Last update: 13 May 2020
6 min read

The Importance of Market Psychology

Market psychology is such a complex subject that it needs at least one article dedicated to it in any Forex academy like the one we’ve built here. It is important to understand what makes markets move, and what to expect next. To be successful when trading Forex and any other financial product means to be able to tell the difference between fake and real moves the market makes. In other words, being able to know yourself as a person and as a trader is key to understanding market psychology. Any trader knows that the market does not always move the way it is supposed to move, as otherwise everyone would make money; which is not the case, as Forex trading is a tricky business.

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How Forex Trading Works

Forex trading means buying or selling currency pairs with the purpose of making a profit. A profit is realised if the difference between the entry and exit price is positive. Let’s assume one is buying the EUR/USD pair at 1.0560 with a take profit at 1.0600 and a stop loss at 1.0510. If the take profit is hit, it means that the pair moved to the upside and the 40 pips difference is the realised profit. On the other hand, if the stop loss is hit, a 40 pips loss is realised, because the market moved against the desired direction. In both cases, someone else takes the other position. To be clearer, when a trade is opened/closed, someone else is on the other side of the trade. If one is buying the EUR/USD, they can only do that for the asking price. It is not possible to buy from the bid. The same is true when selling: One cannot sell at the ask price, but only from the bid price. This means that when one is buying at the ask price, someone else is selling from the bid at the same level. The difference between the two – the spread – belongs to the Forex broker. Considering that both parties are trading the same product but in different directions, they cannot both be  right, and indeed one of them has to be wrong.

Avoiding the Crowd

market psychologyOne way to be successful in Forex trading is to try to avoid the crowd. The crowd is a good indication of market direction, as most of the time the sentiment is extreme. The crowd simply cannot be right, however, as the market does not react to obvious things. What happened with the recent Italian referendum is the perfect example of that. Last weekend the Italians went to vote for a constitutional change in a referendum that has been viewed as influential for the Euro in particular and for the markets in general. Based on how the market behaved before the referendum, the assumption was that if the changes were accepted and the referendum ended up with a “yes” vote, this would be beneficial for the Euro, so the Euro pairs should move to the upside. The opposite was true as well: A “no” vote would see the Euro pairs moving down. Needless to say, the Italians rejected the referendum, so the market opened the following Monday with a gap lower on all the Euro pairs, and on the other related markets. The crowd was right: Euro was sold. However, this was true only for a few hours, as the EUR/USD reversed course dramatically to move from 1.05 to 1.08 in the following days. It is clear from this that conventional wisdom based on crowd behaviour didn’t work, as everyone was stopped on such a move. It was not only the EUR/USD that reversed course; the EUR/JPY also traded from as low as 119 back to 123 and more. Stops were triggered, and margin calls as well, as the crowd paid the price. As it turned out, in the end, the EUR/USD pair reversed course and closed the week around the 1.0550 level. However, before doing that, it stopped most of the traders out. To avoid trading with the crowd, traders look at the different indicators and reports available. One report to consider is the COT (Commitment of Traders) report, as it shows the overall sentiment of a currency pair.

Interpreting the Commitment of Traders Report

This report is very important to Forex traders, as it shows the overall average positioning of market participants. Knowing the exact position is not possible because the Forex market is the most liquid one in the world, and the biggest as well. More than 5 trillion dollars change hands each day, and for that reason it is impossible to quantify all these transactions. We touched on this subject briefly here on the Forex Trading Academy when we discussed the volumes associated with Forex trading. Because of this, traders don’t know what the general market sentiment is, and any information regarding the overall general positioning is regarded as crucial. Such information is contained in the Commitment of Traders report, which shows the overall exposure for a currency and/or a currency pair. It is expressed in percentages, and the bigger the exposure, the less likely that direction is the right one. Trading based on the Commitment of Traders report involves finding extreme crowd positioning, and going in the opposite direction. The idea behind this strategy is that the crowd simply cannot be right, as most of the time it gets caught on the other side of the trade.

Oscillators are also good indicators of market psychology. If the oscillators are showing overbought and oversold levels, then trading with oscillators should be straightforward: buying when price is oversold and selling when it is overbought. While this is true when the market is ranging, it simply does not work when the market is trending. Price can stay in an overbought or oversold area more than a trader can stay solvent. The same is true if one is using divergences: Price can stay in a divergent mode more than a trader’s account can handle. To be able to tell fake moves, market psychology involves looking for things that are not so obvious. This, in turn, will increase trader’s chances of succeeding.

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