Psychology of Herd Behaviour in Forex Trading: How Collective Behaviour Drives Currency Movements

In the volatile world of forex trading, decisions have to be made within seconds, and the stakes are very high. In order to better understand the forex market, traders need to have the trading psychology to make netter decisions, and when they lack this psychology, they turn to the easier way, which is copying someone more successful than them. This behaviour of following others blindly, rather than building one’s own opinions is called herd behaviour. In the forex market, this collective mindset can drive currency movements in ways that don’t always align with fundamental economic factors, leading to rapid market trends, bubbles, or sudden corrections.

Understanding Herd Behaviour in Forex Trading

Herd behaviour stems from the very basic human instinct of following the crowd to ensure survival and is often driven by the fear of missing out (FOMO) or avoiding losses. In the context of forex trading, this behaviour manifests when traders, rather than making decisions based on objective market data or technical analysis, mirror the trades and sentiments of others.

This can lead to mass movements in currency prices, even when there's no substantial shift in economic conditions or geopolitical developments. Traders often believe that the "crowd knows best," and assume that if many people are buying or selling a currency, they must be acting on superior information or insight. However, the reality is that many traders are simply following the actions of others, creating a self-reinforcing cycle of price movements that aren't necessarily rooted in reality.

The Role of Social Proof and FOMO

At the core of herd behaviour in forex trading are two psychological triggers: social proof and fear of missing out (FOMO).

1. Social Proof: Traders look to others, especially at the seasoned traders or market leaders, for cues on how to act in the market. When influential traders or institutions make a move, retail traders often follow, thinking these leaders have access to better information. This can create a domino effect, where large swaths of the market begin to move in the same direction based on nothing more than imitation.
2. FOMO: In a highly volatile market like forex, traders are acutely aware of the potential for rapid profits or losses. This awareness fuels FOMO, as traders rush to enter a market trend, fearing they'll miss out on substantial gains if they don’t act quickly. This frantic behaviour can inflate price movements, pushing currencies to extreme levels without fundamental justification.

The Creation of Forex Market Bubbles

Herd behaviour can lead to the formation of bubbles in the forex market—situations where the price of a currency rises far beyond its intrinsic value due to speculative trading. Traders continue to buy into a rising currency, believing that prices will keep climbing, without considering the true economic or geopolitical factors at play.

For example, a currency might rally due to an unexpected economic report or central bank announcement, causing traders to pile in. As the price rises, more traders join in, driven by the belief that the trend will continue. However, this creates an unsustainable bubble that is often detached from the underlying fundamentals of the currency.

Sudden Market Corrections

Eventually, herd behaviour can lead to sudden and dramatic market events. And the worst part is that they don’t even make sense. ****When the bubble finally bursts, traders panic, and rush to sell off their positions all at once. This creates a rapid reversal trend in the market, with prices crashing just as quickly as they rose. The initial sell-off triggers more panic among traders, leading to even deeper price drops.

One example of a market correction fuelled by herd behaviour occurred during the Swiss franc crisis in January 2015. When the Swiss National Bank suddenly abandoned its currency peg to the euro, the franc surged in value. Many traders had been betting on the franc staying pegged, and when the peg was removed, panic ensued. A massive sell-off followed, causing one of the largest market corrections in forex history.

Avoiding Herd Behaviour

While herd behaviour seems to make opportunities for some quick and easy gains, it’s a risky strategy that can lead to significant losses. Traders who rely too heavily on following the crowd may find themselves caught in bubbles or market corrections, unable to exit their positions before prices reverse.

To avoid falling into the trap of herd behaviour, traders can take the following steps:

1. Independent Analysis: Make trading decisions based on solid research and analysis of the currency's fundamentals, rather than the actions of other traders. Use technical indicators, economic reports, and geopolitical developments to inform your trades.
2. Set Trading Rules: Establish clear entry and exit strategies before entering a trade. This can help you stay disciplined and avoid getting caught up in market euphoria or panic.
3. Risk Management: Always employ risk management techniques, such as stop-loss orders, to limit your exposure to market volatility. This can protect you from large losses if the market suddenly moves against you.
4. Stay Emotionally Detached: Trading based on emotions like fear or greed can lead to poor decision-making. Stay focused on your strategy, and don't be swayed by the actions of the crowd.

Conclusion

Herd behaviour is a powerful, but misleading force in the forex market, capable of driving massive price movements and creating both opportunities and risks for traders. While it’s tempting to follow the crowd, it’s crucial to be aware of the potential bubbles and sudden corrections. By maintaining a disciplined, research-driven approach, one can avoid the herd behaviour and make more informed decisions in the ever-changing forex landscape.

Credits: Luv Bhatia