Forex Strategies #5 – Market Psychology

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 to this topic, Market Psychology. At the risk of oversimplifying it, the logic behind it is that traders are not machines, and what affects traders will ultimately affect the market, and that’s why it is important to understand market psychology.

Market Psychology

Market Psychology is defined as:

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?

Dr. Steenbarger in his blog (traderfeed) 

Before we dive deep into this subject, let me say that this strategy is NOT about the over-saturated talks on emotions of greed or fear, which may be the subject of another strategy. Still, this article is all about identifying market psychological patterns and then taking advantage of them…

Buy on the rumor, Sell on the 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 pull 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 join the crowd of “speculators” and move ahead of the market to take advantage of these events. Here is a list of pre-news tradable events; a word of caution: remember to only trade events with lots of focus from analysts, media, etc… especially those with the potential of surprise…

• Interest Rate Decisions
• Employment Change / Unemployment Rate
• Quarterly GDP (Gross Domestic Product)
• CPI (Consumer Price Index)
• Central Bank Speeches

For example, if the market expects a rate cut from RBA, 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 using the Right Timing (Strategy #2)… Don’t just enter the trade because RBA is cutting interest rates…

3-Sessions Rule

This is another important psychological cue of the market that I’ve seen it taking place repeatedly… which has to do primarily with how the market reacts during the three 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 will likely see a reversal at the highs during the 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, the 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 the 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 negative news, then it is time to BUY the currency instead.  For instance, sometimes a news release signals the economy’s weakness, but the market fails to react; eventually, sellers will 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 a little effect… 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 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.