Because humans are herd animals, market action affects our trading behavior. There is no getting around it. If we could peer into the future and trade on information that guarantees perfect results, we’d ignore the herd. But we can’t, so we don’t.
Instead, we look for clues that will keep us on the right track. This is especially true when confusion reigns. We wait to see what happens before we get comfortable joining in. Again, this is human nature. Most of us are not bold enough to step out of the crowd, away from the warmth and into the unknown.
Understanding and accepting this behavior is key to trading in a volatile or bear market.
How market actions affects our trading behavior
Our trading behavior is affected by price action and sentiment. This is true for bullish and bearish trends. We also tend to meander around the middle of the fear/greed spectrum. This changes when the markets tip in one direction of the other.
This past month is a perfect example. When sellers started to hit the exits in early December (following a volatile November), a lot of investors left. The dip buyers were sick of getting burned, so they took off as well.
By the time Christmas Eve hit, we only had one up session during the month. Is it any wonder everyone joined the herd?
Since December 26, the market action has featured very strong upside moves and a few false starts. Even though we were hitting levels not seen for several months, no one wanted to jump in and buy anything.
By the end of December, sentiment was so bad that money was actively flowing OUT of equities. Was another financial crisis ready to happen, or was this just a deep correction? Again, nobody wanted to stick around and find out the answer.
Now it’s January. We have had a couple of powerful trading days, and some brave buyers ventured back in. Other traders have noticed this, and because they are trained to follow the herd at whatever cost, we are seeing more traders and some bullish indicators. Sentiment is growing, support for equities is improving and price momentum is tremendous. The SPX 500 has rallied 280 points from the lows on December 24, in only three week’s time!
So, is it time to trade again, or stay on the sidelines? Let the market action and good risk management drive your decision.