Any classically trained economist will claim that price is the equilibrium of supply and demand. When that fact remains to be true in Economics 101, in reality price is the collective consensus among market participants. Movement of price on the other hand reflects their combined expectation regarding the directional bias. However, in financial market we often see irrational price behavior. The irrationality derives from a mass psychological event which states often price movement is actually the result of its prior empirical movement.
Mass Psychology and Crowd Behavior in Forex Trading
Individually, market participants can use intrinsic value by analyzing various economic or often technical indicators such as CPI, Inflation or MACD. Regardless, as a group, often Forex traders emphasize on their own herd mentality to buy or sell currencies which we call following the trend.
The trend following or herd mentality can be observed in irrational price movement such as spikes during news releases, working of support and resistance zones where majority of traders react to price action and turns those imaginary lines on their charts into self fulfilling prophecies. Even, often we see during a trend price respects ancient prime numbers, Fibonacci ratios and other fancy numbers. These technical tools sometimes work because the Mass Psychology of the Forex Market or the herd takes those numbers and tools seriously. For example, trend lines work because traders use trend lines! If enough traders end up using some kind of curve lines, those will also end up appearing to be working!
There is actually a cult in the financial market who became very successful by identifying how mass psychology works then blindly following the herd. Richard Driehaus popularized the idea that buying high, compared to buying low can be more profitable compared to the traditional investment paradigm which advocates buying low and selling high! Buying low and selling high is a concept best executed by world’s prominent investors like Warren Buffett. However, Mr. Driehaus became successful by simply following the mass psychology of the market and buying high and selling at even higher price, and revolutionized the theoretical concept of all short term investors, traders and speculators for the good.
Perhaps the finest testament to back this mass psychology based trading approach came from one of prominent British economist of the twentieth century, John Maynard Keynes, who said: “The market can stay irrational longer than you can stay solvent.”
What he meant by this famous quote was that trying to rationalize market or price and trading against the “trend” or herd mentality can ruin your account. However, if we can reverse our psychological conditioning and follow Mr. Richard Driehaus’s advice then contrary to worrying about our solvency, we can make a good amount of profit by simply following the irrational market.
There are a lot of technical trading techniques that follows this type of theoretical concept. For example, “breakouts” are one of the best strategies to follow crowd mentality of the market. When the price closes above or below an imaginary trading range, because key market participants observe this, they join in and push the price even higher once there is a breakout on the upside and vice-versa.
Using mass psychology to gain huge profit has its pitfalls as well. One of the key aspects of using herd mentality is learning to manage the inherent risk associated with using such strategy. Successful Forex traders understand that when irrational price movement can create trends, these phenomena can also change the trend and wipe their account very quickly, if the risk is not managed properly.