How our minds mess with markets — and which indicators tell you more
By Naomi Oba on The Capital
Investing can be a bit like a rollercoaster. Depending on the assets you invest in, you get more or less thrill. Obviously keeping your money in bonds would represent a rather dull rollercoaster experience, while cryptocurrencies can give you the ultimate thrill and maybe even some screaming. But remember, if you’re on a real rollercoaster, scream inside your heart.
During the onset of the pandemic, there was some sort of sell-off and a lot of forecasting that things were going to get worse before they get better. While that is certainly true for the way coronavirus is ravaging in the US or Brazil, for most parts markets have held up quite remarkably. One reason for that could be the performance of tech stocks, but another more interesting one has to do with our minds.
Trading and investing are just fun because we think that something is not priced correctly. If it was, there wouldn’t be a reason to trade for profit. However, with some assets the question arises, where does the assumed value even come from? The most obvious being Cryptocurrencies. For traditional investors or people like my mum, it just doesn’t make sense that something that is not backed by anything “real” could be worth anything. Even my arguing that it’s backed by a decentralized, trustless network and the whole story about limited supply, hedge against macroeconomic developments won’t convince her. Fair enough.
But why is gold worth what it’s worth? Gold is in high demand, which drives prices up. Gold itself is somewhat useful in technical devices and maybe teeth. However, if no one would think it was worth anything, would it still be of value?
The point is, the price we assume for an asset and how we buy and sell it, is often driven by what is going on with our psychology and not necessarily by logic. This makes it a lot less predictable, but also more fun. In particular, when dealing with crypto. Unfortunately, being part of a crowd doesn’t always make for better decisions. In fact, research suggests that we might actually be more stupid in a crowd. So much for crowd wisdom. And when thinking about all the bubbles we have seen from the tulip mania centuries ago over the dot-com bubble to the highest bitcoin bull run….All of these can’t be justified by the decisions of completely rational market participants, but more be explained as a product of herd mentality, bandwagon effect, greed, and FOMO.
Luckily there are some indicators, that can give you hints about what the crowd is thinking. If you are a whale, you might be able to afford trading against the trend for quite some time and ride it out, but as a smaller investor, it helps to go with the trend.
On Balance Volume
On the chart above you can see the On Balance Volume in the lower part of the chart. This indicator is used to predict price movements in advance. It keeps track of the volume in accordance with the direction the price is moving in. As a cumulative indicator on days when the price went down, the volume will be subtracted from the total while on days with increases in price the volume will be added.
The idea behind it is that when the On Balance Volume decreases without a price move of the asset, a downward move would soon follow and vice versa. So what you want to look out for is times, when the OBV is differing from the actual prices. On Balance, Volume keeps track of the investor's emotions and if those don’t align with the value (price) a shift will follow to bring things closer to equilibrium.
The Accumulation/Distribution Indicator was developed to measure the underlying supply and demand. This is achieved by figuring out if investors are mainly buying (accumulating) or selling (distributing) their assets. Mathematically, the formula takes into account the Volume during that certain period, the closing price (Pc), the highest price (Ph), and the lowest price (Pl).
The current A/D is calculated by: previous A/D + CMFV (current money flow volume).
And in case you wonder what current money flow volume is, it’s the volume of money flowing in and out of an asset and is calculated in the following way:
The multiplier in the formula offers an idea of how strong buying and selling have been during a period by determining whether the closing price is in the upper or lower range during that period. This is then multiplied with the volume. If the price closed in the lower range and volume was high, a bigger decline in the A/D is the logical consequence. However, even if the price closed low, but volume remained low, the change in A/D wouldn’t be as significant.
When the A/D and price are moving in agreement, it can be seen as a confirmation of the trend. If the A/D is declining, selling pressure is high and if that happens while prices are increasing, it could forecast a dip in prices in the near future. Similarly, an increasing A/D while prices are falling can signal a trend reversal in the making.
As with all indicators we use for trading, the A/D has some limitations as it doesn’t factor in price changes from one period to the next. Therefore, it’s advised to look out for steep price changes during times of high volume trading, as these might be reflected as rises in the A/D even though, the price actually fell.
Buying and selling pressure which are captured in the A/D are both highly related to investor’s emotions and can serve as a gauge on how strong a trend is and if a reversal is coming.
Open interest is simply the total amount of open futures in a market on any given day and provides some insight into the liquidity of a contract. It doesn’t take into account things such as price rises, as it only increases or decreases when traders are entering new contracts or are destroying their old ones. It’s actually more of a data point than a real indicator, but in combination with indicators such as volume, it can provide some clues on where the money is flowing in a market.
One important thing to remember is that each contract counted by Open Interest is representing a buyer and a seller, hence people who might be having contradicting views on the market.
Let’s say, Alice, Bob, and Claire are all trading the same contract. Alice goes long and buys one contract, Bob also goes long with 6 contracts. The total Open Interest would then be 7. If now Claire comes along and shorts the asset with 3 contracts, the total interest would be taken to 10.
When Open interest is rising during a bull market, it indicates that bears believe that prices are too high and entering new short positions to hedge their risk. However, if the price increase continues, short positions are squeezed and subsequently buying increases.
When open interest is falling, usually it’s because losers are exiting their positions and winners are taking their profits. No further participants enter into new contracts which is why open interest is declining.
Open interest is used by analysts to confirm the strength of a trend. Generally, rising open interest is a confirmation of a trend while declining open interest is seen as a signal that the trend might be losing strength.
All the 3 indicators mentioned here are nothing but that…indicators. So far no one has discovered a golden grail for always having success with your trades. Nevertheless, the more you know about how market participants' emotions, as well as your own emotions and bias, might be messing with your trades, the better.
We all know the grip of FOMO just too well (always happens when BTC breaks through major resistance levels), so when you feel like it’s getting the best of you, take a breath and check the charts and indicators such as open interest, A/D and on balance volume to confirm if the trend is solid or might be fading out soon. Last but not least, don’t forget about the fundamentals 😉.