the hAndbook of technIcAl AnAlysIsshould not invest in a certain market or stock. The final decision is usually one
based not so much on fact, but rather on psychological and emotional preference
or pressure.
As such the study of human behavior is a critical and necessary area of focus
for any serious analyst or trader. Not only is it crucial to understand the underly-
ing behavioral elements that drive the market, but it will also be important for
the analyst or trader to understand and be aware of his or her own psychological
and emotional quirks, biases, predilections, and unique responses when assessing
market information.
the Conflicted analytical trader
It is very hard to adapt or be flexible when one has invested a significant amount of
time, effort, and capital in promoting or supporting a particular view or analysis of
the market. This makes it very difficult for directional traders to keep up with the
constant flow of price action. When a trader or analyst begins to feel discomfort or
anxiety when being confronted with contradictory evidence, we say that they are
experiencing, or are in a state of, cognitive dissonance. The trader or analyst will at-
tempt to reduce this uncomfortable state of dissonance by either selectively choosing
only information that complements or conforms to his or her view of the market,
or by attempting to rationalize away the problem. If the trader resorts to selectively
exposing him- or herself only to information that agrees with the accepted view or
analysis of the market, any opposing news, analysis, newsletter, or article is quickly
dismissed or discarded. For example, once a trader is fully convinced that a particu-
lar market is bullish, there is a tendency to ignore signals that do not conform to this
bullish view. The trader may also begin to mentally compartmentalize information
in such a way that the overall impact of conflicting information is minimized, men-
tally confining and breaking it down into a less significant and meaningful threat.
The trader may also resort to only focusing on the bullish aspects of the market in
the face of overwhelming bearishness. The trader selectively perceives only what is
in agreement with his or her view of the market and even misinterprets information
so that it is in line with his or her current expectations.
In short, traders seldom trade based on what they actually perceive to be oc-
curring in the market. They prefer to trade on what they expect to see occur in the
markets. Hence, the market is driven primarily by trader and investor expectations.
positive Feedback Loops and Market trends
Positive feedback loops are usually responsible for creating spectacular market
tops and bottoms. Positive feedback loops are self-promoting. They are respon-
sible for trend action in the market. Unfortunately, positive feedback loops are
not self-sustaining and are regarded as unstable. For example, a certain stock may
be slightly undervalued. This attracts market participants to invest in the stock.
As more investment flows into the stock, the demand drives the price up. As the
price rises, this in turn attracts even more demand for the stock. The process re-
peats, driving the stock price higher and higher and eventually spiraling up into
a frenzy of irrational buying. At some point, liquidity starts to dry up and prices