There are two basic ways to approach trading: fundamental and technical. Many of the best traders combine the two elements to develop a trading strategy, but a third element can push your trading to the next level. That third element is psychology.
While fundamentals and technicals provide a solid framework for a trade, it is an understanding of the psychology surrounding a stock that can provide additional conviction that will help improve your timing and can turn a good trade into a great one.
To some degree, charts are a depiction of the psychology and emotions that surround a stock. The foundation of most technical analysis is that people have emotional reactions as they incur profits or losses as a stock moves up and down. Someone that is sitting on a large loss is going to feel and act quite differently about a stock than someone that has a sizable gain. Most chart reading is an attempt to figure out how those people may act when further movement occurs.
A good example of the psychology of charts is a 'breakout.' When a stock hits a new all-time high, then everyone that is holding it has a profit. While there will be some tendency toward profit-taking in some cases, many people are happy to simply hold on to stocks that are performing well, and that means less selling pressure.
Charts and technical analysis are an interesting application of psychology, but they are only part of the entire psychological mosaic. There are numerous other factors that impact the emotions of market players, and if they are assessed, they will help you decipher the potential of a chart setup.
Context is key. When considering a chart, there are other factors that may influence how well a trade might work.
1. The overall market environment and big picture sentiment. Stocks are often influenced by overall market conditions. A good setup in a bad market will likely act differently than a good setup in a strong market. I've often found that good chart setups often do well in flat markets because there is a tendency for traders to gravitate toward a smaller group of 'good' setups.
One problem for many traders is that they allow big picture considerations to keep them from taking good trades. We have seen quite a bit of this lately as Big Picture Bears tell us the market is going to collapse. That makes for a good excuse not to take a trade. Ironically good trades in extended markets can work even better as they climb a wall of worry.
2. Sector movement. The current market is a very good example of how important sectors can be. The right stock in the right sector has a much better chance of a powerful move than another stock in a less favored sector. This can change very quickly, but it often surprises me how long sector themes can persist.
3. Stock picking versus an index-driven market. I draw a distinction between markets that are driven by stock picking and those that are index driven. We have enjoyed a great stock picking environment for a while, and that makes good picks work better, when the market is index driven, then stock selection becomes secondary. Most market corrections are index driven which means that trying to pick stocks is of little benefit.
4. Momentum versus bottom picking. There are times when the market favors stocks hitting new highs, and there are times when it favors trying to pick stocks coming off lows. This part of the big picture consideration but being aware of which is in favor is key to good selection.
5. News events and fundamentally driven. It is very helpful to understand what it is that is driving a stock. A good chart coupled with strong news or fundamentals has much greater upside potential than a stock driven just be a technical setup. Knowing and understanding the catalysts impacts the psychology surrounding a stock.
6. A unique story or 'hook'. Stocks that have a unique story often gain strength over time as that story becomes more well known. When the logic of the trade makes sense to a greater number of people, it can build substantial momentum.
There are many other factors that can influence the psychology surrounding a stock. Many of them can not be quantified. Good traders tend to develop instincts about the various factors and will call it 'gut feel' in many cases. The best way to develop this sort of 'gut feel' is to understand that it really is just the assessment of a large number of psychological factors that are often quite murky and can change very fast.
Thinking of trades in psychological terms adds a powerful element to your trading methodology. It can be quite difficult to do well but simply being aware of the potential is a good start.