Volume Profiles, And The Nature Of Psychology In Trading

One of the best things for a trader is to understand market psychology so you avoid being on the wrong end of it. That means not only are you not a victim of market psychology, but you recognize and exploit it without emotion when possible.
Why do stocks go up? There ALWAYS is At a given price there is more DEMAND (buyers) then there are sellers who want to sell at that price. Prices MUST move to where a transaction can place. The market is an auction BUT there are plenty of buyers who may be willing to buy lower and even sellers who arewaiting for stocks to lose momentum and break downwards. Those who believe they bought or sold at a good price will very likely take a second opportunity if they get it. Of course some may be happy to break even and relieved when it went against them, and some may have the rule of not letting a profit turn back into a gain, so it can work the other way. Nevertheless, the areas in which volume takes place tends to repeat and continue to be an area where volume takes place for longer periods of time. Stocks go down because selling demand overwhelms buying demand. There aren't enough buyers to consume the demnd at that price. Anyone who wants to buy needs a lower price, so prices must decline for the last seller standing to get filled. You can say this another way by saying, the buyers who have the mindset of "get me in at any price" cause market to go upwards in order for them to get their order, particularly if at the same time the sellers are cautious and not as willing to sell at current prices. The reverse is also true. If buyers are cautious and don't really want to buy much at this price and sellers instead want in (short) (or out) at any price, then prices must go down in order for them to get filled.

I don't have to find stocks following this exact model, just general understandings of what's going on. It works on 30m chart, daily chart and weekly chart. But just pay attention to the process it goes through and how to recognize it. Typically panic is not the final low but markets the start of the bottoming process. You can have 2 or 3 "legs down" and then a sharp bounce and a retreat to new lows. Then an equal high and then a higher low and then you can start to build upon it. It doesn't always work that way. Sometimes the market will make an equal high and keep going and only move sideways slightly. But if you can recognize what's going on, there will be enough situations when you find an edge. The "aversion" point is a great spot to buy as is the 1st higher low after discouragement. Do not try to bottom pick the exact bottom unless you have advanced plans and really know what you are doing.

Unfortunately, many people still feel emotion when their account is moving and may tend to trade more setups than they should. For this reason it is VITAl that from the start one starts out with a gameplan and sticks to it. If they jump in head first trading without a plan not only do they have significant risks for the trades they make losing money and them losing over time, but even worse, they risk the degenerate gamblers mentality that pulls at their emotions and makes it near impossible to make the corrective action.

I will have another post on this if you are in this position on how you can protect you from yourself, because it can be done to some extent.


Managing the trade is important. If you try to buy at aversion or the 1st higher low you have places to manage your trade. The first higher low you can just cut your risk if you get a close below the discouragement low. The aversion you can use a stop below that same higher low or also the discouragement low.

Aside from this, there is an important concept to understand. Price has MEMORY. I am not trying to personify stocks by saying the market thinks this or goes here or "capital realizes". But the markets are driven by people who have memory and it's just quicker to refer to "the market" to mean anything from "people" to "traders" to "stocks" to "stock holders" to "A collection of many individual price securities driven by the supply and demand forces of both the underlying shares and underlying companies as well as the supply and demand and emotional forces of the individuals."

So "price has memory" what does this mean? It means a stock the has a history of holding at a certain price means the likelihood is good that it will hold their again. Prices that move very quickly up in price have a tendency to both move back down very quickly as it enters those price ranges, as well as move very quickly back up either the 2nd time around, or through an area in which prices moved DOWN very quickly.

Perhaps even more telling and easier to understand WHY this is the case, and also understand some more "hidden" support/resistance areas that perhaps haven't developed yet as well as areas where quick movement is more likely is by learning "volume profiles" or "price by volume".
Here is an example of an amazing setup that occurred in Netflix (NFLX) December 30th, 2011. I circled the support/resistance zones where prices will tend to battle to find direction and may move sideways in the congestion region, as well as the "volume pockets" or "gaps" where prices tend to move quickly.

This highlights an example that is awesom because there also is a "price patterns" We won't cover the details of this, but basically, if we get a breakout, or a failed breakdown and prices go above the bulk of the support resistance area (which occurred later) the possibilities are great for an upward move.
1)On one hand, you have strong support below at that time
2)On the other hand you have weak resistance above. That spells out a high reward, low risk setup with a good probability of working in a short amount of time. In other words, a GREAT entry point. Now, if you can correctly anticipate a breakout, you have a better entry point, however the probability is much greater AFTER the move above resistance  but the tradeoff is a lower reward portential. Lets fast forward and see what it did.

From a psychology perspective, it isn't entirely clear if you have had discouragement AND a higher low yet, but certainly you have had several legs down of panic and you can make a case that the low represents discouragement and you have very tiny minor lows that represent potential for a bottoming process.

Here is the results across several dates. First we have 1/2 then 1/5 then 1/12 then 1/30 then 2/28 then 3/30

This should be pretty eye opening. Study how the moves occurred and could be predicted with reasonable accuracy. Now lets continue from 3/30 to 4/30 and see if we break out or down.
Actually it's down... but let's compare it to the sentiment chart now.

WOW, isn't that stunning? What an eye opener that is. The reason this stuff works because the natures of mankind remain the same throughout history. Now lets go forward 5/30, 6/30 7/30

Oops, failed trade. It's important to understand that even the setups that looks so accurate aren't always right. The idea is that if they are correct, the upside is huge, so just keep the downside tight and you are good. This is why you have to manage your risk, and perhaps even wait until you have a break to the upside from discouragement lows. I will have more on a "bottom picking" strategy that I sometimes use. So did it ever get back into the volume pocket? Actually, it did but you wouln'd have had much of a chance unless you re-entered on discouragement or the first higher high and held through earnings. I don't hold through earnings.  
Finally, lets fast forward to present day.

  This is not a prediction of the future, just a study of the past to teach those for educational purposes only about volume pockets and market psychology. Why do volume pockets work? Because if you trade above a volume pocket, you typically have a lot of sellers who are "underwater" on their position and buyers who are up on their position. There typically aren't goign to be many people who sell, and there only needs to be a few that buy in order to drive prices higher. On the opposite side, you have say a bulk of buyers, a pocket and then a HUGE bulk of buyers. Now the price starts to slip. of course many people may have sold as well, but they typically aren't looking to get back in after they already won and moved on. So while there are a ton of people above who may want to take profits if prices pull back significantly, there also are those that want to sell if they end up under water and made a bad entry. The volume pocket represents a void in much transaction. There is a MARKET at TWO prices, but not much between. Therefore, just a few people bidding price lower and a few people selling it and not only is psychology such that it is set for a panic, but also you will SHIFT from one market of buyers and sellers at a premium price, to the PAST example of people buying. Mutual funds may be willing to buy at a given position as may sellers, but once prices get away from the buyers, the sellers may not want to commit good money after bad and chase a losing position, particularly if prices are moving sharply and momentum is still higher, and the buyers don't want to sell it as long as it's still going up without disruption downwards or any sort of fear of a top. But once that changes and now you add in all the people that did buy higher and now are under water, and you have conditions for a quick move. Of course, some of this is just looking and PREDICTING which means you don't KNOW any of this will happen. You don't know if something in the crowd's mindset may not have changed or fundamentals caused a paradigm shift. But generally speaking you will notice these sort of tendencies with good accuracy. A Gap fill may not be accurate because gaps don't take a look at action prior to the gap. Perhaps one bad earnings casued a gap but previously that whole range was a "congestion zone" and there are plenty of both buyers and selers. As such rather than a quick move back to "fill the gap" you get a sideways battle between bulls and bears. Finally, psychology of an entire market is what I have displayed, chart patterns help better determine the actual institutions beginning to move capital as individuals and open the door for potential rewards. Candlestick patterns help you see what happened more on an intraday basis and as such may help you determine setups, and also let you know what other people are doing. For example a bullish pattern will create a lot of POTENTIAL selling demand IF the pattern breaks below the common "support" area and as such that could create enough selling pressure to make it even more profitable to SELL those patterns. This is known as "broken setups" and they happen on both the bull and bear side. We will get to this as well as the psychology of international traders and investors later.