How can herd instincts be used in trading?
We have already discussed many types of Forex strategies: high-frequency trading, arbitrage, moving averages, cycle theory, price return to average, trend systems and breakdown ones. But there are several more types of vehicles that we have not had time to talk about yet. And one of these types is systems built on the psychology of traders and investors.
It is difficult not to think of the market as a person: his mood can change from irritable to unreasonably joyful, then he can hastily react to something and change everything the next day. But can psychology really help us understand financial markets? Behavioral finance theorists think so. This area of research claims that people are far from being as rational as the traditional theory of finance describes. So let's get it right.
Psychology and Market Efficiency
The idea that psychology drives the market runs counter to the established theory that markets are efficient. Proponents of the efficient market hypothesis say that any new information quickly falls into market prices through the arbitration process.
Behavioral experts explain that irrational behavior is not an anomaly, but a common thing. In fact, the researchers were able to reproduce market behavior using very simple experiments.
Here is one experiment: offer someone the choice between getting $ 50 and getting the chance to throw a coin and win $ 100 or not win anything. Most likely, a person will choose $ 50. Conversely, if you offer a choice between losing $ 50 and the possibility of losing $ 100 or not losing anything, then the person will probably want to throw a coin. The opportunity to throw a coin is present in both scenarios, but people will do it to save themselves from losses, although they may lose even more. People tend to believe that the ability to win back losses is more important than the ability to get more wins.
The loss avoidance priority is also valid for traders. Just think about how popular the various grids and martingales are. Regardless of how low the price has fallen, traders believe that it will eventually rise again, and still hold unprofitable positions up to margin calls.
Herd instinct explains why people tend to imitate others. When the market moves up or down, traders believe that others know more or have more detailed information. The consequence is that traders feel a strong desire to do what others do.
Behavioral finance also found that traders tend to place too much emphasis on judgments from a small sample of data or from individual sources. For example, it is known that if an analyst chooses winning stocks, then traders attribute this to skills, not luck.
On the other hand, the beliefs of traders are not so easy to shake. In the late 1990s, long-term traders were embraced by the belief that any sudden drop in the market is a good time to buy. Moreover, this point of view still prevails. Traders are often too confident in their judgment and tend to rush into a single “talking” detail, rather than listen to a more obvious mean.
Why do people behave so badly with their money?
In the decision-making process, people use facts as factors, but they perform actions under the influence of emotions. Even if it seems to you that you are working with a cold head, you are mistaken. There is no magic button that, even for a short time, could completely turn off the emotional component.
In the world of statistics, there are classifications for different types of variables. These are the rules that guide research and trading decisions. They relate to how we analyze models and conduct stress tests to achieve statistically significant results, and how we ultimately make decisions. These variables are procedural, and they are highly controlled.
Imagine that you were taken to a police station to testify. Police will conduct interviews according to their procedure. Will you look at real suspects? Will they show you photos? If so, will the photos show one by one? Or six at a time? At this time, the officer will look over your shoulder? What gender, race and age will the officer be with respect to the witness? Or in relation to the suspects? This is the choice to make when conducting a specific procedure.
Now imagine your mental state when you are sitting in the police station. How can your mental and emotional status change depending on the nature of the crime? What if a weapon was used in a crime, do you focus on the weapon or on the attacker? How confidently will you answer questions if the crime happened an hour ago, or a day ago, or a week ago? If it happened next door or far from your home? Are you more or less likely to point to a photograph appropriate to your race or gender? Are people with tattoos malefactors or creative individuals?
These are all “contextual variables,” because they apply to you and the context surrounding your individual decision-making process, in our case, your ability to provide reliable testimony.
There is a connection between system and context variables, they are not completely independent of each other. For example, optimizing system variables by introducing procedures that reduce witness anxiety and the time period between crime and clarification of circumstances can help stabilize other volatile context variables, which will lead to more accurate eyewitness testimonies.
Trade works in much the same way. We constantly strive to research new methods, integrating ideas, where appropriate, and introducing variables into the working system that show strong statistical significance. And we know that if we succeed, then, most likely, we will get the effect of suppression in other volatile context variables. In simple words - if we develop a system that ensures stability and growth, and at the same time try to suppress the influence of context variables as much as possible, then such a system will be easier to follow, and the probability of incorrect decisions due to emotions and monetary losses in this regard will be minimized .
Unfortunately, in most cases, the influence of contextual variables in the development of trading systems is blind. The average trader gets significantly worse results than an investor who adheres to a simple buy and hold strategy. Most of this gap in results is explained by behavioral deficiencies (they are also context variables). Too many investors, who are possessed by fear and greed, buy at high prices and sell cheaply.
Therefore, despite good, accurate theories, instruments are often traded at unreasonable prices, traders make irrational decisions, and you find it difficult to find a person who has such a coveted and such advertised income with 60% per annum every year, as scheduled.
So what does all this mean for us? This means that when traders make decisions, emotions and psychology play a big role and sometimes make them behave unpredictably or irrationally. This does not mean that theories do not matter - their principles work. But not always. And since people often behave like idiots, you just need to earn money on this. It remains only to understand how.
How can you use knowledge of behavioral finance in practice?
So, will these ideas help make a profit? In the end, a lack of rationality should provide many lucrative opportunities for smart people. However, in practice, few people use behavioral finance in their trading strategies. The influence of behavioral finance, as before, is more often studied in scientific circles than in practical money management.
Although behavioral finance points to numerous deviations from rationality, they offer few solutions that make money out of market passions. Robert Shiller, author of Irrational Exuberance, 2000, found that the American stock market was in the center of the bubble in the late 1990s. But he could not say when it burst. Similarly, in the fall of the market, human behavior experts will not be able to tell us when the market will bottom out. However, they can describe how this is likely to look.
Human behavior experts have not yet come up with an intelligible model that actually predicts the future, and does not just retroactively explain what the market has done in the past. The main lesson is that theory does not tell people how to make a profit. Instead, she says that psychology affects the fact that market prices deviate from the norm over time.
Behavioral finance does not offer investment miracles, but perhaps they will help you learn how to monitor your actions, which in turn will help to avoid mistakes that reduce personal well-being.
The differences between theoretical and behavioral finance are best viewed as follows: theory is the basis from which to build on an understanding of the subject of study, and behavioral aspects are a reminder that the theory does not always work as expected. Accordingly, a good knowledge of both points of view can help you make better decisions.
The idea that financial markets are effective is one of the basic principles of modern portfolio theory. This principle, upheld in the theory of an effective market, suggests that at any given time prices fully reflect all available information about a particular market. Since all market participants know the same information, no one will have an advantage in predicting profitability, because no one has access to information that is not available to others. In efficient markets, prices become unpredictable, therefore, patterns are not traced, which completely negates any planned approach to trading. On the other hand, studies in behavioral finance, which examine the effects of investor psychology on courses, reveal some predictable patterns in the markets.
In theory, all information is distributed equally. In fact, if this were true, then insider trading would not have existed, unexpected bankruptcies would never have happened. There would be no need for the Sarbanes-Oxley Act (2002), which was designed to move markets toward higher levels of efficiency. And let's not forget that personal preferences and personal abilities also play a role. Obviously, there is a gap between theory and reality.
Theoretically, everyone makes rational decisions. Of course, if everything was rational, there would be no speculation, bubbles, and irrational abundance. No one would buy when the price is high, and would not sell in a panic when the price drops. Not taking into account the theory, we all know that there is speculation, that the bubbles grow and burst.
In 1995, the Gartner consulting company introduced the so-called “hype cycle,” or technology maturity curve.
Since then, Gartner has regularly published a technology maturity chart, which notes in which phase this or that innovation is now. These publications are closely monitored by investors to understand when and in what to invest.
This is a typical development of hype not only for technology, but also for any events in the markets. In fact, the reaction to any news can be placed in such a pattern. Rename the stages from the first image in relation to the market.
It is clear that the model is idealized. In reality, the configuration may have differences (as, in fact, for the parent cycle for technologies), but the main thing remains - the sequence of stages, expressed in price changes.
Let's look at work in reality. Hype cycle for annual data on US GDP released on January 30, 2019:
In this case, the graph fits the model well, as the news is strong and pulls the blanket over itself. In general, many events take place in the markets at the same time, and the hype cycles can overlap and influence each other, resulting, ultimately, in price.
An example of a long-term hype cycle is peaks on bitcoin. But there they can directly be called HYIPs. The Bitcoin chart is a direct link between the charts of financial markets and the parent hype cycle for technology:
In a market where we can enter the sales, it seems like a good idea to sell on a rollback, counting on the lowest point of disappointment. By the way, for news that causes a market drop, the same applies inverted when shopping on rollbacks will be interesting.
However, the pattern is intuitive, and, for sure, many of you came to it yourself. I personally met several traders trading this model (though they didn’t know that it was she).
The ratio of open positions of traders
As you probably already understood, traders and investors (even professional ones) often make mistakes when trading in the markets and follow their emotions. Therefore, another completely logical idea would be to use their mistakes for our purposes. The Supremacy strategy, which was discussed earlier on the blog pages, is built on this principle. You can also see the Cayman indicator, which allows you to track the mood of traders directly in the terminal.
Some people think that if you go in against the crowd, it will always give a result, because the crowd is constantly mistaken. The crowd really loses money in the long run. But not at all because he constantly predicts a trend incorrectly. Most determine it correctly, since it is not difficult at all.
Observing the open positions of retail traders, when the price approaches significant support / resistance levels, trend lines, important news, all this will allow you to look behind the scenes of the retail market and understand what emotions are hidden in the head of the average currency speculator.
Of course, we all heard that more than 90% of people lose money in the foreign exchange market. But, as we have already said, this does not mean at all that in any given period of time more than 90% of traders incorrectly predict the market movement. According to a simple study that I cited at the beginning of the article, the problem is different. A person’s psychology is such that he is more likely to take a guaranteed profit and pull until the very end with the closing of a losing trade. According to statistics, the average profit of traders on the EURUSD pair is 48 points, and the average loss is 83 points. This difference is almost 70%, and it is critical.
Thus, forex traders lose more money on unprofitable transactions than they earn on profitable ones. An ordinary retail trader is extremely jerky, poorly disciplined - he does not know how to work with risks and money. Hence the typical paradox - most of them forecast the price movement well (the trend line is not so difficult to draw), but cannot make money on it.
Also do not forget that this is the data on the retail Forex market.An ordinary retail trader, as a rule, jumps a lot and rarely holds a position open for more than 2 days, which should be taken into account when analyzing his transactions. Take into account the fact that the entire retail forex market is less than 15% of the total foreign exchange market, a tiny niche. Therefore, use data such as another market indicator, which will allow you to get another hint regarding market movement.
Pay special attention to strong skews. If you see overbought or oversold for a certain currency pair of 80% or more - this may indicate a reversal. Look for boundary, polar values, inconsistencies, market "vulnerabilities", which is confirmed by various correlations.
In fact, there is not enough data to analyze this approach, and it’s not easy to find a history of changes in the position ratio for at least one of the currency pairs. But I am absolutely sure that it is possible to build a profitable TS from this idea, it is enough to collect this data and carefully test the strategy on a sufficient amount of them. To make sure that further research is advisable, just look at the first chart with a mark of the zones where the ratio of open positions exceeds levels 30/70:
So, with a quick assessment, we got 8 losing trades and 5 profitable ones. The total loss amounted to 220 points, total profit - 486 points and net profit - 266 points.
As you can see, levels above 80% are best practiced. If we took only deals where the imbalance was above this level, we would not have a single losing trade, the profit would be 486 points, and the maximum drawdown in one of the open positions would be only 25 points. Then it would be possible to work calmly with a stop of 50 points, which with an initial deposit of $ 1,000 and trading with a risk of 3% per trade would bring us 324 dollars in profit or 32.4% for one currency pair with a drawdown of 1.5% literally for a month and a half! Of course, in reality, the picture may not be (and will) be so rosy, but a similar result indicates a certain potential of this approach.
To develop this idea and turn it into a potentially profitable strategy, statistics should be accumulated for at least a year for all available currency pairs and all brokers. Then, through testing, determine the best data sources. Perhaps you should use the average values of sources showing the best results on tests - a pool of the best brokers.
Key Findings and Trading Opportunities
So, as we have seen, most traders behave inappropriately in the markets. Based on a study of the behavior of traders, the following conclusions can be drawn:
1. Most deals often open against the trend. This is especially evident when the trend is protracted.
Around the middle of the trend, most traders open positions in the opposite direction, hoping to predict its reversal and jump at the very beginning of the price movement. Naturally, this almost never happens:
Therefore, when over 80% of traders believe that the trend is over, the most ideal time comes to enter to continue it. Such a signal on our test data gave 100% hits.
2. Profitable trades are closed much faster than unprofitable ones. And this is also confirmed by our test data.
Please note that even at the level of 70%, when we received 8 unprofitable and only 5 profitable trades, the profit was just about twice the loss. This is clearly visible even visually:
The first purchase transaction, which turned out to be profitable, was closed very quickly by most traders. The second and third, which immediately went into the negative zone for the majority, lasted a very long time and the drawdown was much deeper than the profit on the first transaction. The fourth transaction (for sale) immediately went into profit and was immediately closed by the majority, although the trend continued for a long time and, potentially, could bring at least four times more profit.
All this once again confirms the appropriateness of the “anti-crowd” trading approach and gives us an important lesson - if you want to make money in financial markets, you have to go against your own psychology and against comfort, do the opposite, and not follow the main herd for slaughter.
3. Another conclusion - traders most often do not forget to set take profits and often completely forget about stop loss.
Thinking about profit is always much more pleasant than about possible losses. In addition, it is entirely possible that traders rely on their iron will and that fantasy, where they close a losing position at a pre-considered level. I admit the possibility that most do not know what mathematics is, and that is why their profit to loss ratio is 1 to 2, but, nevertheless, this theory is unlikely.
4. The favorite level for the stop of most traders is the extreme. The following picture perfectly illustrates this idea:
As you can see, in unprofitable zones, the imbalance between open positions quickly resolves when the previous extremum breaks through. This suggests that the majority of the feet are just at these levels. As soon as the price falls a little lower or rises a little higher, many positions close in the footsteps, and the imbalance disappears. No need to do that. Place your feet with a little thought.
So, we are once again convinced that 90 - 95% of idiots who, one way or another, lose their money are trading in the Forex retail market. Again, we became convinced of the already banal and beaten cliche that "psychology in trade is the most important", and that, despite all its beaten and banality, no one listens to it.
Very often in human psychology there is such a funny contradiction - too banal advice is ignored. Take at least human health. Doing exercises in the mornings and not eating any dubious things are very banal tips that help extend your life for years, or even decades. But look around and you will be surprised to find that almost no one follows these tips. The same is true in trade.
We live in a far from ideal world, and the main source of this imperfection is precisely human nature. Therefore, all that remains for us, no matter how funny it may sound, is to use it in our trading to the fullest. As long as there are people on the market with their manual strategies, there is always the opportunity to earn a little money from their holy faith in themselves and their strengths. And one of the great tools for this is working against the crowd.
We’ve taken apart two great tools today - the hype cycle, which gives good opportunities for trading against traders who are led by the news, and the ratio of open positions of traders, which provides excellent opportunities for transactions with a high probability of a favorable outcome.
And finally, I urge you to think with your head more often and not give in to emotions. This is unacceptable both in life and in trade, with only one difference - in life you pay for idiotic behavior only by relationships with people like you, people, possibly work, and rarely something valuable, but in trade you are losing your real money.