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Web3  · 05/17/22

Thoughts on Reversals and Psychology

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Bottoming process, just as any other market reversal, is strongly influenced by psychology.

Key Points

  1. What it is: Market Psychology
  2. Tools that do it:

The previous altcoin trading strategy post was on Fulcrum Bottom - a technical chart pattern.

But there is a lot more to say to reversals in general, not only to bottoming processes.

The nature of market reversals

Market reversals are by nature psychologically difficult for traders: Something quite fundamental for speculation and future expectations on the market are changing. Because of this aspect, a market reversal cannot be reduced to a purely technical event. You can certainly trade it that way, but you may miss important information that could be valuable for your other trading decisions.

John Bollinger’s focus on three pushes to a high is related to this understanding: It was observed that the decisions of people who bet on an uptrend to go on forever typically prints on the chart as three pushes followed by the fall.

Three pushes…and then?

That is not where it ends though: One can always hold on to the belief that the old times are coming back soon anyway. When a lot of traders come to think so, the reversing process can drag on for years. In the end, the same majority will flip to the opposing side and maybe cause similar drag during the opposite reversal.

The problem with this is the growing frustration in the community and the doubt regarding fundamentals of the market even though they are not related to this problem at all.

So, even if you won’t carry on to study market reversal patterns and making an epic discovery there, at the very least it is important to realize that the struggle with people’s expectations is not an unusual thing. Also, it is probably quite nice to have something clever to respond to other people’s “I told you crypto is a scam”.

The power of expectations

To illustrate the power of expectations, I am leaving here the following excerpt from a text about inflation. It is unrelated to cryptocurrency, but it shows the point very well.

The (shortened) excerpt below comes from the book “The Mystery of Banking” by Murray Rothbard. PDF and other formats of it are available for free at mises.org.

“During the 1920s, Ludwig von Mises outlined a typical inflation process from his analysis of the hyperinflation in Germany in 1923 — the first runaway inflation in an industrialized country.

The German inflation had begun during World War I, when the Germans, like most of the warring nations, inflated their money supply to pay for the war.

The money supply in the warring countries would double or triple. But in what Mises saw to be Phase I of a typical inflation, prices did not rise proportionately to the money supply.

If M in a country triples, why would prices go up by much less? Because of the psychology of the average German, who thought to himself as follows: ‘I know that prices are much higher now than they were in the good old days before 1914. But that’s because of wartime, and because all goods are scarce due to diversion of resources to the war effort. When the war is over, things will get back to normal, and prices will fall back to 1914 levels.’

In other words, the German public originally had strong deflationary expectations and the Germans’ demand for money rose.

Unfortunately, the relatively small price rise often acts as heady wine to government. Suddenly, the government officials see a new magic elixir. They can increase the money supply to a fare-thee-well and prices will rise only by a little bit!

But let the process continue for a length of time, and the public’s response will change - gradually, but inevitably.

In Germany, after the war was over, prices still kept rising; and then the postwar years went by, and inflation continued in force.

Slowly, but surely, the public began to realize: ‘We have been waiting for a return to the good old days and a fall of prices back to 1914. But prices have been steadily increasing. So it looks as if there will be no return to the good old days. Prices will not fall; in fact, they will probably keep going up.’

As this psychology takes hold, the public’s thinking in Phase I changes into that of Phase II: ‘Prices will keep going up, instead of going down. Therefore, I know in my heart that prices will be higher next year.’

The public’s deflationary expectations have been superseded by inflationary ones. Rather than hold on to its money to wait for price declines, the public will spend its money faster, will draw down cash balances to make purchases ahead of price increases.

In Phase II of inflation, instead of a rising demand for money moderating price increases, a falling demand for money will intensify the inflation.

There is no scientific way to predict at what point in the expectations will reverse. The answer will differ from one country to another, and from one epoch to another, and will depend on many subtle cultural factors, such as trust in government, speed of communication, and many others.”


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