What Is Herd Instinct in Forex, and How Does It Influence Trading?

What Is Herd Instinct in Forex, and How Does It Influence Trading?

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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 instinct can harm a trader.

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.

What Is Herd Instinct in Forex, and How Does It Influence Trading?
Bitcoin price chart

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.

A similar thing happened to GameStop stocks: private investors from Reddit started buying the stocks to oppose a trust that was selling those stocks. At first, the stock price was growing, indeed, and the media was shouting that individual investors won the war with professional traders. The stock price reached 480 USD, and the community of “buyers” increased several times. Individual traders kept buying, hoping for the price to overcome 1,000 USD because many named this level as the next goal on forums and persuaded others to hold the stocks until this level is reached. In the end, the stocks dropped to 50 USD, and those who had rushed at buying them for 400 USD each, pushed by the media, suffered palpable losses.

What Is Herd Instinct in Forex, and How Does It Influence Trading?
GameStop price chart

Buy when blood flows

The other side of the situation when non-professionals start massive buying is the deep slumping of the price for financial instruments. Experienced investors start buying when it seems that this is it, and the price will never rise again.

For example, not long ago, Bitcoin rose to 42,000 USD but fell to 30,000 USD shortly afterward. Individual investors just sprung out of the market: they might have used leverage and waited for the price to grow right after they bought. Simultaneously, a major player Michael Saylor wrote that his company was buying the Bitcoin. On Twitter, he advised to buy when the price was falling. In fact, a decline by 12,000 USD overnight might be a disaster for a private investor whose euphoria had made them buy at the peak; however, for an experienced trader, this is an opportunity to buy at a better price.

What Is Herd Instinct in Forex, and How Does It Influence Trading?
Bitcoin price chart

It is psychologically uncomfortable to buy, say, the Ethereum when it has dropped from 1,350 to 100 USD, i.e. over 13 times, so it seems that it will soon hit zero. The same thing happened to oil at the beginning of 2020, when the quotations dropped dramatically, and the price of futures turned out below zero. However, today, Brent oil costs over 61 USD per barrel. Quite logically, oil price cannot stay close to zero, however, fear held traders back from buying.

What Is Herd Instinct in Forex, and How Does It Influence Trading?
Ethereum price chart

Summary

We have just seen some examples of how the influence of the majority can harm an individual investor, making them forget their rules and act irrationally. In the crowd, you avoid responsibility for your mistakes, open positions easily, but the result might turn out disastrous. A bright example is the slump of crypto at the end of 2017 or the decline of GameStop stocks in January 2021.

Experienced traders even try to create strategies by which they track the number of positions open in an instrument, and if it is above 80% in one direction, they open their positions in the opposite direction. Also, major players buy when the market is panicking, and weak players leave the market with large losses.

First and foremost, a trader should believe in themselves, work by a high-quality trading strategy, and stick to their money management rules. Stay apart from the majority but do not purposefully contradict it – Warren Buffett cannot be wrong.




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