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Understanding Market Sentiment

In one of the most popular books about crowd psychology, The Crowd: A Study of the Popular Mind, the author Gustave Lebon claimed “that an individual immersed for some length of time in a crowd soon finds himself – either in consequence of magnetic influence given out by the crowd or from some other cause of which we are ignorant – in a special state, which much resembles the state of fascination in which the hypnotized individual finds himself in the hands of the hypnotizer. This ‘special state’ mentioned by the author is often characterized as fear and greed in the financial markets.

Successful trading requires the right trading system(s), and knowledge of basic trading strategies. However, the human side of trading is equally important.

Traders’ psychological and emotional outlooks often impact the market. As a trader, comprehending the ‘special state’ of mind of most market participants is crucial, just like the ability to recognize your own thoughts and feelings vis-a-vis the market.

Temet Nosce (Know Thyself)

Having a feel and understanding of the psychological components that can affect the market helps you in many ways. The more you can read your ‘opponents’ thoughts and feelings, the better you can react to their moves or take advantage of them. More importantly, a deeper awareness of your own feelings and thoughts enables you to trade at your absolute best!

There are many tools to measure and calculate the overall market sentiment, like the Fear and Greed Index by CNN. But there is hardly a tool that can help traders with the fear and greed trap of the market (apart from the psychological self-help rhetoric).

Like Gustave mentioned, the individual seemingly often finds himself in the hands of the hypnotizer. A pilot study done by Lo and Repin (2002) shows that even the most seasoned trader exhibits significant emotional response during market events (price volatility or intra-day breaks in trends). Also, in a series of case studies, Steenbarger (2002) shows evidence linking emotion to individual trading performance.

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