"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/euro, USD/yen, USD/sterling, USD/Australian dollar, USD/Swiss franc and USD/Canadian dollar – 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 versus the U.S. 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 versus 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 U.S. 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 U.S. dollar at that time was largely attributed to the rebounding U.S. 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 U.S. dollar. Therefore, consider going long CAD and AUD versus 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.

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.

* In yen carry trades, speculators borrow the yen at near-zero interest rates, sell it for U.S. dollars and plough the proceeds into higher-yielding (and riskier) assets such as equities, other currencies or commodities. Steady yen depreciation is a prerequisite for such carry trades to be successful, because a smaller amount of foreign currency is required to repay the initial yen loan.

Related Articles
  1. Forex Education

    Top 8 Most Tradable Currencies

    Currencies can provide diversification for a portfolio that's in a rut. Find out which ones you need to know.
  2. Forex Education

    How To Set A Forex Trading Schedule

    Just because the forex market trades 24 hours a day doesn't mean you have to.
  3. Forex Education

    Forex Trading: A Beginner's Guide

    Learn about the forex market and some beginner trading strategies to get started.
  4. Trading Systems & Software

    Trading Systems: Run With The Herd Or Be A Lone Wolf?

    Find out if taking the path less traveled will work in your favor - or against it.
  5. Forex Education

    Top 10 Forex Trading Rules

    Get some guidelines on how to survive - and thrive - in a variety of markets.
  6. Forex Education

    Top 6 Most Tradable Currency Pairs

    The most frequently traded currency pair is the euro/U.S. dollar. The euro is the base currency in the pairing, while the dollar is the quote currency.
  7. Forex Fundamentals

    How to Buy Chinese Yuan

    Discover the different options that are available to investors who want to obtain exposure to the Chinese yuan, including ETFs and ETNs.
  8. Forex Education

    9 Tricks Of The Successful Forex Trader

    These steps will make you a more disciplined, smarter and, ultimately, wealthier trader.
  9. Forex Strategies

    3 Simple Strategies For Euro Traders

    Euro traders can execute three simple but effective strategies that take advantage of repeating price action.
  10. Forex Education

    4 Of The Most Popular Traded Currencies

    Every day, trillions of dollars trade in the forex market. Here are a few of the most popular currencies, and some characteristics for each.
  1. What are the goals of covered interest arbitrage?

    The goals of covered interest arbitrage include enabling investors to trade volatile currency pairs without risk as well ... Read Full Answer >>
  2. How do I Implement a Forex Strategy when spotting a Sanku (Three Gaps) Pattern?

    A forex trading strategy can easily be implemented to profit from a market reversal signal that comes from the sanku, or ... Read Full Answer >>
  3. What's a good forex strategy to use when spotting a Wedge-shaped Pattern?

    Use wedge-shaped patterns to identify bullish or bearish price action when trading currencies in the foreign exchange (forex) ... Read Full Answer >>
  4. How do I use Time Segmented Volume (TSV) for creating a forex trading strategy?

    You could use time segmented volume (TSV) to build a forex trading strategy, which allows you to compare volume data to determine ... Read Full Answer >>
  5. How do I close a long position in forex?

    Closing a long position in forex trading depends on whether you are using a broker operating under U.S. trading regulations. In ... Read Full Answer >>
  6. Where did the term 'pip' in currency exchange come from?

    The term pip is an acronym for percentage in point or price interest point. It measures a unit of change within a pair of ... Read Full Answer >>

You May Also Like

Hot Definitions
  1. Take A Bath

    A slang term referring to the situation of an investor who has experienced a large loss from an investment or speculative ...
  2. Black Friday

    1. A day of stock market catastrophe. Originally, September 24, 1869, was deemed Black Friday. The crash was sparked by gold ...
  3. Turkey

    Slang for an investment that yields disappointing results or turns out worse than expected. Failed business deals, securities ...
  4. Barefoot Pilgrim

    A slang term for an unsophisticated investor who loses all of his or her wealth by trading equities in the stock market. ...
  5. Quick Ratio

    The quick ratio is an indicator of a company’s short-term liquidity. The quick ratio measures a company’s ability to meet ...
  6. Black Tuesday

    October 29, 1929, when the DJIA fell 12% - one of the largest one-day drops in stock market history. More than 16 million ...
Trading Center