Crypto Market Psychology: How to Trade Rationally

One thing that both traders and investors have in common is that they understand crypto market psychology. They know that real people trade financial markets, and that they follow patterns and react similarly to certain market events. Every person is the same to some degree, so it’s only natural to trade markets according to how the average person behaves.

People love herd-like behavior. They panic when the crowd panics, and cheer when others cheer – even I do it! I might panic when I see Bitcoin flash crash from $12,000 to $3,500 and do something dumb like selling an already oversold asset. In fact, most people did so during the infamous March crash of 2020.

If you don’t want to trade like the herd and lose, I recommend that you stop trading emotionally. Staying rational at all times might be difficult, but I promise it’ll be easier once you understand crypto market psychology.

What is Crypto Market Psychology?

An eureka moment hit me while observing the market for the past few months: nothing has changed.

Investors are falling for the same scams today as they did years ago. The ICOs of my time are now called NFTs. People mint JPEGs in the hopes of being early and selling their bags to another fool after the floor jumps ten times in size. Bitconnect is now Terra. ‘The DAO’ is now every DAO – no less resistant to hacks than the original. And the carrot and stick in 2022 are lavish liquidity pools that feature unsustainable APY rates.

I watch Bitcoin drop from $69,000 to $26,000 and see people calling for a year-long bear market, not knowing that 50% drops are common for bull markets. They panic and sell expecting lower prices, just like how they did when I bought the bottom of Bitcoin in December 2018. Will they wait for $20,000 or $14,000 just like how some waited for $1,000 Bitcoin?

There are more than 300-million crypto holders in 2022 – significantly more than 2017. But although the market is more diverse than ever, nothing has changed. People still show the same signs of fear and greed as before.

Crypto market psychology is a way to view the market as a whole. You need to realize that each trader is his own world, but when grouped together, traders behave the same. Just like how shoppers create a stampede in your local Walmart on Black Fridays, so too do your fellow traders when markets crash on crypto’s very own black friday.

Behind this collective behavior are patterns, emotions, psychology, and crypto market cycles.

Crypto Market Psychology: Dos and Don’ts

Psychology is believed to drive markets because the market participants themselves are influenced by psychological phenomena. Emotions such as fear, greed, and anxiety tend to aggravate the market and make its participants act in tandem.

For example, if a majority of the market believes they’re in a bubble, they will panic and sell. The initial influx of selling pressure will cause others to panic and sell as well. At a moment like that, the market is driven by psychological influences rather than fundamentals.

Another argument supporting market psychology is that more often than not, investors trade according to narratives. A narrative is a story that connects events and explains why the market might plunge or rise. Crypto’s institutional surge is a great example of a bullish narrative that persuaded investors to buy and go ‘risk on.’

Herding Behavior

The phenomenon as a whole can be classified as herding behavior. This concept denotes that investors follow other investors believing that they have done their research, are more knowledgeable, or have more experience.

Human beings are naturally inclined to follow others and behave like a herd. Although it is a positive trait in nature, the same cannot be said of financial markets. The fear of missing out (FOMO) can cause one to adapt black-and-white notions of the market’s behavior. It also causes traders to live in echo chambers and only interact with people who share the same beliefs. This leads to situations where the investor is unaware of what is really going on in the market.

This doesn’t necessarily mean that herding behavior is unprofitable for investors. Those participating in bubbles can still exit the market in profit, as long as they do so on time. But it’s difficult to know when it’s time to bail out of a market that moves on speculation, rather than fundamentals.

At the tip of the dot-com bubble, Federal Reserve Chairman Alan Greenspan used the phrase, “irrational exuberance,” to state that stocks had grown beyond their fundamental value. Greenspan warned the public about the market’s overvaluation fearing that the U.S. market had entered a contraction period similar to Japan a decade earlier.

Irrational exuberance is what happens when investors are overly optimistic. It leads to higher and higher prices that must collapse. The problem is that when the collapse does come, the panic-selling that ensues will cause prices to fall below their fundamental value. Some economists believe that such behavior is detrimental as it can cause a global recession.

The best way to fend off herding behavior is to practice thoughtfulness. Try not to blindly follow other investors thinking that they know better than you. Study the market yourself and come to your own conclusions.

Use Market Psychology to Your Advantage

You can still use an irrational market to your advantage. The two best ways to profit from crypto market psychology are from counter-trading and identifying trends.

Counter trading is part of contrarian trading, an investment style in which one goes against the market. If the market rises, you sell, and if it drops, you buy. The basis of counter trading is that assets must be sold when they are overvalued and bought when undervalued. Whenever an asset is in either state, it is bound to head into the opposite direction.

A contrarian must know the market well to determine whether it is overpriced or underpriced. He or she can also make use of market data via technical indicators, such as RSI, to come to a conclusion. However, the problem with contrarian trading is that herding behavior sometimes prevails and drives an asset beyond or below its fair market value.

Identifying trends on time is another strategy you can use. As mentioned with herding behavior, the only problem with psychology-driven trends is that some investors exit the market too late and thus suffer losses. However, if you can identify trends on time and buy or sell early, you are bound to end in profit.

You can identify trends by noticing narratives shifting ahead of time or by using hard data to identify strengths and weaknesses in the market. For example, ample buying pressure and high volume near the bottom of an asset’s price is a good indicator of a trend reversal, similarly to how a lack of buying power on an overextended asset implies it has reached the top.

Crypto Trading Psychology: How Is it Different?

While market psychology refers to the market’s psychological state as a collective, trading psychology refers to the psychology of the trader as an individual. Trader psychology is important because identifying negative emotional patterns through self-reflection improves trading success.

Certain mental states have a profound negative effect on traders. States of anxiety, fear, greed, anger, and overenthusiasm combined with impulsive behavior lead to more mistakes. It is often advised to stay level-headed and disciplined in order to remain profitable and protect your capital. For some, it is more important than trading experience or knowledge.

The two major emotional states that traders face are fear and greed.

Greed

Greed is a state in which the trader is unsatisfied with his profitability and wishes to earn more money. This usually happens when traders interact with successful veterans who have more capital to play with and enjoy showing off.

The state of greed is comparable to situations where a person decides to start going to the gym for the first time. During the first year, a would-be bodybuilder sees extraordinary progress that outmatches his wildest dreams. But at a certain point, he reaches a plateau and fails to grow muscles as quickly as he used to. Or perhaps he becomes envious of people who have worked hard for years to achieve their current physique.

What does the beginner do? He injects various performance enhancing drugs into his body to gain tons of muscles in a short time just to become the biggest guy in the gym. But what happens? He sacrifices health for short-term gains and ruins his body’s longevity.

What’s the trading equivalent? A crypto investor feels unsatisfied seeing the seven-figure portfolio of a fellow trader and decides to use leverage to increase his wealth. What happens? The inexperienced trader liquidates his assets and goes from owning a modest portfolio to owning nothing.

Fear

Fear is another emotional state that plagues traders. It sets in when we fear making the wrong call or repeating a mistake. Suffering losses for a prolonged period causes traders to refrain from trading fearing they will lose money again. This leads to situations where even if a setup seems logical on paper, the trader will not enter the trade fearing that an unexpected event will appear and ruin the setup.

A phenomenon called regret theory postulates that traders fear regret and actively avoid making the wrong choice, which ironically, affects their success. For example, one can refuse to sell an asset that suffered heavy losses fearing that it will cement the loss. They will hold onto the asset hoping it will retrace.

The reason why traders deal with fear so often is because losing has a larger emotional impact than winning. The momentary euphoria experienced upon winning $50,000 on a trade is nothing compared to the stress and regret faced after losing the same amount – or even half of it. A loss always hits differently because traders become accustomed to sudden inflows of wealth, but they do not react the same to outflows.

Crypto Trading Psychology vs. Crypto Market Psychology

When should you rely on crypto trading psychology and when on crypto market psychology? It all depends on whether you’re trading the range or a larger narrative on a macro scale. However, I recommend dabbling with both in order to improve your abilities as a market participant.

When I trade with leverage, I always focus on what usually leads to my downfall. Maybe I’m too impatient or lack the attention needed to scalp a trading pair. I don’t care about the market as a whole because there are other problems that require attention. Maybe my strategy is wrong or I’m in a bad mood – preventing me from trading effectively.

But if there’s nothing wrong with my trade positions or strategies, I take a good look at the broader market. If I can tell that people will market sell in response to a terrible market event, there’s nothing that I can do to change that. Even a perfect TA analysis will fail if the market decides to act irrationally.

My best advice is to analyze the psychology of both the market and individual market participants. That’s the only way to anticipate every move – good or bad. But you need to understand crypto markets before you can analyze them. Thankfully, you can read the beginner-friendly ebook that I put together – it’ll help you master crypto currency trading without any prior crypto knowledge.

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