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Emotions, Traders, and Markets

Madness is rare in individuals, but in groups, parties, nations and ages, it is the rule...

friedrich nietzsche

In his brief but powerful commentary on the nature of insanity and human emotion, Friedrich Nietzsche unknowingly but explicitly described the nature of the human condition in the stock and futures markets. To apply his profound words to the markets is, perhaps, to pervert his intent, yet they are so deeply apropos that the comparison begs to be made. For the day trader intent upon success, Nietzche's words may well prove to be a cornerstone of market fact.

The history of humankind is the history of speculation. In one form or another, speculation dates back thousands of years to the earliest days of recorded history. Our forebears speculated daily on the weather in their search for shelter. In growing crops and in warding off hostile animals and aggressors, their speculative ventures became matters of life and death. Whether for the purpose of survival or success in business, risk taking has always been a vital and necessary part of life on our planet.

With risk and speculation, however, come the inevitable and unavoidable consequences and evils of emotion. We fear that our decisions will lead to pain or losses, and we are therefore ready victims of other emotional and behavioral consequences. We fear that failure to take action will lead to negative consequences, so we act impulsively. Impulse is the primary enemy of all traders; however, it can be particularly destructive to the day trader.

We seek to protect what we have gained for fear it will be lost or that its quantity may be diminished. We are motivated by greed to expect large profits from small investments, which causes us to ignore our rational thoughts and prompts us to act on emotion. There are literally thousands of human behaviors that are motivated by the expectation of financial gain or by the fear of financial loss.

Even a cursory study of world financial history leads to the inescapable conclusion that there has always been a close relationship between the intensity of human emotions and significant market turning points. Whether novices or seasoned veterans, investors and traders know that the madness of crowds is often hard at work when markets establish major tops and bottoms. As a day trader, you will need to keep your emotions in check at all times, since the intensity of emotional expression is most readily observed within the trading day and in response to news reports, international events, and crises.

We know, almost intuitively, that the crowd will be wrong most of the time. In order to avoid being trampled to death in a burning theater, we must choose the exit that the mob has not chosen. To survive financial panics and crashes, it is imperative for us to muster every ounce of courage so that we may buy when the "whole world" is selling or sell when the panicked crowd is in a buying frenzy.

We know from repeated and often costly experience that those who can buy into crashes and panics will be successful, while those who can sell into buying panics will also profit handsomely. Yet we are also painfully cognizant of the fact that to do so runs totally contrary to the primordial maps that have shaped our behavior for hundreds and thousands of years. The "fight or flight" response causes us to fight markets or to flee from them, rather than to evaluate them objectively and unemotionally.

Emotional extremes correlate closely with major market tops and bottoms. This correlation can be readily ascertained by examining certain evidence such as newspaper accounts, magazine articles, television and radio reports (where available), and trader anecdotes. Study them to know whether a market is close to bottoming or topping. When the news is most bullish a top is imminent. Pervasive bearish news suggests a bottom. Many of the day-trading indicators discussed in this book translate emotion in market methodology.

Various technical market indicators such as trading volume, specific chart formations, and timing signals also have shown considerable predictive validity when correlated with measures of investor emotion, particularly in the day time frame. Mob psychology is clearly in evidence at virtually all major market tops and bottoms. Emotion can be your worst enemy or it can be your best friend. Make it your friend and ally in the day time frame, for it is a formidable enemy that cannot be defeated. In order to do this, you will need to rely on objective, operational, and definable methods.