What Is Herd Instinct in Forex, and How Does It Influence Trading?
Author: Andrey Goilov
Dear Clients and Partners,
A trader must work alone – or at least, this is the opinion often voiced by experts. For example, the Oracle from Omaha (which is the nickname of Warren Buffett) says that an investor should not concentrate on the ideas of the majority but neither should they go against the crowd.
The majority might be mistaken, but when a person follows the crowd, they take off themselves a load of responsibility for a wrong decision. You can even notice that when people trade together, they open positions with much more ease than when they trade all alone, with no one else to consult. Acting counter the general opinion would also be a mistake because in such cases the trader does not make decisions based on analysis but just tries to spite others and prove themselves right.
It is hard to find two identical traders: everyone has their own investment horizons and risk limits. Some a ready to tolerate a drawdown by 100 points, while others will close a position as soon as the price drops slightly below the entry point. Profits also make people act in different ways: some close a position with a minimum profit, while others will squeeze everything they can out of it. Let us figure out how the herd
Unique skills of a trader
Bill Wolfe in his book on Wolfe Waves points at the knowledge and skills that a trader must have to succeed. They must acquire those skills on their own and bring them to perfection. This is what differs a good investor from all the rest. In that book, it is also mentioned that Wolfe Waves is not a very popular trading method, which is why it can lift a trader to a new level of work.
On the other hand, if a trader works in a group or reads forums and make decisions based on conversations there (for example, whether to buy this or that asset), they lose skills and use side noises for trading.
With this second approach, an investor might start working against their own ideas. For example, they expect EUR/USD to fall, but on forums and in the news the majority is buying or ready to buy the EUR because things are going poorly in the USA, and Biden has launched the printing machine again. This way, the investor might change their mind about the market, under the pressure of the crowd and the news. Here, the herd instinct is triggered: so many people cannot be wrong – and trading skills get shoved away for good.
Of course, a decision can be correct today, but will it be correct tomorrow? This is the main question. A trader can stop analyzing the market and make decisions based on their experience – and if so, all the advantages of experienced, important for reaching a long-term result, will be lost.
Trading is unnatural
In a psychology book by Thomas Oberlechner, you can find some questionnaires and tests distributed in a group of respondents. Analyzing the results, the author concluded that for people, it is much easier to tolerate losing trades than profitable positions.
As soon as a loss appears on the account, a person is ready to watch it grow, even if there is a minimal possibility of making a profit. With profitable trades, things are quite the opposite: most often, people are ready to take it immediately and never let it grow, even if this is highly probable.
Such polls and tests show that people cannot evaluate risks correctly and will hope for a reversal to the bitter end, while it is much wiser to close losing positions and let profitable ones grow.
However, a crowd will do just the opposite. This is most obvious in strong trends when market players start selling when the price is “too high” or start buying when the price seems “too low”.
The effect of lagging
The idea that “when a shoe shiner starts to buy stocks, it is time to leave the market” appeared in the 1930s during the Great Depression in the USA. When the majority begins buying stocks, get prepared for the stock market collapse. We could see a similar situation at the end of 2017 when Bitcoin reached its high at 20,000 USD and nothing seemed to predict a disaster.
However, a year later, its price dropped to 3,000 USD per coin, and the whole industry experienced a noticeable slump in activity. At the times of aggressive growth, when the quotations kept rising without a pullback, many people who had hardly ever been interesting in trading before kept an eye on the price of the asset and discussed its perspectives to overcome 100,000 USD. No family dinner went without a discussion of the Bitcoin future. As we know, the euphoria did not last, the Bitcoin collapsed alongside the hopes of individual investors. This example shows that the crowd actively buys at the top of the market. This behavior creates that very lagging when the majority enter the market too late and at an excessively high price.
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Sincerely,
RoboForex team