Market psychology is the idea that the movements of a market reflect (or are influenced by) the emotional state of its participants. It is one of the main topics of behavioral economics – an interdisciplinary field that investigates the various factors that precede economic decisions.
Many believe that emotions are the main driving force behind the shifts of financial markets. And that the overall fluctuating investor sentiment is what creates the so-called psychological market cycles.
So, the sentiment is made up of the individual views and feelings of all traders and investors within a financial market. Another way to look at it is as an average of the overall feeling of the market participants.
But, just as with any group, no single opinion is completely dominant. Based on market psychology theories, an asset’s price tends to change constantly in response to the overall market sentiment – which is also dynamic. Otherwise, it would be much harder to make a successful trade.
In practice, when the market goes up, it is likely due to an improving attitude and confidence among the traders. A positive market sentiment causes demand to increase and supply to decrease. In turn, the increased demand may cause an even stronger attitude. Similarly, a strong downtrend tends to create a negative sentiment that reduces demand and increases the available supply.
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