1600s and has been repeated in the same behavioral pattern in every major market top and bottom of the past century.

The chart to the left displays an easy to understand spectrum of emotion in most all market cycles. As you take a look you can probably even admit that you have felt these emotions when you first started out trading in the markets, I know I did. Or if you have never traded then I'm sure you can correlate an event from your life into the visual you see here. Whether its that first time you took a risk with a new career venture or a serious relationship you had when you were young, you can probably see that most things in life can be emotional at nearly every stage.

So at the risk of sounding like a psychologist, or even worse, a philosopher; I will always stress that you must keep your emotions in check. This is especially important when trading in the markets. A famous quote from Warren Buffet states, "Be fearful when others are greedy, and be greedy when others are fearful".

So when everyone and their uncle is piling into some specific asset like there is no tomorrow then you either want to be selling it to them or just sitting on the sidelines. For example, oil anyone? In July 08 oil topped at $147/barrel and that was pure euphoria reminiscent to the dot-com bubble in 2000. The chart of oil went parabolic during the bubble. People thought oil and all commodities were going to the moon. 3 months later oil hit $65 . You do the math. The same can be said for being greedy when others are fearful. When the fear is so thick you can cut it with a knife and the markets are in full panic mode you want to be on the opposite side of this emotion. Capitulation happens when the weak hands just throw in the towel at whatever price they can get because the pain, both financial and emotional, is simply too great. Usually markets will overshoot the upside and the downside so be prepared for the market to surpass where you "thought" it was going as it surprises the masses once more.

If you can get a grasp on the market psychology of the crowd and do the opposite of what the crowd is doing then you will be in a much more favorable position to make money in the markets. The crowd is right during the trend but WRONG at both ends. This is true in any timeframe and can be applied to most anything that has a cycle. I have learned that being a contrarian in the markets can pay off very handsomely because stocks are like rubber bands or springs that can only stretch so far. Once supply and demand has been stretched in either direction, it usually comes back to a sense of normalcy due to the concept of mean reversion.

Its almost impossible to time the exact top or bottom in a market but thats why I let the charts tell me when the trend is done and a reversal is for real. Measuring market sentiment is just as important as technical or fundamental analysis. There are numerous indicators out there that measure this sentiment (VIX, put/call ratios, volume spikes, extreme newspaper headlines, investors surveys, mutual fund inflows/outflows, etc.). But more often than not you will see it in the extremity of the crowd's raw emotion when they are involved in tops and bottoms.

Hopefully after reading this, you will have a better idea of market psychology and not get caught on the wrong side of the trade. :)

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