The gregarious instinct of traders

forex traders' herd mentality

In forex trading, a gregarious instinct (or herd mentality) refers to traders who blindly follow the trend of the masses. These traders generally adhere to the well known investment saying "the trend is your friend". This principle is likely to provide better returns in forex trading compared to stock trading for several reasons.

First of all, forex is probably more influenced by technical analysis and stock trading than it is by fundamental analysis. Second, the forex market is the most liquid financial market in the world, with daily turnover estimated at more than $5 trillion dollars. Six currency pairs account for two thirds of this volume - EUR/USD, USD/JPY, USD/GBP, USD/AUD, USD/CHF and USD/CAD. (Conversely, there are several thousands of stocks available on the main stock markets).

These currency pairs are closely monitored by legions of currency traders around the world, and they track the same technical levels in order to decide when to buy and sell. When prices reach these technical levels, other traders enter the market and reinforce the initial trend, thereby increasing what's known as the "herd effect".

 

Using herd mentality in forex trading

Being a part of the herd mentality in the foreign exchange market is simple. Simply place your trades based on the opinion of most traders and and the established trends.

On the stock market, being a contrarian can help you make money assuming you're smart enough to get out of the markets at the right time. However, this strategy can be a recipe for disaster whenever currencies are unable to defy fundamentals for an extended period of time.

The decline of the Japanese yen in 2013 is a typical example of the herd mentality in forex. In April 2013, the Bank of Japan (BoJ) announced that it was going to buy back government bonds and double the country's monetary base in 2014. The BOJ embarked on unprecedented monetary stimulus efforts to boost growth and break the deflationary spiral that had been plaguing the Japanese economy during the last two decades. As a result, going long on the USD/JPY was one of the most popular forex trades during the first half of 2013.

Traders bet on a declining yen until 2013 due to Japan's aging population and the country's massive debt, and the fall of the yen accelerated due to the increase in the number of traders and speculators who bought into this trend. The Bank of Japan's pursuit of monetary easing also accentuated this trend. During 2013, the yen fell by 12.4% against the dollar. Traders rushed to short the JPY and the currency crossed the 100 yen = 1 dollar threshold.

For trend followers, the long USD/JPY trade actually replaced the short EUR/USD trade since the rebound of the euro in mid-2012 off of the 1.20 level. This change in sentiment can be measured by the performance of the two currencies versus the U.S. dollar over a period of one year ending on 7 May 2013, where the euro gained 0.2% while the yen lost 19.3%.

Herd mentality is also reflected in the strength of the U.S. dollar in relation to the other major currencies. In May 2013, the greenback rose against 13 of the 16 most commonly traded currencies. The unexpected strength of the dollar was largely attributed to the rebound in the U.S. economy which led the Dow Jones Industrial Average and S&P 500 indexes to record levels.

 

Forex traders' herd mentality

Currency price action in recent years suggests that trades were mainly based on herd mentality. This is only one of several scenarios, though, so if you intend to trade these currencies, it is strongly recommended that you conduct your own research.

China is the world's largest importer of many commodities. The Chinese economy is growing rapidly and the currencies of commodity-exporting countries such as Canada and Australia are benefitting from this situation. In the first decade of this millennium, demand for commodities increased due to the Chinese boom, and the AUD and CAD both soared 37% versus the U.S. dollar. It therefore makes sense to consider going long on the CAD and AUD versus the greenback, as the Chinese economy is booming.

The AUD and CAD tend to be in good shape when the global economy is growing rapidly and when appetites for risk are strong. Conversely, when there are concerns about global growth and there is a reduced appetite for risk, currencies and commodities will be on the decline while safe haven currencies like the dollar and the Swiss franc (CHF) will be on the rise. In these situations, popular herd mentality trades will consist of short positions on the AUD and CAD and long positions on the USD and CHF.

The Japanese yen lost much ground in the spring of 2013, the trend was the opposite of one featuring a global appetite for risk due to the yen's popularity as a financing currency for carry trades. The carry trade strategy can be disastrous when risk appetite disappears and panicking investors rush to close their positions due to the sale of risky assets and the yen's peak due to increased demand for the currency to repay loans. Over $1 trillion dollars had been invested in yen carry trade in 2007, but when the global economy turned sour in 2008, the currency rose by 20% in relation to the dollar.

Speculators who had borrowed yens to invest in the AUD (which is equivalent to a long AUD/JPY position) experienced pain when they saw the AUD plunge by 49% in relation to the yen between October 2007 and October 2008. The conclusion is that the yen can often be particularly volatile, so before considering a transaction in a carry trade currency based on the yen (such as long CAD/JPY or even long EUR/JPY), make sure to plan your exit.

Canada is a major exporter of oil, the Canadian dollar therefore has a positive correlation with crude oil prices. Furthermore, Japan is world's largest importer of oil, making its economy vulnerable to higher crude oil prices. Next time there is a peak in crude oil prices caused by a sudden conflict in the Middle East, make sure you consider initiating a long USD/JPY trade.

The worldwide macroeconomic risk between 2010 and 2012 was focused on Europe and a potential collapse of the euro zone. These fears vanished substantially starting in mid-2012, however, rising concerns in the eurozone driven by a new debt crisis in one or more of the most heavily indebted countries could lead to a sharp increase in short EUR/USD and EUR/CHF positions.

 

Tips regarding traders' herd instinct

Experienced traders should be aware of the following rules regarding the "herd instinct":

  • Beware of long-term trends, because they often indicate that there is an imminent danger of a market reversal. Currency trends can reverse abruptly. Similarly, unless you're George Soros, do not be a contrarian on the forex.
  • While trading in the direction of a trend, define your exit strategy in advance. Remaining in the herd can provide security, but you should plan your exit so that you don't get crushed when the herd leaves in droves.
  • Stop losses are essential, because leverage in retail forex can lead to ruin if strict trading discipline is not applied.
  • Don't forget that being long on a currency means that you are short on another one. Short positions seem to justify closer scrutiny and this approach may enable you to avoid seeing winning positions turn into losing positions.
  • Increasing your exposure on a losing position is not recommended, martingale strategies are not viable strategies for forex trading.
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