What is herd instinct in Forex and how does it affect trading? | R Blog RU


“A trader should trade alone” – this is the opinion often expressed by experienced investors. For example, the Oracle from Omaha (as they call Warren Buffett) says that the investor should not focus on the opinion of the majority of the people, but also should not confront the crowd.

The majority opinion may be wrong, but when a person follows him, he relieves himself of the burden of responsibility for the wrong decision. You might even notice that when people trade together, it is much easier to open positions than when you have to trade alone without prompts. Trying to resist the opinion of the majority is also not worth it, because in this case the trader does not make decisions based on his own experience, but tries to act evilly to the majority in order to prove his case.

It is difficult to find two identical traders: each has its own investment horizons and risk limits. Someone is ready to sit out a drawdown of 100 points, while another investor will exit the position as soon as the price falls just below the point of entry into the market. A person behaves differently when there is a profit: someone closes a position with a minimum profit, and someone will squeeze the maximum out of it. Let’s figure out how herd instinct can harm the trader.

Unique trader skills

Bill Wolfe in his book on “Wolfe Waves” points out the knowledge and skills that a trader must have to be successful. He must come to these skills on his own and hone them. This makes the right investor different from everyone else. In the same book, it is indicated that “Wolfe Waves” is not a very common trading method, and that is why it is able to push the trader to a new level.

If an investor works in a group or reads a forum and makes decisions based on the opinion of the majority, for example, actively buying or selling a particular one, then he loses his skills and uses information noise to enter the market.

With this approach, the investor can start going against his own ideas. For example, he expects a fall in the EUR / USD pair, begins to read the news and forums and sees that the majority is buying, or is ready to buy the euro against the US dollar, because things are bad in America, and Biden started the printing press at full power. Thus, due to the strong news background and the opinions of others, the investor can change his own opinion about the market. This is where the herd instincts come into play, because so many people cannot be wrong, and the skills gained through trading by levels completely fade into the background.

Of course, the decision may 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 his own experience. With this approach, all the gained benefits that are important for achieving long-term results will be lost.

Trading is unnatural

In a book on psychology Thomas Oberlechner there are interesting questions and tests that were asked to a group of subjects. After them, he came to the conclusion that it is much easier for a person to sit out unprofitable positions psychologically than to endure profitable trades.

As soon as a loss appears on the account, a person is ready to watch it and let this loss grow, even if there is a minimal probability that the trade will become profitable. The opposite situation is observed when there is a profitable trade: more often than not, a person is ready to take profit and not wait for it to increase, even if there is a high probability of this event occurring.

Such surveys and tests indicate that a person does not know how to correctly assess risks and will hope to the last that the market is about to turn around and go in the right direction. After all, it is much wiser to close a losing position in order to prevent an even greater loss, and let the profitable trade grow.

The crowd will act exactly the opposite. This is clearly seen in moments of strong trends, when market participants begin to sell, because the price has gone too far up, or buy when the price falls, because in this case it seems too low.

Lag effect

The phrase “when a shoe shiner starts buying stock, it’s time to leave the market” originated in the 1930s during the Great Depression in the United States. When the majority starts buying stocks, you need to prepare for a stock market crash. We could see a similar situation when Bitcoin peaked at $ 20,000 at the end of 2017, and it seemed that nothing portended a major crash.

Bitcoin Price Chart

However, a year later, the price dropped to $ 3000 per coin, and the entire industry experienced a serious decline in activity. At the moment of aggressive growth, when quotes were moving upward without retracements, a lot of people far from the market were involved in the discussion of the value of an asset and talked about growth to 100,000 and above. There was also a trend about obligatory discussion of Bitcoin at dinner. As you can see, all the euphoria did not last too long, and the exchange rate collapsed, and with them the expectations of private investors. Consequently, the crowd is actively buying at the top of the market. This behavior creates a lag effect when the majority enters the market too late and at the highest price.

A similar situation happened with the company’s shares. GameStopwhen private investors from the Reddit forum began to actively buy shares in order to resist the actions of the fund that was selling these shares. The share price really began to rise, and all the news sources wrote that retailers had won the fight against professional investors. The price reached the level of $ 480, and the community of “buyers” has grown several times. Private investors continued to buy and expected growth above $ 1000, because many wrote on the forum that this is the next goal, and you only need to hold shares until such a price is reached. As a result, the shares fell to the $ 50 level, and all those who from news and television rushed to buy shares at $ 400, suffered serious losses.

GameStop Price Chart

Buy when bleeding!

The downside of the situation with massive purchases of “housewives” is the moment of a strong fall in the prices of financial instruments. When it already seems that this is the end, and the rate will never rise, experienced investors buy.

For example, quite recently, the Bitcoin rate rose to $ 42,000 and immediately fell to $ 30,000 in a few days. Retail investors simply flew out of the market, as they may have bought with a lot of leverage or expected the rate to rise immediately after buying. At the same time, a major player Michael Sailor wrote about his company buying Bitcoin. “Buy when the price falls,” he tweeted. Indeed, a drop of $ 12,000 in a couple of days can be disastrous for a retail investor, when, against the background of euphoria, he buys at the maximum, and for an experienced trader it is an opportunity to buy at a better price.

Bitcoin Price Chart

It is psychologically uncomfortable to buy, for example, Ethereum, when it fell from $ 1350 to $ 100, because the value of the asset has fallen in price 13 times, it seems that a little more, and it will fall to zero. A similar situation was with oil, when quotations fell sharply in early 2020, and futures went below 0. However, today the price of Brent crude rose above $ 61 per barrel. It makes sense that the price of oil cannot be close to zero, but fear prevented traders from buying so low.

Ethereum Price Chart

Conclusion

As you can see, there are examples when the influence of the majority can harm a private trader, force him to abandon his rules and act irrationally. In a crowd, you can avoid responsibility for your mistakes, positions with this approach will be easy to open, but the result can be disappointing. An example of this is the collapse of the cryptocurrency market at the end of 2017, as well as the fall in GameStop shares in January 2021.

Experienced traders even try to build strategies in which they track the number of open positions for the instrument, and if the level of transactions in one direction exceeds 80%, they open positions in the opposite direction. Also, large players buy when there is panic in the markets, and weak investors leave the market with large losses.

First of all, a trader needs to believe in himself, have a high-quality trading system and strictly follow the rules of money management. But stay away from the majority, but you should not resist him, because Warren Buffett cannot be wrong!


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