Lesson 37 – Following the Sheep to Slaughter

Topic Progress:

In our last lesson we looked at two of the most common mistakes that traders make when entering the market, sticking with a trade where the market moves against the trader but he knows he is right, and altering a trading plan on the fly as a result of missed opportunities. In this lesson we are going to look at another aspect of trading psychology that causes many traders to fail which is known as crowd psychology.

The best summary that I have seen on this subject, as well as a great book on trading in general is Dr. Alexander Elder’s book Trading for a living. As the Trader and Psychologist points out in his book, people think differently when acting as part of a crowd than they do when acting alone. Dr Elder points out that

“People change when they join crowds. They become more credulous, impulsive, anxiously search for a leader, and react to emotions instead of using their intellect.”

In his book Dr. Elder gives several examples of academic studies which have been done which show that people have trouble doing simple tasks such as choosing which line is longer than the other when put in a situation with other people who were instructed to give the wrong answer.

Perhaps no where is the strange effect is the psychology of crowds seen than in the financial markets. One of the more recent examples as I have spoken about in my other lessons of the effect that the psychology of crowds can have on the markets is the run-up of the NASDAQ into 2000. As you will find by pulling out the history books however, this is not an isolated incident as financial history is littered with similar price bubbles created and then destroyed in the same way as the NASDAQ bubble was.

So why does history continue to repeat itself? As Dr. Elder points out in his book, from a primitive standpoint chances of survival are often much higher as part of a group than they are alone. Similarly wars are often won by militaries with the strongest leaders. It is thus only natural to think that humans desire to survive would breed a desire to be part of a group with a strong leader into the human psyche. So how does this relate to trading? Well as we learned in our lessons on Dow Theory, the price is representative of the crowd and the trend is representative of the leader of that crowd. With this in mind think about how difficult it would have been to short the NASDAQ at the high’s in 2000, just at the height of the frenzy when everyone else was buying. In hindsight you would have ended up with a very profitable trade but, had the trade not worked out, people would have asked how could you have been so dumb to sell when everyone else knew the market was going up?

Now think about all the people who held on to their positions and lost tons of money after the bubble burst in 2000. As they had lots of company there were probably not a whole lot of people who were laughing at them. Yes they were wrong but how could they have known when so many others were wrong too?

By looking at this same example, you can also see how panic selling often ensues after sharp trends in the market as this is representative to a crowd whose leader has abandoned them.

In order to trade successfully people need a trading plan which is designed before entering a trade and becoming part of the crowd so they can fall back on their plan when the emotions which are associated with being part of a crowd inevitably arise. Successful traders must also realize that there is a time to run with the crowd and a time to leave the crowd, a decision which must be made by a well thought out trading plan designed before entering a trade.