How Crowd Behavior Affects Investment Trading
Technical analysis involves identifying crowd behavior in order to join the crowd and take advantage of its momentum and direction. This is called the bandwagon effect.
Here’s how a bandwagon works: A fresh piece of news comes out, a majority of traders interpret it as favorable to a security, and buying overwhelms selling so that the price rises. You profit by going with the flow. Then when everyone is jumping off the bandwagon, you jump, too.
As market participants get excited about a security, they become increasingly bullish and either buy for the first time or add to positions, a phase named accumulation. When traders become disillusioned about the prospect of their security price rising, they sell, in a phase named distribution.
To buy 100 shares of a stock is to enter a position. To buy another 100 shares for a total of 200 is to add to your position. If you have 500 shares and sell half, you would be reducing your position. To sell all the shares you own is to square your position. When you’re square (also called flat), you have no position in the security. All your money is in cash. You’re neutral.
After traders have been accumulating the security on rising prices, eventually the price goes too far. Too far is a relative term and can be defined in any number of equally valid ways, but basically it means any price extreme that’s wildly abnormal, statistically speaking.
When a price has reached or surpassed a normal limit, it’s at an extreme. In an upmove, everyone who wanted to buy has already bought. The market is called overbought, a term specific to securities trading. In a downmove, everyone who wanted to sell has already sold. The security is called oversold. The concept of overbought/oversold is applied to market indices as well as individual securities.
By the time most of the market participants have jumped on the bandwagon, it has become so heavy it can’t move forward. Traders are tapped out. All their money is in a position. Traders have to square their positions just to put cash back into their pockets so they can conduct additional trades.
When a price has gone too far and traders deem the security overbought or oversold, the price stops rising or falling. Instead of hovering at a particular level, however, the price moves in the opposite direction for a while. A move in the opposite direction of the main trend is named a retracement. (Other names for it are correction, which explicitly recognizes that the security had gone too far and is now correcting course, pullback, or throwback.)