​Her effect in the foreign exchange market: How to overcome blind follow-up

Forex trading, as one of the world’s largest financial markets, attracts countless investors to participate every day. In this complex and changeable market, understanding various market effects is crucial to developing effective trading strategies. Among these effects, flock theory is undoubtedly a topic worthy of in-depth discussion. So do you know what the flock theory is in the forex market?

Basic concepts of flock theory

The herdbehavior is an irrational imitation and follow-up phenomenon, mostly reflected in economic life and financial markets. In foreign exchange trading, the herd effect refers to the trader blindly following the established investment trend or pattern. These traders are usually believers in the investment philosophy of “Trend is your friend”. When most people think that the price will move towards a certain trend, they will keep buying or selling, which in turn will strengthen the trend.

Reasons for the formation of the flock theory

• Information asymmetry: Investors will experience obvious herd behavior when they are incomplete in information and have high market uncertainty. This is to reduce the investment risks brought by information asymmetry and obtain higher asset returns.

• Return externalities:Investors’ own return structure will be affected by the decisions and behaviors of other investors. For example, in a bank run, depositors’ understanding of the externalities of income structureIt will lead to herd behavior.

• Information externality:The private information of a certain first actor will affect the decisions and behaviors of other actors. Later entrants are prone to ignore the private information they own and follow the decision-making behavior of the pioneer.

• Reputation and Principal-Agent Issues:Her behavior based on reputation and Principal-Agent Issues is also common for institutional investors and fund managers. Fund managers care more about their reputation for a certain period of time, so they are prone to investing in the herd.

The performance of flock theory in foreign exchange trading

In the foreign exchange market, the herd effect is particularly obvious. The foreign exchange market is the most liquid financial market in the world, with huge trading volumes of major currency pairs and has received close attention from a large number of foreign exchange traders around the world. Once a key technical level gives way, other traders join and consolidate the initial trend, thereby exacerbating the herd effect.

For example, the depreciation of the yen in 2013 is a typical case of the herd effect. Traders shorted the yen as the Bank of Japan announced a massive purchase of government bonds and increased its monetary base. As the trend strengthens, more and more traders join, causing a sharp decline in the yen against the US dollar.

Negative effects of flock theory

Her behavior in most cases will have relatively negative consequences, affecting the stability of the market.

Overreaction:In the rising market, the herd effect will cause investors to blindly pursue overheated assets, further push up asset prices and create bubbles; in the falling market, investors’ selling behavior will deepen the decline.

Silent spiral:When investors find that their views are inconsistent with those of most people, they will choose to remain silent, resulting in the continuous spread of the views of most parties, forming a spiral evolution process. This will cause irrational voices to be amplified, causing divergence between asset prices and their intrinsic value.

How to avoid the herd effect

Develop a trading plan: Always have a trading plan, and do not immediately abandon the original plan because of changes in the market. The importance of planning is self-evident, and a transaction without planning is like gambling.

Emotional self-test:Learn to reflect on your emotional state and avoid trading under adverse emotions such as stress, fatigue, and tension. It is important to think calmly, don’t let emotions lead decisions.

Think independently:Don’t rely on other people’s opinions, you need to become an independent trader. Everyone has different market understandings, and other people’s opinions cannot determine your transaction.

Using Stop Loss:Stop Loss is very critical because high leverage forex trading can lead to significant losses if strict trading discipline is not followed.

Planning exit strategy:When following a trend, plan the exit strategy in advance. When the trend reverses, it can exit in time to avoid catastrophic losses.

Flock theory is a common phenomenon in foreign exchange trading, which has both positive and negative effects. The positive effect is to accelerate the release of information and the absorption of new information by assets, while the negative effect is to easily lead to excessive market reactions and instability. As traders, we need to have a deep understanding of flock theory, develop trading plans, keep thinking independently, learn emotional management, and use stop loss and exit strategies to avoid blind follow-ups. Only in this way can long-term and stable returns be achieved in the foreign exchange market.