The price chart of a stock or a crypto currency is a graph of the price over time. That is useful data, but you need to understand what is causing the price to move if you want to predict what the price will do next and make money instead of losing it.
Behind every buy or sell order is a human who is trying to make a profit. And while humans ideally base their buy and sell decisions on sober financial analysis, they are also motivated by emotions. Logic is often overcome by greed to make money, as well as the fear of losing money.
The herd instinct also influences emotions and behavior. If everyone is running in the same direction screaming in fear, our overwhelming instinct is to follow the herd. If something is desirable, we also want a piece of the action and can experience FOMO, the fear of missing out.
A price chart can be seen as a picture of emotions and human behavior. As the price chart moves slowly higher, it is plotting optimism, and as optimism intensifies, it turns into enthusiasm. When enthusiasm intensifies the upward price movement becomes more rapid and when it turns into a steep upward line, you are looking at a picture of greed.
When a price chart moves lower it is plotting doubt and uncertainty. When doubt and uncertainty intensify it turns into fear and the chart takes on a steep downward trajectory. People panic and start selling because they don’t want to lose all their money.
A price chart is nothing more than all the humans who have bought and sold in that time period. When the price starts rising, the people who hold the stock will start selling some to take their profit. Supply exceeds demand and so the price drops. Now people see a bargain, if the price drops 10% we see it as a 10% discount. People start buying the bargain. And the cycle repeats.
The same thing happens in reverse when the price starts falling. People sell in fear it will go even lower and they will lose all their money. In a rising market we see emotions of optimism and greed, in a falling market we see fear and panic. They are different emotions, but in both cases it is emotions which are behind the price movement.
Price movement is also affected by round numbers. Round numbers often act as both resistance and support levels. The psychology behind this has been known for a long time, which is why prices are set at $1.99 rather than $2.00 to take advantage of human psychology. It doesn’t even matter that we all know the trick, it still works because it’s human instinct.
We see the same psychological instincts affecting behavior in financial markets. In an upward bull market trend, previous levels of resistance start to act as support. Once all-time high prices are breached, the price often tends on a steep upward rise. Then once the exuberance wears off, the price drops to a support level.
A double bottom in the chart represents a stronger level of support, this is a price that has been bought on more than one occasion. The more times that happens at a particular price, the stronger the level of support. This represents a safer level to buy because the market has shown willingness to buy at that level on multiple occasions.
The market is a collection of humans. And the price chart is a graphic illustration of that collective human behavior. And that collective behavior is the general human sentiment about the value of a stock. The value does correlate to factual information about profitability, expected income or capital gains, but don’t underestimate the role emotion and confidence play in the price. Things ultimately have value because we agree they do. Value and price is a function of supply and demand.
Having this theoretical knowledge of how emotion affects price is one thing, but putting into practice when it's your hard earned money at risk is more difficult. When the price has gone on a sharp upward trend, that is an excellent time to sell at least some of the stock. But that is when greed takes hold and we are reluctant to sell. Because we see that everyone else wants it, and we have it, and it’s going higher and higher, all the way to the moooon! Our emotion and herd instinct is telling us to buy, to get some now before the price goes even higher and we miss out on having that desirable thing.
And when the price is dropping it’s a good time to buy. But that is when fear takes hold and we are reluctant to buy. Because we see that everyone else is trying to get rid of it and they want us to take it, and it’s going lower and lower, all the way to zero! Our emotion and herd instinct is telling us to sell, do it now before the price drops even lower and we are stuck with undesirable thing that is worthless.
If we follow your emotions when investing we will buy high and sell low, a recipe for losing money. If we want to make money investing we need to learn to control our emotions, we need to do the opposite, buy low and sell high. Our investment buying and selling decisions will depend on our individual financial goals and the safest way to achieve those goals is to have a plan and stick to it. That is usually a dull and boring activity. If your investment decisions fill you with excitement and exuberance, followed by fear and depression, you’re probably doing it wrong. Those are the emotions that accompany gambling, not investing.
