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Where the Herd Instinct Works
05/24/2013 9:00 am EST
Although this behavior doesn’t work well in the stock market, it does work better in the forex market, writes the staff at Investopedia.com.
"Herd instinct" in the investing lexicon refers to the tendency of traders to blindly follow an established investment trend or pattern. Such traders are typically adherents of the well-known investment axiom "the trend is your friend." This principle is likely to provide better returns in forex trading than in equities trading for a couple of reasons.
Firstly, forex trading is arguably driven by technical analysis to a greater extent than stock trading, given that fundamental analysis plays a much bigger part in the latter than it does in the former. Secondly, while the forex market is the world's most liquid financial market with estimated daily turnover exceeding $4 trillion in 2010, just six currency pairs—USD/EUR, USD/JPY, USD/GBP, USD/AUD, USD/CHF, and USD/CAD—accounted for two thirds of this trading volume. (Conversely, blue-chip stocks on the major global equity exchanges collectively number in the thousands).
These currencies are avidly watched by legions of currency traders around the world, and the same technical levels are monitored around-the-clock by these traders for buy and sell signals. Once a key technical gives way, other traders jump in and reinforce the initial trend, thus exacerbating the herd effect.
Using Herd Instinct in Forex
The guiding principle for using the herd instinct profitably in the forex market is a simple one—base your trades on the majority view and established trends in global markets. Being a contrarian may enable you to reap rewards in the stock market—assuming that you are astute enough to time the markets effectively—but it can be a recipe for disaster in the forex market, where a currency can defy fundamentals for so long and drift so far that it can test the resolve of the biggest and best traders.
The decline of the Japanese yen in 2013 is a prime example of the herd instinct at work. In April 2013, the Bank of Japan (BOJ) announced that it would buy government bonds and double the country's monetary base by 2014. The BOJ embarked on this unprecedented degree of monetary stimulus to foster growth and break the deflationary spiral that had plagued the Japanese economy for two decades. As a result, the short JPY/long USD trade was one of the most popular forex trades in the first half of 2013.
While traders were already shorting the yen going into 2013 on account of Japan's aging population and massive government debt, the yen's descent picked up steam as traders and speculators grew increasingly confident that the Bank of Japan would continue to ease monetary policy. By the first week of May 2013, the yen was the biggest decliner of the major currencies for the year, with a 12.4% fall vs. the US dollar. With forex traders rushing to put on short JPY positions, the currency looked set to break the 100 barrier, at which point the herd instinct would have added to its downward momentum.
The short JPY/long USD trade had in fact superseded the short EUR/long USD trade by 2013 as the "go to" trade for trend followers, as the attention of currency bears shifted to the Japanese currency following the euro's rebound since mid-2012 from a low of around 1.20. This sentiment shift could be gauged by the performance of the two currencies vs. the greenback in the one-year period ending May 7, 2013; while the euro had gained 0.2%, the yen was down 19.3%.
The herd instinct was also evident in the strength of the US dollar against most major currencies by May 2013, with the greenback on the ascent against 13 of the 16 most widely-traded currencies. The unexpected strength of the US dollar at that time was largely attributed to the rebounding US economy, which had driven the Dow Jones Industrial Average and S&P 500 indexes to record highs, attracting further capital inflows in a virtuous circle.
Common Herd Instinct Forex Trades
Currency action over the years indicates that the following trades are the most common "herd instinct" ones. These are only suggestions, and if you intend to trade these currencies, it is strongly recommended that you conduct your own research and due diligence.
As China is the world's biggest importer of numerous commodities, when the Chinese economy is growing strongly, currencies of commodity exporters such as Canada and Australia benefit. In the first decade of this millennium, as commodity demand soared due to the Chinese boom, the AUD and CAD surged 37% against the US dollar. Therefore, consider going long CAD and AUD vs. the greenback when the Chinese economy is expanding rapidly.
The AUD and CAD tend to do well when the global economy is growing strongly and demand for risk appetite is strong. Conversely, when fears abound about slow global growth and risk appetite shrinks, these commodity currencies decline and safe-haven currencies such as USD and Swiss franc (CHF) rise. At such times, popular herd instinct trades are short CAD or AUD and long USD or CHF.
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While the Japanese yen had lost substantial ground by spring of 2013, it has tended to trade in a direction opposite to that of global risk appetite because of its popularity as a funding currency for "carry trades." The carry trade strategy can be disastrous when risk appetite vanishes and panicked speculators rush to close their positions, because of the double whammy arising from the fire-sale of risky assets and the spike in the yen exchange rate due to demand for the currency to repay carry loans. More than $1 trillion had been invested in the yen carry trade by 2007, but as the global economy unraveled in 2008, the currency rose 20% versus the greenback that year.
Speculators who had borrowed yen to invest in AUD (which is equivalent to a long AUD/short JPY position) had the mortification of seeing the AUD plunge by a staggering 49% against the JPY in a one-year period, from October 2007 to October 2008. The bottom line is that the yen can often be exceptionally volatile, and before determining your entry into a currency carry trade based on the yen (such as long CAD/short JPY or even long EUR/short JPY), make sure you have planned your exit as well.
The Canadian dollar has a close positive correlation with crude oil prices because of Canada's status as a leading oil exporter. On the other hand, Japan is the world's biggest oil importer, making its economy vulnerable to high crude oil prices. If crude oil spikes, say because of a sudden conflict in the Middle East, consider long CAD/short JPY.
Global macroeconomic risk from 2010 to 2012 had centered on Europe and a potential break-up of the euro-area. While these fears have dissipated substantially from mid-2012 onward, an increase in Eurozone concerns precipitated by another debt crisis in one or more of the most highly indebted nations could lead to a surge in short EUR/long USD or short EUR/long CHF positions.
Herd Instinct Tips
Inexperienced forex traders should note these "herd instinct" tips:
- Beware of a stale trend or a long-lived one, since it may be in danger of imminent reversal. Currency trends can reverse quite sharply, and being on the wrong end of a trend reversal can lead to catastrophic losses. By the same token, unless you're George Soros, don't be a currency contrarian.
- While playing a trend, plot your exit strategy in advance. Staying in a herd can provide safety in numbers, as long as you don't get crushed when the herd stampedes for the exits.
- Stop losses are very critical, since the inordinately high degree of leverage in retail forex can lead to financial ruin if strict trading discipline is not implemented.
- Don't forget that being long one currency means you are short the other. Short positions seem to warrant closer monitoring by traders, and this approach may help avoid the complacency that can turn a profitable position into a losing one.
- Adding to a losing position is not advisable, since "averaging down" is seldom a viable trading strategy in forex.
The Bottom Line
The herd instinct can help you profitably trade established trends in forex; but use caution and commonsense within the herd—use stop losses, avoid complacency, and plan your exit strategy. As innumerable traders have discovered to their cost, the trend is your friend, but only until it comes to an end.
By the Staff at Investopedia.com
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