How to Read the Market's Psychological State

When volume is high, traders unlucky enough to be losing money in their positions feel the sharp sting of their losses. To alleviate the pain, traders quickly close their positions (at a loss). As losers exit the market, a trend based on high volume is likely to be short-lived. But a trend based on moderate volume can last a long time since small losses can accumulate over time to become large losses. The longest trends are probably driven by markets either going nowhere, changing moderately, or even moving both up and down day after day. These movements form a gradual trend, which is only apparent when viewed in retrospect.

But volume also pertains to market psychology, a broad subject because there are many more trading indicators that gauge the market's psychological state. This article focuses on Dr. Alexander Elder's work, which describes many of the following concepts and indicators in a clear, concise, and understandable way for traders everywhere.

Devised by Joseph Granville, on-balance volume (OBV) is a running total, which rises or falls every trading day based on whether prices close higher or lower than the previous day. OBV is a leading indicator, so it typically rises or falls before the actual prices. A new OBV high indicates the power of bulls, the weakness of bears, and the likely resultant rise in prices. A new OBV low indicates an opposite pattern: the power of bears, the weakness of bulls, and a possible decrease in value. When OBV shows a signal differing from that of actual prices, it indicates that volume (emotion of the market) is not consistent with the consensus of value (actual prices)—a shift in price, which would alleviate this imbalance, is imminent.

Accumulation/distribution is also a leading indicator pertaining to volume, but it takes opening and closing prices into account. A positive A/D indicates that prices were higher when they closed than when they opened; a negative A/D indicates the opposite. But the bull or bear winners are only credited with a fraction of each day's volume depending on the day's range and the distance from opening to closing price. Obviously, a wide range between open and close produces a stronger signal A/D, but the pattern of A/D highs and lows is most important. If a market opens higher and closes lower thereby causing A/D to turn down, an upward-trending market may be weaker than it initially appears.

The significance of accumulation/distribution lies in the insight it provides into the activities of the distinct groups of professional and amateur traders. Amateurs as a group are more likely to influence the opening price of the market. Amateurs base their first trades on the financial news they have read overnight as well as on the corporate news issued by their favorite companies after market close. But as the trading day wears on, professionals determine the day's ultimate results. If the professionals disagree with the amateurs' bullishness at the open, the professionals will drive prices lower for the close. When the pros are more bullish than amateurs, the pros will drive prices higher all day and into the close. As indicators of future trends, the activities of professionals are typically more important than the activities of amateurs.

Open interest is another major indicator of crowd psychology. Open interest applies to the futures market and refers to a reading of future contracts or options expiring at a certain time in the future. Open interest adds the total long and short contracts in the market on a given day, and the absolute value of open interest corresponds to a cumulative long or short position. Open interest only rises or falls when a new contract is created or destroyed—one long and one short seller must enter the market to increase the open interest, and one long and one short seller must close their positions for open interest to fall.

Open interest is only of interest (pun intended) when it deviates from its norm. An absolute value is of no interest. Open interest reflects the psychology of the market through the market's inherent conflict between bulls and bears. To move the open interest indicator up or down, both bulls and bears must be equally confident that their long or short position is correct (or incorrect). A rising open interest demonstrates that bulls are confident enough to enter into contracts with bears, who are equally confident in their bearishness to enter into the position. One group will inevitably lose, but as long as potential losers (either bulls or bears) enter contracts, the rise or fall in open interest will continue. But there is more to open interest than meets the eye.

A rising open interest points to an increase in the supply of potential losers, propelling the trend forward. Open interest that increases during an uptrend reveals that a certain number of bears believe the market is too high; but, if the uptrend increases, their short positions will be squeezed, and their subsequent buying will propel the market even higher. However, open interest that remains relatively constant during a market uptrend indicates that the supply of losers has stopped growing as the only potential candidates to enter into a contract are previous buyers who are looking to profit from their position. In this case, the uptrend is likely nearing its end.

During a downtrend, shorts are selling aggressively while the only participants buying are bottom pickers. But even value investors exit their positions when prices fall too far, so prices will go even lower. If open interest rises in a declining market, the downtrend is likely to continue. If open interest remains flat in a downtrend, there are few remaining bottom pickers, and the only remaining candidates for the contract are additional bears that shorted earlier and now want to cover and leave the market. Bears that exit with a profit cause a flat open interest in a downtrend meaning that the best gains from the downtrend are likely to have already been had.

Finally, a falling open interest shows that losers are exiting positions while winners are taking profits. It also shows there are no additional losers to take the place of those who have given up. Falling open interest is a clear signal that winners are taking their profits and running for the border while losers are giving up hope. A loss of a contract (and a declining open interest) points to the likely end of a trend.

There are times when reading market trends and market psychology using specific metrics seems as effective as reading the tea leaves. However, if you carefully pick the indicators, understand their limitations, and apply them holistically, you will be in a much better position to gauge the mood of the market and adjust your position accordingly.