This is a 7-part series on Forex Trading Strategies, Click here for my strategy #4: Support & Resistance
I have given a lot of thought into this topic, Market Psychology, and at the risk of oversimplifying it, the logics behind it is that traders are not machines and what affect traders will ultimately affect the market, and that’s why it is important to understand market psychology.
Market Psychology is defined as:
The general feeling of investors in and about the market. Emotions have a strong impact over the investing mentality of the market and can lead to unexpected changes in the market – Investorwords
As Dr. Steenbarger put it in his blog (traderfeed) “the best measures of market psychology are not polls of trader sentiment, as what traders say and what they do can be quite discrepant. Rather, we want to track what traders are ‘actually’ doing in the marketplace…” So in essence, to understand the market, you’ll have to understand human behavior, simple isn’t it?
Before we dive deep into this subject, let me just say that this strategy is NOT about the over saturated talks on emotions of greed or fear, that may be the subject of another strategy, but this article is all about how to identify market psychological pattenrs and then take advantage of them…
Buy on rumor, Sell on news
In the previous Forex Trading Strategies I’ve covered briefly about this phenomenon based on market psychology as it is probably the most obvious example of how the market is driven by traders who often act in anticipation of upcoming events. As these events take place, the same traders who acted early pulls out of the market and cause a reverse reaction that sometimes may be puzzling to novice traders.
The good news is that once you’ve been exposed to this information, you can too, join the crowd of “speculators” and move ahead of the market to take advantage of these events, here is a list of events that are pre-news tradable; a word of caution: remember to only trade events with lots of focus from analysts, medias, etc… especially those with the potential of surprise…
- Interest Rate Decisions
- Employment Change / Unemployment Rate
- Quarterly GDP (Gross Domestic Products)
- CPI (Consumer Price Index)
- Central Bank Speeches
For example, if the market is expecting a rate cut from RBA, then by all means SELL AUD ahead of the news… You should try to enter the market at least 24 ~ 48 hours before the event, using Support/Resistance levels (Strategy #4), following the Correct Trend (Strategy #3), and use the Right Timing (Strategy #2)… Don’t just enter the trade because RBA is cutting interest rates…
This is another important psychological cue of the market that I’ve seen it taking place time and time again… which has to do primarily with the way that market reacts during the 3 daily trading sessions, namely the Asian, European, and U.S. sessions.
The basic idea is that whenever we have an overall positive market during the Asian session followed by a continuation into the European session, we are likely to see a reversal at the highs during U.S. session due to market psychology… This scenario excludes any strong news events or risk sentiments as we know those factors have long lasting effects.
The logic is that traders who trade the U.S. session came into the market at the tail-end of the trading day, with most exchange rates already at their best/worse, traders are more likely to sell into the rally following the “sell high, buy low” philosophy, combining the profit taking mentality of traders from previous sessions, we often see the market unable to make new highs… and more often than not, market will fall back to the same levels it started the day with.
Therefore, when you find yourself looking at a possible breakout trade during late European/mid U.S. session, consider the 3-sessions rule and perhaps it is best to sell from the high (or buy from the low) as breakouts are highly unlikely during the last session of the day without news catalysts.
Market Bias / Currency Pair Resilience
I have often used this analogy in my trade room that the currency market flows like plumbing, and water will flow in the direction of least resistance… If a currency is strong despite of negative news, then it is time to BUY the currency instead. For instance, sometimes a news release signals weakness of the economy but the market fails to react; eventually sellers are going to change their minds and buy the currency, as the market flows in the direction of least resistance…
The reverse is also when the market overreacts to a news event that normally has very little effects… These are the signs that perhaps it’s time to sell the currency on rallies as traders are looking for reasons to sell.
A quick example: Euro became indifferent to negative news towards the end of the second Greek Bailout talks, which proved to be a great time to buy the currency as many traders felt it was undervalued…
In conclusion, I believe that one needs to not only study the effects of news on the market, but should also pay attention to the CONTEXT of the market, as the context is as important as any other factors that impact the market. I hope these Market Psychology scenarios help you in your trading.