The general idea behind market psychology is that market behavior tends to repeat itself around specific financial events and therefore can be predicted via technical indicators.
Personal behavior or each trader individually cannot be represented in graphs; however the behavior of bunch of traders all together can be in some way analyzed and concluded in reaction to several economic highlights based on historical movements in the past using indicators and oscillators.
The most common oscillators used by forex traders are MACD, RSI and Stochastics. The mentioned indicators help to figure out the psychological state of mind of the market, by calculating and showing the constant interaction between buyers and sellers in forex market. The oscillators are made of mathematical formulas in order to show market signals which react to overbuying or overselling signs.
Behavioral psychology of forex market goes back to The Theory of Moral Sentiments with two important concepts:
People usually behave irrationally during important decision making
The way a decision is put to a person can influence that decision
In other more comprehensive words, the market is rather unpredictable because you cannot summarize human decision making process into mathematical equation. The more you analyze the market, the more it becomes clear that most decisions in financial markets are arbitrary and irrational!
Let’s go over some of the psychological characteristics of traders’ behavior. Among others, consider the following features ruling the market:
Reaction to gain can turn into overconfidence and believe in luck
Reaction to losses can trigger higher risk taking
Disappointment after bad decision can lead to fear and avoidance to open new trading positions
Greed can create overtrading
Fixation on amount of possible profits instead of focus on making logical trading decisions
Together with fundamental analysis which shows the “why” of the market behavior, technical analysis allows you to analyze a collective data in order to predict the future market movements.
Like it or not, there are visible and usable patterns in foreign currency behavior, which do repeat themselves. This proves that even irrationality of human traders involved in the market can be used to predict certain future outcomes of the market performance.
Most of us perceive ourselves as rational decision makers; few of us are actually constant and predictable. This is because instead of focusing on each event separately, perceptions are often influenced by the outside factors.
Take for example, the process of buying a car. The car is supposed to take you from place A to place B with a certain level of comfort. Most of us, however allow the car of our neighbors, friends and TV advertisements influence our opinion and need.
If all around you drive the latest Land Rover, would you be comfortable with Peugeot 107 (which you can actually afford) or would you take a loan from the bank to be just everyone else in order to fit in? Every single day we buy things we want instead of things we need. Do you really think that it is any different in currency trading arena?