Traders Toolbox: Psychology of a bottom

As bull markets roar to a top, it is relatively easy to see the emotional or psychological signs of an impending top. Virtually every source of news will provide coverage of the seemingly endless climb towards higher levels. Greed infests the public as the inexperienced flock to get a piece of the action. Finally, when it is "impossible" for a market to decline and everyone who wants to buy is in, the top will be struck. Buyers become sellers and a downmove ensues.

To an extent, the same sort of pattern unfolds at major bottoms. However, since the events surrounding the decline are not as exciting or newsworthy as those in a bull market, the signs are harder to see. Instead of greed permeating the atmosphere, fear becomes the emotion of significance. As the news becomes per- ceived as increasingly bearish, traders who had been bullish give up. The emotional stress of margin calls and "bad" news finally forces long liquidation.

Despair, disgust and disillusionment abound among the public traders. Producers resign themselves to selling their production near current levels and, in fact, often sell future production as well. They become convinced the market is destined to move even lower. As the bearish attitude spreads, an important sign of a nearing bottom is declining open interest. This is especially true if this long liquidation of futures positions drops the open interest below recent low levels. In markets where individuals are the original holders of production, an additional sign is liquidation of cash positions.

Traders and marketers take any rally as a "gift" to sell on. Bullish fundamental conditions which may exist are discounted as the memory of the persistent downtrend remains entrenched. As a market starts up from the lows, the rallies are viewed with suspicion. Even the few who remained bullish don't trust the rebounds and often take advantage of early rallies to liquidate long positions. Setbacks from the early rallies are often sold as the participants don't want to miss the next washout to new lows. And, if enough gain this attitude, the break will not continue and traders then have to wonder why the markets won't go down on "bad" news. Eventually, their short covering triggers additional gains.

A final important component of an approaching bottom is the inability of a market to sustain a downmove on bearish news. The most common form of this action is seen when government reports are released. The bulls no longer rationalize a bearish report into a bullish one. Instead, the bulls resign themselves to additional declines. Bears move towards overconfidence and start selling the breaks as well as the rallies. Bearish reports often trigger downmovement, initially, but then additional declines fail to materialize. Moves to new lows are rejected as everyone who wants to be short already is and the longs have been liquidated, thereby leaving the markets with no one to initiate new selling. And, as at the top, but in reversed roles, the sellers become buyers.

7 thoughts on “Traders Toolbox: Psychology of a bottom

  1. Herb,

    I would look at all time frames ... paying particular attention to the longer term time frames.

    All the best,

  2. I also looked at the weekly and monthly time frames for a few years back and on the monthly you especially get a diffrent picture on divergance etc.. I guess my question would be as a new trader should one only look at the daily time frame?


  3. agree with all of you, and i am pretty good with technical analysis, learned over the years. i try to ignore news and others opinion by not reading it. you all know you cant trade on emotion.

  4. I agree. A very good explanation. Of course you never know when the absolute bottom is reached on the price charts until after the event and we have witnessed a resumption of sustained upwards price movements - not sideways movements in a trading range. Watch for price recoveries from a bear mkt relative to the 100 and 200 day MAs on price.

  5. A excellent explaination of a market ,or maybe I should say people and the emotions they go through. I'm a firm believer of news, for the most part is worthless. I trade the charts, use my stops and do not watch or listen to market news. If people didn't watch and listen, all you would here is market up .5% or down. No hype to buy or sell. Then the talkers would have to learn to trade or find work they would be accountable to!

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