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The Psychology of Trading--The Mind of the Market

What is the purpose of the foreign exchange market, or any trading market for that matter?  It seems like a simple question with a simple answer. The purpose is to facilitate exchange, to permit participants to sell and buy commodities, equities or futures and to trade one currency for another.  But that simple definition disguises a world of complexity.

If two parties wish to conduct an exchange, of one currency for another or of an equity or bond for a sum of cash the first question is at what price should the transaction take place?  In the consumer world, in a supermarket or department store, the price is predetermined by the seller and is rarely changed. The purchaser measures their need for the item against the price asked and makes the decision to buy or not.  There is little discussion and no bargaining over the price. The consumer does not say the price will be lower in a few minutes; I will wait until then to make my purchase.  Likewise the seller does not normally remove the item from sale expecting the price to rise in a few days.  This basic function of price determination or price discovery is essentially different in a trading market. A market transaction differs from a consumer purchase because both the seller and the buyer continually adjust their price expectations to information flowing out from the market to participants and into the market from outside sources. 
Market participants, in theory, incorporate all available information into the prices at which they buy and sell. This is called the perfect information assumption of efficient markets theory.   Each participant in the market acts as an independent decision maker. Each decision influences the overall market and price level.  The market or to be more precise, the price level of a market traded item, is, at any time, the amalgamation of all the price decisions made by all market participants. 

On this one topic-- what should the market price be-- the market reflects the decisions of its participants.  In foreign exchange markets the decision makers are the traders, all of them, from the smallest retail trader to the largest hedge fund.  But how do 1,000 or 10,000 individual decisions, made in ignorance of each other become a market price?  How do we know that the price of this mass decision accurately reflects the wishes of 10,000 people?

If three market participants want to buy a commodity at a certain price level and 50 want to sell, the market price for that commodity will fall.  But what actually happens?  The three bids in the market will be filled but that leaves 47 sellers.  If no other bids enter the market the sellers will begin to react to the lack of bids by adjusting their offering prices down, displaying lower and lower prices until buyers enter bids and a trade is made at the new lower level.  The sellers and the buyers incorporated the information flowing out of the market, the temporary lack of bids, into their price expectations producing a new price.

A commentator would perhaps say ‘the market fell today ‘. But a market is not an entity. It is only a method for coordinating the decisions of its participants.  What occurred is that each participant in the market reacted to the information coming to them from within the market and their combined reaction is the movement in price.  It appears to an observer that the ‘market’ traded lower because the thousands of individual decisions that comprise the movement are not given separate life. Only the mass decision, ‘the price’, is represented.

This sense of the decision making power of markets and of the ‘market’ a living entity is reflected in the terms we use to describe the price action.  We often say’ ‘the market reacted badly to the news’ or ‘the market took profit today’.  We personify the market and its behavior.  Of course we know that there is no “market” somewhere below the pavement on Wall Street making the decisions for the stock exchange.  But the common use of this ‘market’ shorthand tends to obscure what is the most important psychological point in understanding market behavior.  Namely, that the ‘market’ is a picture of the thoughts of its participants, the market is a snapshot; it is a mass mind.

We can remove some of the sense of mystery from the term, “the market” when we remember just who or what ‘the market’ is.  The answer is plain enough, to paraphrase the comic strip character Pogo, “we have met the market and he is us’.  The logic, analysis and fear that motivate market behavior have their source within the mind and psychology of market participants, that is, within each of its traders.  

When analyzing market behavior it is instructive to keep this very simple fact in mind. The market is a mass mind focused on one topic, price.  It represents the momentary culmination all of the external and internal inputs that bear on the price of the traded commodity as ranked by the traders in that market.  But even if the method by which the market arrives at a decision is obscure, its ingredients are not—they exist in the analysis, outlook, aspirations and psychology of each individual trader.

Since the market is a reflection of the minds of its participants and a traders job is to make profits it follows that a trader’s primary task it to match his decision to that of the mass, to anticipate and mimic the decision of the market. There should be no mystery in ‘the market’ even when it thrashes our positions, for the chances are that the operating logic was known to most traders. Known and rejected by the losing minority of traders but embraced by the majority.

When our trades lose money, whatever the logic of the position, we can be sure we were not alone. But we can equally be sure that we were in the minority. Had we been in the majority the market would have performed as we had anticipated.  The market decision process is that simple.  It is a matter of putting our assumptions in line with the majority as often as we can.  The most effective tool to achieve that is our own empirically tested market psychology.  We are the market, if only we can let the mass mind of the market and not our individuality rule our decisions.

The market does not reward iconoclasts.