How to Identify Crowd Behavior - dummies

How to Identify Crowd Behavior

Technical analysis is the art of identifying crowd behavior in order to join the crowd and take advantage of its momentum. This phenomenon is called the bandwagon effect. Here’s how a bandwagon works: A fresh piece of news comes out. Many traders (or a few with deep pockets) interpret the news as favorable to the 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 should jump, too.

Traders are people, and people often behave in predictable ways. People can become reckless and irrational in trading, whether buying or selling:

  • Mania: A situation in which traders buy an object or security without regard for its intrinsic value or even whether they’ll be able to sell it again later at a higher price. They fear being left out of an opportunity. They’re caught up in the moment and temporarily irrational.

  • Panic: The opposite of mania — people can’t sell the thing fast enough and will accept ever-lower prices just to get any money back at all.

In economic history, a mania or a panic comes along only a few times in a century. However, in the technical world, mania and panic happen every day, in miniature. Emotional extremes lead to price extremes in the context of the hour, day, or week — mini-manias and mini-panics occur all the time.

Don’t be surprised when traders invent rumors to try to create a stampede — in either direction. As a technical trader, you want to be sensitive to what the crowd is doing without succumbing to the ruling passions of the crowd itself. Technical traders work hard at not listening to chatter about securities, even from experts. You may get information overload — and you may get disinformation (deliberately misleading information).

When you try to understand crowd behavior for a certain security, keep these tips in mind:

  • Focus on price. All the information you need to make a trading decision is embedded in the price. The price incorporates the crowd reaction to information, and it’s more practical to look at prices than to guess what the crowd might be thinking. When you check the news for the cause of a price action, do it with a healthy dose of skepticism.

  • Know your crowd. Each security has its own crowd, and you’ll get a payoff if you can figure out what pushes the buttons of the crowd that trades your security. One crowd may always respect a support line, for example, while others enjoy breaking the support line by just a little to induce selling so they can buy at a cheaper price.