How Does a Herd Instinct Affect Trading in the Forex Market?
In Forex speak, “herd instinct” is the tendency of traders to blindly follow a trend or pattern that has been established by a large group of traders. These traders are often firmly abiding by the well-known investment term “the trend is your friend.” This principle usually provides better returns in Forex trading than in equities trading for a couple of reasons.
First, Forex trading is mainly driven by technical analysis to a greater extent than stock trading, since fundamental analysis plays a much larger art in equity trading then it does in currencies.
Second, even though the Forex market is the world’s most liquid financial market with an estimated daily turnover exceeding $4 trillion, only six currency pairs, USD/euro, USD/yen, USD/sterling, USD/Australian dollar, USD/Swiss franc and USD/Canadian dollar, account for two thirds of this trading volume. In comparison, there are thousands of blue-chip stocks on the major global equity exchanges.
These currencies are closely watched by a majority of traders all around the world, and the same technical levels are monitored around-the-clock by these traders for buy and sell signals. When a key technical is triggered, other traders jump in and reinforce the initial trend, this compounds the herd effect.
Using the Herd Instinct in Forex Trading
The main theory for using the herd instinct profitably in the Forex market is very simple, base your trades on the majority view and established trends in global markets.
If you are able to effectively time the markets, being a contrarian may enable you to profit in the stock market, but it can be disastrous in the Forex market. A currency can defy fundamentals for so long and drift so far that it can test the resolve of even the best traders.
Tips for Herd Instinct Trading
Here are some tips to help you with a herd instinct trading strategy:
Watch out for trends that have been going on for a long period of time, they may be in danger of a reversal. Currency trends can reverse quickly, jumping into a trend that has been long-lived could wind up leading to huge losses if it makes a reversal.
Plan your exit strategy in advance when plotting a trend. There is safety in running with the herd as long as you have a plan to get out before your trampled on.
Trading discipline is very important in the Forex market. That is why stop losses are critical, the high degree of leverage in retail Forex can lead to financial ruin if you don’t implement strict trading rules for yourself.
Adding to a losing position is never a good idea. This is why “averaging down” is not a viable trading strategy in Forex. Never try to catch falling knives.
The herd instinct can help you trade established trends in the Forex market profitably, but be careful and use common sense while in the herd. Use stop losses, avoid complacency and plan your exit strategy.