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The Psychology and Mindset of Forex Market Trading

One reason many forex traders feel confident in their ability to make a profit in the foreign exchange markets is the idea that much of the marketplace’s price activity is due to psychological behavior that can be predicted. In fact, technical analysis is an entire school of thought based on the notion that the general psyche of the population is what drives the market and occurs in patterns that continually repeat themselves. Several leading analysts have developed computational models for predicting these patterns, and many forex traders actively follow many of these techniques today.

In 1938, an accountant named Ralph Nelson Elliott published a book entitled “The Wave Behavior”, and it outlined his theory that market prices fluctuate in a predictable pattern of waves. According to this idea, later dubbed the “Elliott Wave Principle”, group psychology oscillates between optimism and pessimism, and this is reflected in market prices as they travel up and down. More specifically, Elliott theorized that prices move in predictable patterns of five waves followed by three waves, with the direction of each wave dependent on whether the instrument is rising or falling. With a rising trend, the first five waves are started with an uptrend, and each up wave is longer than the subsequent down wave. The final three waves start with a downtrend, with the two down waves longer than the lone wave traveling upward. This pattern is reversed when the overall price direction is down. In addition, each of these waves is made up of its own 5-3 pattern of smaller waves, and the pattern continually repeats itself fractally on an ever-smaller scale.

Another analytical device based on human psychology that has been put into practice in the forex market is the Coppock curve. An economist by trade, Edwin Coppock was asked by the Episcopal Church to help them recognize opportunities for long-term investors to buy instruments such as stocks. He was determined to find a way to figure out when a bear market has “bottomed” so his client would know when to enter the market, and likened a long bear market to a period of mourning. Upon asking bishops of the church how long this period generally lasted in persons who have suffered a loss, he arrived at a figure of 11 to 14 months. This time period became the basis for his calculation of the indicator’s buy signal. As the calculation is based on trends, the signal generally lags the recent performance of the market, and as such doesn’t technically pick the absolute bottom of the bear market. Rather, it attempts to indicate the point where a new rally has become firmly established. Originally designed for the S&P 500, it has also been applied to the forex markets, as well as the Dow Jones Industrial Average.

There is much debate as to the validity of the principles of technical analysis. The efficient market hypothesis dictates that if this type of trading actually works then everyone would be using it, and the resulting trading behavior would affect the market to the extent that the patterns would no longer exist. Indeed, it has been observed that the use of Bollinger Bands has become so pervasive that market prices are routinely affected when prices near the signals generated by this analysis.

Regardless of one’s belief as to the validity of technical analysis, it is without a doubt that psychological forces affect foreign exchange market prices. Whether they are reactions to unpredictable political or economic news, or simply primal emotional patterns that have repeated themselves since the beginning of time, the foreign exchange market is partly driven by human emotion.

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