Crypto Market Psychology and The Prospect Theory

What's your favorite color? What about the last movie you watched? How much do you love ice cream? We make decisions every day, but those decisions are not always influenced by what we think is best.

The term "market psychology" refers to the market's aggregate tendencies. Individual traders' trading decisions are combined to form market psychology.

That makes it essentially a big pile of individual trader trade decisions. However, these personal decisions influence each other, which makes reading the markets so complicated.

It's also why a market analysis is more art than science. Of course, technical tools are needed, but they are just tools - precisely like in arts.

Difference between Market Psychology and Trading Psychology

The terms "trading psychology" and "market psychology" are sometimes used interchangeably, referring to two distinct concepts.

As a trader, your attitude and decision-making process have helped establish the market and have influenced market psychology in one way or another.

You might agree with the market's current trend, act on it, and make the movement even more powerful. You may be in disagreement with the market's overall direction, so you decide to put your money where your mouth is and go against it. This weakens the trend.

At some point, enough traders with powerful trading positions might take the same side as you, and eventually, the overall market trend will reverse.

Market Psychology Research: Prospect Theory

Market psychology has been studied in the context of performance and investment returns. The idea that humans in financial markets would always make rational decisions based on publicly available and relevant information in prices was challenged by economists Amos Tversky and Daniel Kahneman, who were the first to do so. They did not buy into the claims of the efficient market theory.

Instead, they pioneered the area of behavioral economics, which is a response to the idea that people don't generally make rational decisions.

The efficient market theory says that market prices fully reflect all available information at any point in time and that market participants act rationally to exploit any arbitrage opportunities.

In their Nobel Prize-winning research paper, "Prospect Theory: An Analysis of Decision under Risk" (1979), Kahneman and Tversky proved that people do not always make rational decisions regarding financial risks.

Kahneman and Tversky claimed that market bubbles and crashes could often observe irrational investor behavior. In market bubbles, for example, investors may irrationally attribute more significant value to an asset than its fundamental worth, leading to overvaluation. During market crashes, some investors may panic and sell their purchases at a loss.

Technical Analysis and Irrationality in Crypto

In crypto, we know that it is not as black and white as that. There are plenty of participants on the dog money markets who do not plan to become long-term holders of a DOGE token clone. They are simply hoping to "flip the altcoin"; they speculate on it and buy it to sell it a bit more expensive.

This behavior is rational because it is well supported by experience. Compare it to emotional trading, for instance.

It is also worth mentioning that this type of behavior is by no means rare on legacy markets either.

The Prospect Theory findings nonetheless claim that this behavior is irrational.

Kahneman and Tversky focused on detecting systematic biases in decision-making driven by cognitive biases such as loss aversion, recency bias, and anchoring. And of those, there is plenty on the markets.

Their research has, of course, been widely recognized. But what it says on the face of it is that tradable assets are perpetually overvalued or undervalued, depending on the current bias.

Financial analysts like John Bollinger even say that this is what makes technical analysis such a good tool for trading. It simply works. Who cares if the patterns appear on the charts due to investors behaving irrationally.

Technical Analysis and Cryptocurrency Market Psychology

Technical analysis and market psychology are two essential aspects to consider when trading in the crypto market.

Technical analysis studies market trends and patterns to predict future price movements. It is based on the idea that market prices reflect all available information, even if some of it is fallacious.

Market psychology, therefore, shouldn't be seen as something that works against technical analysis or vice versa. They both work in conjunction, and market psychology is an important aspect to consider.

You can combine market analysis with market psychology and technical analysis to make even better decisions on your trades.

Study market psychology and market cycles to understand how people are behaving with their money right now, and combine it with technical analysis of historical price movements (chart patterns) and market timing indicators (support levels, resistance, basket indexes, etc.).

I think that market psychology should be one of the core aspects that traders try to master because it gives them an edge over other less consciously aware participants in the market who base their actions impulsively or irrationally, especially if they understand Kahneman and Tversky's Prospect Theory.

Example of Irrational Behavior: Why Altcoins Follow Bitcoin?

Market cycles are the simplest manifestation of the irrationality that is to be seen on the markets. Even if the asset's fundamental value has not changed, markets will still go through their cycles.

A market cycle is generally associated with the stages of greed and fear. In a bull market, everyone loves the asset, so their optimism makes it so expensive that new buyers can't afford them anymore.

In a bear market, investors are afraid something terrible might happen to their assets, so they sell them rapidly, further decreasing the value.

Changes in fundamental value indeed prop up some market cycles. Bitcoin halving is an excellent example of that. The supply of BTC lowers; as long as there is demand, the price needs to rise eventually.

But you will notice that other cryptocurrencies might follow Bitcoin's cycles, even if they do not have halvings. That's one of the examples of irrational behavior.

Summary

Markets are irrational, but they're still predictable. That's also the conclusion of Nobel Prize-winning economist Robert Shiller in his latest book "Phishing for Phools," by the way.

And that is what makes crypto markets so interesting to study and predict.

The bottom line is that no one knows what the future holds. There are risks to every decision, but it can be an excellent way to make money if you have a strategy for dealing with risk and discipline in your trading.

Chris Appell