Friday, May 1, 2015

Micropsychology of the Markets

Like the Roman god Janus, trading psychology has two faces: one turned toward
traders and their processing of market events; the other gazing upon the market and the
sentiment of the crowd. In one incarnation, trading psychologists analyze the trader; in
the other, they evaluate the market.
While many traders in the stock indexes are intraday participants, closing out
positions by the end of the day, the majority of sentiment/market psychology tools are
computed at best on an end-of-day basis. Here I’m thinking of such standards as put/call
ratios, surveys of investor/trader sentiment, and money flows into various market sectors.
By the time such macro measures of trader psychology are disseminated, the trade is over
for the active participant.
My experience is that successful traders are exquisitely sensitive to moment-tomoment
shifts in market psychology. They seem to be able to identify the ebb and flow
of greed and fear within the trading day by attending to subtle market cues. What micro
events could they be looking at? Are there measures of market micropsychology that
could inform decision-making among active traders?
Let’s consider an analogy from my book. Psychotherapists pace themselves by
“markers” of client emotional processing, timing when they will comfort an afflicted
person and when they will afflict that individual’s comfort. I might notice, for example,
that—in the midst of discussing a humiliating incident from the past—the client makes a
pained face and shifts positions in her seat. Later, when I call attention to the woman’s
failing, abusive marriage, she makes the same face and turns slightly from me. “Are you
feeling ashamed to discuss your marriage with me?” I might ask gently. “Does it feel
like talking about your past all over again?” The subtle cues of facial expression and
body posture alert me to the psychological reality that the woman’s marriage is activating
excruciating memories of her past, keeping her trapped in distress.
Markets communicate similar signals to the perceptive trader, sometimes on a
minute-by-minute basis. Each market day is a narrative written in chart form, detailing
the hopes realized and dashed amidst the struggles of bulls and bears. Consider the
following scenarios:
* After a market move that falls within the previous day’s extremes, volume
suddenly dries up and the trade becomes highly non-volatile;
* Thousands of contracts trade at the offer price, with 800 more stocks
trading at the offer than at their bid. Upon falling back, price returns to
that level, but now only a few hundred contracts trade there and barely
more stocks trade offer than bid.
* As price moves to new lows after an extended downswing, option
participants suddenly begin to snap up calls, driving the intraday put/call
ratio to new lows.
* During a selling episode in the S&P eminis, traders are bidding up
contract prices in the more volatile Russell and semiconductor indices.
* An economic report comes in much weaker than expected and stock
indices drop immediately, but then quickly return to their original range
amidst choppy action in the interest rate and currency markets.
In each of these situations, short-term behavioral cues of traders are informing the
perceptive trader about the market’s micropsychology. As with my therapy client, we
can make reasonable judgments about the market’s “state of mind” by detecting patterns
in the market’s behavior.
Since 2003, two important events have occurred in the stock indexes:
1. Volume in the Merc e-mini products has expanded greatly. Where hundreds of
contracts once traded at various price levels, we now see thousands trade.
Recognizing this, the Merc increased its maximum order size from 500 to 1500
early this past year.
2. Volatility in the indexes has contracted greatly. The option-derived volatility
index (VIX) has dropped from the 20s and 30s to well below 15. It is not at all
unusual to see a daily price range of less than ten S&P points—well below 1%--
whereas moves of 2% were not uncommon during the bull market of the late
1990s and the subsequent bear market.
What this means is that we have more market participants chasing less market movement.
This is akin to adding players to a game of musical chairs, while decreasing the number
of chairs. The result is an increasingly frantic scramble for the remaining seats, which
takes the form of violent runs up and down in the indexes, punctuating quiet, tense
periods when the market’s music keeps playing.
In this game of musical market chairs, the largest traders control the pause
button. They wait for the other players to bunch together; then they grab a seat just as
they stop the music. Much of the intraday movement of the market is attributable to
precisely this bunching and its exploitation by large traders.
At the level of micropsychology, the successful trader can detect the dynamics of
the musical chairs game, just as the therapist detects a client’s dynamics. Sellers pile into
a market, failing to drive it to new lows; buyers reach for stocks and can’t break them out
of a range. All of those players will eventually have to puke their positions, as the market
pushes them past their stop-loss or holding period comfort zones. These dynamics are
announced by cues, no less than the client’s marital distress.
This, I believe, is one of the greatest frontiers of trading psychology: Not the
application in which traders are clients, but applications in which traders become
psychologists, analyzing the markets. As each client has his or her own markers of
emotional states and cognitive processing, each market day manifests its own distinctive
cues. The ability to listen, formulate, and act is a core competency linking the trader and
the shrink.

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