Psychology is the biggest driver of foreign exchange market. As a trader you should know this! You might ask how? Well the explanation is simple. Foreign exchange market is made up of thousands and thousands of people and it is their psychology that drives the market in the short run. In the long run we have the global economy and individual countries economies that drive the foreign exchange market. So in the short run, foreign exchange market is purely driven by emotions based on psychology. In the long run we have things like the Purchasing Power Parity (PPP), interest rates, trade balance and the stuff like that that drives the foreign exchange market. Let’s go in depth and see how psychology plays its role in the short run. We will focus on US Dollar as it is the one of the major currencies in the global economy perhaps the major currency is also true about US Dollar. Did you download Forex Trading Magazine latest issue?
Foreign exchange market is the largest financial market in the world with a size that dwarfs other financial markets like the stock market and the commodity market. Foreign exchange market is 20 times the size of the stock markets combined around the world. Exchange rates affect our individual lives on a daily basis even if we are not traders. Daily we buy goods like chocolates, rice, beauty products, medicines, gasoline etc, exchange rates are affecting the prices of these commodities. Like a spider web, currency market connects all other financial markets.
Rationality And The Foreign Exchange Markets
All modern economic models are based on people making rational decisions all the time. According to these economic models, we humans are always trying to maximize our utility function. Modern portfolio theory is based on the concept of rationality built into these economic models. You must have heard about the mean-variance optimization and the efficient frontier when learning portfolio theory. Using this concept of investor rationality, a financial theory has been build that tries to explain how asset prices get determined. According to this classical portfolio theory, risk can be divided into market risk and a specific asset risk. We can use diversification to almost eliminate asset risk but we cannot eliminate the market risk. Read the post on how to trade the FOMC Meeting Minutes release each month.
This concept of rational investors ruling the market leads us to the concept of markets being efficient. Efficient markets means that asset prices reflect all available information. Efficient market concept means we cannot beat the market and make excess profits as prices are always at their optimal level and we have noway opportunity to earn excess profits. Economists reason like this. Individual investors want to maximize profits. They can only maximize profits by thinking objectively and rationally. So either you become a rational investor or go bankrupt and leave the market. Many of us have seen when trading the currency market, how irrational the market can be. Many of us have started asking are investors rational? Are the markets really efficient? How do we explain that? Most of the time we have biases that get reflected in our decision making.
Myth Of Foreign Exchange Rate Random Walk
Another relevant question: Are markets really efficient? For a financial market to be really efficient, it should follow a random walk. Random walk is a stochastic process in which the agent does not the remember the past meaning every new step is a random step. If markets were a random walk, it would be very difficult for the buy low and sell high trading strategy to work. But it works. Random walk means we cannot systematically make profit from the market. This is not true. Random walk means market prices should show no auto-correlation. But study after study has shown present price to be auto-correlated with past price. Studies have shown that price auto-correlated in the short term. This is what we see when price starts to move up it moves up and gives us the up momentum in the market. In the same manner, we see when price starts to fall its fall continues giving a down momentum. In the long term, prices are negatively correlated. This gives us the phenomenon of reversals that we experience when price move in one direction and then reverse. So prices definitely are not random walk. Sometime market prices get affected by totally irrelevant news. This totally contradicts the efficient market hypothesis.
Are Markets Really Efficient?
Stocks having similar ticker symbols have been found to have returns that show significant correlation. Many cases have been reported in which newspapers published old news which should have been already incorporated into the market price according to the efficient market hypothesis. This notion of efficiency is based on the concept of rationality. What if there are many irrational players in the market? Economists argue that even if we have many irrational players in the market, as long as their actions are random, their moves will cancel out at the market level. In reality decisions made by people are psychologically influenced in systematic ways and cannot be taken as random. Framing effects have been found to effect decision making regarding risk taking by investors. There are self reinforcing patterns when investors imitate each other. Read this post on how the Swiss National Bank shocked the currency market.
Researchers believe that Technical Analysis is one such self reinforcing pattern that many investors imitate and copy. Retail investor market is now flooded with technical analysis courses. Many retail investors learn technical analysis and practice it in there trading and investing decisions. This is something interesting. I believe in technical analysis. But researchers in the field of finance believe that technical analysis is flawed and has no predictive powers. Researchers believe that the famous Head and Shoulder pattern has no predictive power at all. Nonetheless daily it generates around 60% of the trading volume in the market. So many flawed things that get taught in these technical analysis courses get shared by many retail traders when they make their buy/sell decisions.
Finance researchers think that technical analysis introduces positive feedback in the market in which a price rise generates buy orders that increase as prices rises more and more as a result of these buy orders. In the same manner price declines generates sell orders that increase as price falls more as a result of these sell orders. This introduces positive feedback in the market what some analyst call the self fulfilling prophecy. So technical analysis can result in sustained price change that is fundamentally flawed. This has been called Irrational Exuberance. Read about the 5 different Pivot Point formulas used by floor traders.
Advocates of market efficiency believe that no matter how many market participants are irrational, there are some rational market participants present in the market known as arbitrageurs that ensure that market does not stay away from the fundamentally incorrect levels for long periods of time. These rational market participants sense when the market is fundamental incorrect act decisively and make handsome profits. Irrational market participants lose as a consequence. So either they also learn to behave rationally or they become bankrupt and leave the market forever.So a learning effect takes place for these irrational players and they learn to analyze the market rationally through experience. We can give the example of George Soros who sensed that the British Pound was fundamentally weak but being propped up by the Bank of England in early 1990s. He betted heavily against the British Pound and drove it down to its correct level while reaping $1 Billion as a profit in 24 hours. We can think of George Soros as the rational market player the arbitrageur who brought sanity to the irrational market player which was Bank of England in this example.
So supporters of efficient markets argue that market at all times reflect all economically relevant information. There are people who have started questing this viewpoint as I am going to show below. Arbitrage opportunities are very limited in the market and are not without risk. Risk free arbitrage is simply impossible. We traders believe that rationality is a subjective thing. A decision which I think is rational can be viewed as irrational by another market participant. When we cannot explain a market movement we explain it by saying that market has become irrational. So irrationality is a sort of after thought most of the time and is a retrospect thing. Many traders believe that now a days 75% of the market is rumor driven while only 25% is rational driven. Watch this video on important candlestick patterns.
Psychology Behind Trading Decisions
Markets are social systems. Decision making in the financial markets involves thousands of participants who all are making individual decision that is highly dynamic and takes place under conditions of vague market conditions. If you are an outsider with no investment in US Dollar, it doesn’t matter to you whether USD rises or falls. If someone asks your opinion whether USD will appreciate or depreciate as a result of recent Trump Trade Sanctions decision, you can take a position without any feeling of risk. But suppose you are a market maker and you have active positions open in USD. You lose dollars, you make dollars based on your decisions. Unlike the person who had no real positions in the market, you have to constantly fight your own emotions psychologically when making the trading decisions because your know you can win or lose your investment as a result of your decisions.
For the market participants trading decisions are not easy and are based on complex factors like expectations, open positions, trading limits, exposure, actions of other market participants etc. All these complex factors are in conflict with one another making the trading a highly ambivalent process. Every decision that you take can have a reward as well as a risk factor associated with it. If you lose you feel the pain and if you win you feel exhilaration. Reinforcement Learning is an exciting new field of artificial intelligence that is revolutionizing many field like autonomous car driving and is based on making decisions under reward and pain scenario. There are many hedge funds who are using reinforcement learning based algorithmic trading systems that use reward and pain for each action taken. So we need to learn more about decision making under conditions of reward and pain.
Feelings are very important for a trader. Correct market psychology anticipation is also important for a good trader. Now compare this to the rational decision making process involving analytical thinking based on economic data. In the end for a trader, the correctness of a trading decision can be only evaluated on the basis of how many pips got made or how many pips were lost as a result of those trading decisions. Trading decisions get measure in terms of profit alone. Watch this recorded 1 hour webinar on candlestick maths.
Decision Making In The Financial Markets
Financial markets are considered to the backbone of the capitalist system that faced many challenges in the last few years but has emerged as the sole surviving system in 21st century after the demise of communism. The primary purpose of a financial market is to channel investment to the most productive sectors of the economy. This is done through a price mechanism that acts as a signal to the investors to channel funds to the most productive and profitable sectors of the economy. Financial markets generates capital at very cheap rates for companies engaged in productive activities. In the beginning there was very little understanding of how the price mechanism works. Did you take a look at my course Bayesian Statistics for Traders? In this course I take you by hand and show you how to improve your trading system using Bayesian Statistics.
It was Daniel Bernoulli who first introduced the concept of Utility. Utility allowed price to be differentiated from value. Price is a characteristic which is the same for an object for everyone. But utility is something that can be different. Utility tries to measure how much value an individual gives to an object. Soon the Law of Diminishing Marginal Utility was established. According to this law $10K has high utility for a person with only $100 but it worthless for a billionaire. Concept of utility was used to explain why investors are risk averse. Risk aversion means we value a sure thing more than a thing that is not sure. For example if we are given two choices. Under one choice we get $10 for sure and under the second choice we get $20 if we win a head on the toss of a coin, we will choose $10 for the time and forgo $20. This behavior is known as Risk Aversion.
Today economics teaches us that we as investors are always to trying to maximize our expected utility. Expected utility means we try to weight the different alternatives and then make decisions that maximize our expected utility. John von Neumann and Oskar Morgenstern did pioneering work in 1940s and 1950s in proving that given the choices we always try to maximize expected utility. In the last few decades economists have questioned this premise and instead introduced the Prospect Theory. The two psychologists who developed Prospect Theory were awarded the Nobel Prize in Economics. Read this post on what makes a successful trader.
We all know we make decisions under time pressures with ambiguous and missing information most of the time with the situation changing dynamically we need to recognize predictive patterns in the environment. Economists and psychologists differ in their basic understanding of the decision making process in the financial market. Economists use the Normative approach that says that market participants process information rationally. On the other hand psychologists use a descriptive approach of decision making in the financial markets. Under this approach decisions are psychologically effected by how the problem is framed and subjectively perceived by the market participants. This is known as Framing Effect. Financial markets are full of framing effects which are ignored by the traditional economists.
Social Herding In The Financial Markets
As I have said above, financial markets are in reality social systems. In the end it is the mass psychology that determines the price of a stock or a currency pair. Herding takes place in the financial markets. In a social group most members try to conform. This conformity is also observed in the financial markets. This is how herding takes place in the foreign exchange market. Participants in the foreign exchange market are always under pressure to analyze and turn highly ambiguous and complex market information in trading decisions which has a high probability of being wrong. Since the situation in the currency market is frequently changing, ambiguous and uncertain, we start looking towards other more bigger players in the market in forming our opinions thinking that they know more than us.
In the foreign exchange market and in any financial market there are certain opinion makers. Most of these opinion makers are writing for important financial news websites or working for big banks or big hedge funds. For example, in a conference Goldman Sachs chief economists says that New Zealand Dollar is too strong now and needs to depreciate. This statement is immediately picked up by financial news sites like Bloomberg, CNBC etc and posted on their website. By the end of the day, you see the herd mentality taking shape when majority of the market participants think that there must be something behind this statement and viola NZDUSD falls be 2%. Forex traders are investing in ICOs.
Central Banks and important politicians like the Presidents, Prime Ministers and the Finance Ministers can also initiate herding in the market. Last year, when the French President publicly said that Brexit will have a hard landing, this initiated herding in the market and GBPUSD fell heavily. The French President had only expressed his opinion but the market participants took it seriously and acted upon it to make it a reality. Following the herd in the initial phase can be profitable. It is this herding mentality that sets the trends in the foreign exchange market and for that matter other financial markets. It is good to join the trend in the building phase but it is wisely to get out in the dissolution phase.
This herding behavior is very important during times of market crash. In the last few years, we have seen frequent flash crashes in the foreign exchange market. Just two years back, GBPUSD fell more than 1500 pips in a matter of a minute and than recovered. Read about the GBP Flash Crash. Similar flash crashes have been experienced in other financial markets especially the stock indexes like S&P 500 and DOW have experienced flash crashes and then recovered. Market crashes are the result of sudden change in the collective perceptions of the market participants. This is known as Emotional Contagion. Everyone tries to synchronize decisions. Humans tend to overweight recent information more as compared to past information. We traders also try to give more weight to recent prices as compared to past prices when we use exponential moving averages.
Exchange Rates are very important prices for any economy as they have a strong impact on the country’s current account that shows the trade surplus. US Dollar Index measures the strength of US Dollar against a basket of seven currencies that includes EURO, YEN, POUND, CANADIAN DOLLAR, SWEDISH KRONA and SWISS FRANC. When US Dollar Index rises it means USD is getting strong. When US Dollar Index falls it means USD is getting weak. Between 2014 and 2016, US Dollar Index rose by 25% which means USD appreciated a lot during this period. As currency traders we always take a look at US Dollar Index daily especially if we are trading currency pairs like EURUSD, GBPUSD, USDJPY, USDCAD, USDCHF, AUDUSD and NZDUSD. I am not sure if US Dollar Index can be used to predict AUDUSD and NZDUSD as it does not contain AUSTRALIAN DOLLAR and the NEW ZEALAND DOLLAR in the basket of currencies that measure it. But we can definitely use US Dollar Index to predict EURUSD, GBPUSD, USDJPY, USDCAD and USDCHF. In this post I want to discuss in depth the fundamentals that drive the exchange rates in the long run. I have done writing this post. Return to my News Trading blog after a few weeks and check the next post on how psychology drives the currency market.