The Psychology of Market Cycles and how Algorithmic Trading mitigates emotions

Fri Apr 28 2023

Market psychology refers to the idea at the market is influenced by the emotional state of its participants. Let's explore this idea and how tools like algorithmic trading can help manage your own emotions.

Market psychology refers to the idea that market movements are influenced by the emotional state of its participants. It is a topic of behavioral economics, which investigates the factors that precede economic decisions. Emotions are believed to be the driving force behind the shifts in financial markets, and the overall fluctuating investor sentiment creates the psychological market cycles. In algorithmic trading, it’s essential to understand market cycles in order to create crypto trading bots that are compatible with the current market trend.

Market Sentiment and Cycles

Market sentiment is the overall feeling that investors and traders have regarding the price action of an asset. When the market sentiment is positive, and prices are rising continuously, there is a bullish trend, often referred to as a bull market. The opposite is called a bear market when there is an ongoing decline in prices.

The sentiment is made up of the individual views and feelings of all traders and investors within a financial market. But, just as with any group, no single opinion is completely dominant. Based on market psychology theories, an asset’s price tends to change constantly in response to the overall market sentiment, which is also dynamic.

In practice, when the market goes up, it is likely due to an improving attitude and confidence among the traders. A positive market sentiment causes demand to increase and supply to decrease. In turn, the increased demand may cause an even stronger attitude. Similarly, a strong downtrend tends to create a negative sentiment that reduces demand and increases the available supply. Understanding bull and bear markets is an essential prerequisite to creating your own algorithmic trading bot for cryptocurrency.

Emotional Changes During Market Cycles

All markets go through cycles of expansion and contraction. During an expansion phase or a bull market, there is a climate of optimism, belief, and greed. These are the main emotions that lead to strong buying activity.

A cyclical or retroactive effect is quite common during market cycles. For example, the sentiment gets more positive as the prices go up, causing the sentiment to get even more positive and driving the market even higher.

Sometimes, a strong sense of greed and belief overtakes the market to the point where a financial bubble forms. In such a scenario, many investors become irrational, losing sight of the actual value and buying an asset only because they believe the market will continue to rise. They get greedy and overhyped by the market momentum, hoping to make profits. As the price gets overextended to the upside, the local top is created. This is deemed as the point of maximum financial risk.

When the market starts to turn the other way, the euphoric mood can quickly turn into complacency, as many traders refuse to believe that the uptrend is over. As prices continue to decline, the market sentiment quickly moves to the negative side. It often includes feelings of anxiety, denial, and panic.

Using Market Psychology in Algorithmic Crypto Trading

Assuming that the theory of market psychology is valid, understanding it may help a trader to enter and exit positions at more favorable times. This holds especially true in algorithmic trading where the crypto trading bots you make, will need to perform in the current market cycle.The general attitude of the market is counterproductive: the moment of highest financial opportunity for a buyer usually comes when most people are hopeless, and the market is very low. In contrast, the moment of highest financial risk often arises when the majority of the market participants are euphoric and overconfident.

Thus, some traders and investors try to read the sentiment of a market to spot the different stages of its psychological cycles. Ideally, they would use this information to buy when there is panic (lower prices) and sell when there is greed (higher prices). In practice, though, recognizing these optimal points is rarely an easy task. What might seem like the local bottom (support) may fail to hold, leading to even lower lows. Using sentiment Analysis in algorithmic trading is a good indicator of where the market is at, but by itself it’s rarely enough to create a winning strategy.

Technical Analysis and Market Psychology

TA indicators are tools that may be used when trying to measure the psychological state of the market. For instance, the Relative Strength Index (RSI) indicator may suggest when an asset is overbought due to a strong positive market sentiment (e.g., excessive greed).

The MACD is another example of an indicator that may be used to spot the different psychological stages of a market cycle. In short, the relation between its lines may indicate when market momentum is changing (e.g., buying force is getting weaker).

Adding a layer of Technical Analysis to your Sentiment Analysis can confirm that the market is indeed likely to head in one direction, helping you make a more informed decision.

Bitcoin and Market Psychology

The Bitcoin bull market of 2017 is a clear example of how market psychology affects prices and vice-versa. From January to December, Bitcoin rose from roughly $900 to its all-time high at the time of $20,000. During the rise, market sentiment became more and more positive. Thousands of new investors came on board, caught up in the excitement of the bull market. FOMO, excessive optimism, and greed quickly pushed prices up – until it didn’t.

The trend reversal started taking place in late 2017 and early 2018. The following correction left many of the late joiners with significant losses. Even when the downtrend was already established, false confidence and complacency caused many people to hold on to their losing positions.

A few months later, the market sentiment became very negative as investors’ confidence reached an all-time low. FUD and panic caused many of those who bought close to the top to sell near the bottom, incurring in big losses. Some people became disillusioned with Bitcoin, although the technology was essentially the same. In fact, it is being improved continuously.

Cognitive Biases in Trading

Cognitive biases are common thinking patterns that often cause humans to make irrational decisions. A few common examples are:

• Confirmation bias: the tendency to overvalue information that confirms our own beliefs, while ignoring or dismissing information that runs contrary to them.
• Loss aversion: the common tendency of humans to fear losses more than they enjoy gains, even if the gain is similar or greater.
• Endowment effect: This is the tendency for people to overvalue things that they own, simply because they own it.
  
  

These patterns can affect both individual traders and the market as a whole.

Algorithmic Crypto Trading helps manage emotions

The market is emotional because its participants are emotional. Mitigating against your own emotions is equally important. When trading using a trading bot or an algorithmic trading platform, you’re naturally less likely to react emotionally to the market as you are more detached from it. In algorithmic trading, you can lay out your strategy before starting to trade, and essentially delegate it to a trading bot to do it for you.

Conclusion

Market psychology has an impact on market prices and cycles. Although the psychological market cycles are well known, they are not always easy to deal with. Investors face the difficult task of understanding not only the market’s psychology but also their own psychology and how that is affecting their decision-making process. Tools like Technical Analysis and Algorithmic Trading platforms can help mitigate your own emotions. The best way to learn is by doing, so go ahead and create an account on our algo trading platform, Æsir today, and use our Free paper trading option to test out different strategies for free, without needing risking real funds.