Market perspective in day trading refers to how we perceive and understand the market’s dynamics and functioning. It is crucial because it serves as the foundation for our trading strategies. To fully grasp, trust, and implement my trading approach, you must first adopt my perspective on the market.
Let’s begin with a simple and universally accepted statement: Markets move in response to the interplay of supply and demand. This principle is recognized by everyone, from theoretical economists to everyday individuals.
Various fundamental factors are responsible for shifts in supply and demand within the market. These factors are numerous and diverse, encompassing elements such as interest rates, economic policies, company management, and technological advancements. These fundamental factors lead to changes in supply and demand, subsequently influencing price movements.
Fundamental analysis involves the study of these fundamental factors and the creation of models to forecast their impact. Practitioners scrutinize all available information about a country, industry, or company to predict how it will affect supply and demand. This analysis helps determine whether the current market price is overvalued or undervalued, forming the basis for potential trading strategies.
Conversely, technical analysis relies on the observation of price movements to predict future price actions. This approach assumes that past and present price movements influence shifts in supply and demand within the market.
But how exactly do price movements trigger changes in supply and demand? The answer lies in human psychology. Among all the variables that influence trading and investment decisions, price elicits the strongest emotional responses from both traders and investors. Regardless of other factors like interest rates or fundamental economic indicators, price is a universal focal point.
Price directly impacts profit and loss, ultimately determining whether one succeeds or fails in the trading arena. Even fundamental analysts pay heed to price because the gap between market price and their calculated fair value reveals whether an asset is over- or undervalued. Every market participant reacts to price, not only analytically but also emotionally.
The collective response of market participants to price fluctuations leads to changes in supply and demand, which in turn affect market prices. The diagram below illustrates this feedback loop.
The formal study of how human psychology influences the market is known as behavioral finance. While delving deeply into this field is beyond the scope of this discussion, understanding its fundamentals is crucial since our analytical method depends on market participants’ psychology.
Unlike traditional finance theories, behavioral finance posits that investors often act irrationally. They tend to overreact or underreact to market information. Behavioral finance seeks to explain the reasons behind these irrational behaviors, with many explanations centering on cognitive and emotional biases, which lead to illogical decision-making. Common biases among investors include confirmation bias, the bandwagon effect, loss aversion, and endowment bias.
Rather than just reading about these biases, take a moment to reflect on your own experiences. Have you ever felt fear or anxiety due to market price fluctuations? If your answer is yes, it’s evident that you, like most investors, are not the perfectly rational actors assumed by traditional finance theories. This underscores the importance of behavioral finance in understanding market behavior.
Behavioral finance is closely linked to psychology, which is a social science, not a natural science like physics or chemistry. Psychology deals with likelihood and tendencies rather than rigid formulas and concrete facts. Therefore, trading also revolves around probabilities.
We will explore the role of psychology in trading in greater detail later in this series. For now, remember two key points:
- Price changes serve as vital market indicators due to their strong ties to psychological factors.
- Psychology is not a natural science with definitive formulas, so trading requires an ability to navigate uncertainty.
Given the significant role price plays in the market, it is logical to prioritize the study of price as we endeavor to trade effectively.
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