In investing vocabulary, "herd mentality" refers to traders blindly following established investment trends or patterns. Such traders are usually believers in the well-known investment philosophy - "the trend is your friend". In currency trading, this principle has the potential to yield better returns than in stock trading for several reasons.
First, unlike stocks, currency trading is largely driven by technical analysis, and fundamental analysis plays a much larger role in stock trading than in forex trading. Secondly, the currency market is the most liquid financial market in the world. According to the latest data, the global average daily trading volume of currency trading exceeds 5 trillion US dollars, and 6 pairs of currency pairs - USD/EUR, USD/JPY, USD /GBP, USD/AUD, USD/CHF, USD/CAD – that alone accounted for two-thirds of the volume traded. (In contrast, the total number of blue-chip stocks on the world's major stock exchanges runs into the thousands).
These currencies are closely watched by a large number of currency traders around the world, and the same technical levels are monitored 24/7 by these traders as buy and sell signals. Once a key technical level gives way, other traders join in and solidify the initial trend, exacerbating the herd effect.
Using the Herd Effect in Currency Trading
The guiding principle of utilizing herding in the currency trading market is very simple - based on the opinion of the majority and the trend of the global market. Countertrends can make you very profitable in the stock market - assuming you are smart enough to time the market effectively - but in the currency trading market, it can spell disaster, where exchange rates can defy fundamentals for so long, moving Going this far can test the resolve of the best-funded and best traders.
The depreciation of the yen in 2013 is a classic example of the herd effect at work. In April 2013, the Bank of Japan announced that it would buy government bonds by 2014 and double Japan's monetary base. The Bank of Japan launched an unprecedented monetary stimulus policy to boost economic growth and break the deflationary spiral that has plagued the Japanese economy for 20 years. As such, the short JPY/long USD trade was one of the most popular currency trades in the first half of 2013.
Traders are already shorting the yen due to Japan's aging population and large government debt, while the yen's decline comes as traders and speculators grow more confident that the Bank of Japan will continue to ease monetary policy. Through the first week of May 2013, the yen was the biggest loser of any major currency that year, falling 12.4% against the dollar. As currency traders rushed to buy short positions in the yen, the yen broke through the 100 mark, when the herd mentality added to the downward momentum.
Short JPY/USD trades effectively replaced short EUR/USD trades in 2013 as trend followers started trading, with the euro bouncing off lows around 1.20 starting in mid-2012 and the attention of currency trade bears turning to the JPY . Over the one-year period ended May 7, 2013, the performance of both currencies against the dollar provides a measure of this shift in sentiment, with the euro up 0.2 percent and the yen down 19.3 percent.
The dollar's strength against most major currencies since May 2013 also reflected a herd mentality, with the greenback gaining against 13 of the 16 most traded currencies. The unexpected strength of the U.S. dollar at that time was largely due to the rebound of the U.S. economy, which pushed the Dow Jones Industrial Average and the S&P 500 to new highs, attracting more capital inflows and forming a virtuous circle.
Common Herd Psychology Currency Trading
The exchange rate trend over the years shows that following the transaction is the most common "herd mentality". These are just suggestions and it is highly recommended that you do your own research and due diligence if you intend to trade against these currencies.
China, the world's largest commodity importer, has seen strong economic growth, benefiting the currencies of commodity exporters such as Canada and Australia. In the 2000s, the Australian and Canadian dollars rallied 37 per cent against the U.S. dollar as China's economic boom spurred demand for commodities. Therefore, long-term use of CAD and AUD/USD should be considered at a time when the Chinese economy is growing rapidly.
The Australian and Canadian dollars tend to do well when the global economy is growing strongly and demand for risk appetite is strong. Conversely, these commodity currencies have depreciated and safe-haven currencies such as the U.S. dollar and Swiss franc have rallied when concerns mount over slowing global growth and risk appetite. A popular herding trade at such times is to short the Canadian or Australian dollar and long the US dollar or Swiss franc.
Although the yen had lost material ground in the spring of 2013, it tended to trade against global risk appetite due to its popularity as a funding currency for the "carry trade". When risk appetite evaporates and panicked speculators rush to unwind their positions, the carry trade strategy can be disastrous, as the yen is needed to repay the carry borrowings, with the double whammy of fire sales of risky assets and a surge in the yen . By 2007, more than $1 trillion had been invested in the yen carry trade, but with the onset of the global economic crisis in 2008, the yen rose 20 percent against the dollar.
From October 2007 to October 2008, speculators who borrowed in yen and invested in AUD (equivalent to a long AUD/short JPY position) saw AUD/JPY drop by a massive 49% over a one-year period, losing money heavy. In fact, the yen is often very volatile, and before deciding to enter a currency carry trade based on the yen (such as long CAD/short JPY, or even long EUR/short JPY), make sure you have an exit planned.
Due to Canada's status as a major oil exporter, the Canadian dollar has a strong positive correlation with crude oil prices. Japan, on the other hand, is one of the world's largest oil importers and its economy is vulnerable to high oil prices. Consider long CAD/short JPY should crude oil prices spike, such as a sudden conflict in the Middle East.
From 2010 to 2012, global macroeconomic risks focused on Europe, and the risk of disintegration of the Eurozone existed. While related concerns have largely dissipated since mid-2012, another debt crisis in one or more of the most indebted countries has fueled growing concerns about the Eurozone, leading to short EUR/long USD, or short EUR /Surge in long Swiss franc positions.
Herding Techniques
Inexperienced currency traders should be aware of these "herd mentalities":
An exhausted trend or long-term trend because of the danger of an imminent reversal. Currency trends can reverse dramatically, and being on the wrong side of a trend reversal can lead to catastrophic losses. Likewise, unless you are George Soros, don't be a counter-trend currency trader.
When following a trend, plan your exit strategy ahead of time. Herds provide enough safety, as long as you don't get run over when the herd rushes for the exit.
Stop losses are critical, as over-leveraged retail currency trading can lead to liquidation if strict trading discipline is not observed.
Remember, being long one currency means shorting another. Short positions appear to allow traders to monitor them more closely, a practice that may help stave off the complacency that can turn a profitable position into a losing one.
"Amortizing costs" is not a viable trading strategy in the currency trading market, so adding to a losing position is not advisable.
in conclusion
Herd mentality can help you make profitable trades in the currency trading market, but be cautious and use common sense when in a herd - use stop losses, avoid complacency and plan your exit strategy. The trend is your friend when millions of traders realize the cost, but only when it comes to an end.
*In a yen carry trade, speculators borrow yen at zero interest, use it to buy dollars, and invest the proceeds in higher-yielding (and riskier) assets such as stocks, other currencies or commodities. A steady depreciation of the yen is a prerequisite for the success of this carry trade, since the amount of foreign currency used to repay the initial yen borrowing is small.
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