The Smart money And The Emotional Roller Coaster
You have probably heard of the saying "the markets are driven by greed and fear". And the emotions of the herd are very predictable.
I can clearly remember the time of the Dot-Com bubble between 1995 and 2000, and the subsequent burst of the bubble. In the last year before the burst, at the absolute top of the bubble, everyone was talking about stocks even if he previously wasn't interested in stocks. You could read about stocks of new IT start-ups in every daily newspaper even if the newspapers normally didn't cover such topics at all. For instance, the IPO of the IT-company, Infineon, in the year 2000 was oversubscribed 33 times. The euphoria of new highs in the stock market was tangible everywhere.
Then immediately after the Dot-Com bubble burst after 2000, the newspapers were full of negative articles about stocks. Everyone was in panic. Everyone sold his stocks. Nobody wanted to buy stocks anymore. In the years 2003 and 2004, when the absolute bottom of the downward trend of the stock market, and therefore the best entry prices were reached, the same newspapers didn't write about buying stocks. And most of the investors who lost money during the previous crash wasn't interested in buying at that point either.
The cycle of the emotions of the stock investors during the period 1995 and 2003 is widely known as the "The Roller Coaster of Emotions". The following diagram nicely depicts this roller coaster:
With rising prices, the herd becomes optimistic, then excited, then thrilled and in the phase of euphoria, at the point of the highest prices, the herd is most willing to buy even more stocks. When the prices begin to fall, negative emotions are triggered, beginning with anxiety, then denial and then depression.
These emotions lead to more people selling their stocks. When the prices are falling further, the pain of losing money from holding stocks becomes too high. More and more people are selling their stocks. The herd as a whole capitulates the most at the worst possible price. The herd sells most of their stocks at the lowest prices.
This roller coaster of emotions exists in every financial market and in every trend size!
If you are an active trader, then you know what I am talking about! If a trade goes in your direction, your floating profit is rising and you have good feelings. If the price retraces against your position, your floating profits are shrinking and you start worrying. Negative emotions are rising. This is a normal human reaction that every trader has to deal with.
Such emotions can't be avoided. Dr. Gary Dayton describes this very well in his book "Trade Mindfully". The only thing you can learn is to control how you react to the emotions when they arise during a trade. The ultimate goal for a trader is to learn to recognize your emotions as "only" emotions and not to let your emotions force you into actions that are not part of your trading plan.
Lest we digress too far, let’s get back to the topic on the roller coaster:
The emotional roller coaster exists in every financial market and in every trend size. Liquid markets have 4 or 5 nested trends of different sizes. Each trend size has its peaks and valleys. Therefore we have 4 or 5 emotional roller coasters which are nested too. Now we shall generalize the emotional roller coaster so that it can be applied to any trend size and any financial markets where traders can enter long and short positions.
We shall first look at the emotional roller coaster of the group of bullish traders, and later at the group of bearish traders. The bullish traders of the herd, the people who see chances to make profits on rising prices, because of the upward trend, will bring long orders into the market. With further rising prices, this group of the herd has the tendency to bring more and more long orders into the market. The triangle in the next diagram shows what I mean; the bullish traders of the herd during rising prices support the continuation of the uptrend:
After the price starts falling more and more, bullish traders of the herd are exiting their long positions. They exit their long positions by placing short orders in the market. In all the phases of negative emotions during the downward move, the fearful exiting traders of the herd, who were long in the market, support the downward trend. In the capitulation phase, the pain is on its peak for this group of traders. Most of the long positioned traders exit at the worst possible price, as depicted by the red triangle on the right in the following diagram:
After the capitulation phase the price starts to rise again. Those who are still thinking that the initial trading idea (making money from rising prices) is still valid, but were shaken out of their long positions by price movement against their position, are now in the phase of desperation. After that phase and with further rising prices, new hope is created in the group of bullish traders of the herd. More people of this group are now entering again with long orders. A new upward cycle towards the euphoria phase begins as shown in the following diagram.
But there are always two groups of people within the herd at the same time!
The group explained above was the bullish group of the herd. Their analysis of the market conditions has informed them that the price would most probably rise. Therefore they entered long into the market.
A bearish group of the herd exists at the same time. Their analysis has informed them that the price would most probably fall. They wanted to make money on falling prices. Therefore the bearish group of the herd would enter short into the same market!
How does the emotional roller coaster look for the bearish group of the herd in the same market?
Bearish traders of the herd are entering with short orders into a falling market. With further falling prices, there is a bigger tendency that this group places more and more short orders into the market. Their actions support the downward trend. They have their euphoria phase at the lowest prices of the downward cycle. The triangle in next diagram below shows the tendency of placing more and more short orders by this group.
After the price starts rising, the bearish traders of the herd start worrying. More and more bearish traders are exiting their positions. They do that by placing long orders into the market. Their actions support the upward trend in this phase of the cycle.
Their tendency to exit their positions rises with further rising prices. Most of them will exit in the capitulation phase. The right triangle in following diagram shows the rising tendency to bring in long orders.
The bearish traders of the herd who were positioned during the previous upward move on the left part of the diagram had the same emotions and behavior. The following diagram shows what I mean:
We have now seen in detail how the emotional roller coaster of bullish and bearish traders looks like. We have also emphasized their actions during each phase of the cycle. Maybe you have already recognized a similarity in both groups.
Both groups of the herd, the bullish and the bearish traders, tend to make the same mistakes:
1. Both groups tend to place the biggest amount of long orders at highest prices.
At the highest price bullish traders are in the euphoria phase, whereas the bearish traders are in the capitulation phase at the same time.
2. Both groups tend to place the biggest amount of short orders at lowest prices.
At the lowest prices the bearish traders are in the euphoria phase, while the bullish traders are in the capitulation phase at the same time.
Now we can answer the question "Where does the herd get into imbalance?" The herd gets into imbalance on the way to the price extreme points. The biggest imbalance is reached when the price extreme points are reached as shown in following diagram:
We are now at a very important point. Please remember that each order needs a counterpart to get executed. If the herd is net long, this means that the herd has placed a lot more long orders than short orders in the market. Who is the counterpart of the herd? Who holds a huge short position while the herd is holding a big long position? If you remember the previous article "The Role of Smart Money in The Forex Market" then you know the answer.
While the herd is holding a long position, the major banks (the interbank market) are holding the equivalent size of a short position. The major banks are acting as market makers. They must always provide an ask quote for a currency pair even if no one else on the planet wants to sell this currency pair.
Therefore the more the herd gets net long, by definition the interbank market gets net short by the same amount.
The next diagram below shows the roller coaster from the view of the major banks. On the left side during the upward move the banks are net long from the beginning. On the way up they sell their long positions with profits back to the herd. The banks are in a profit release phase. Please remember that the herd is buying more and more on rising prices. After the banks have sold their long positions completely, they must still sell to the herd because the herd is heavy in buying. The banks have then started an accumulation phase. They accumulate short positions at the highest prices.
When the price starts falling, a new profit release phase for the banks begins. They are now buying their short positions back with profits. Their short positions become smaller on the way down. At some point the banks are net flat. Because of the further heavy selling of the herd, the banks get into a net long position. The new accumulation phase begins. The banks are accumulating a long position at the lowest prices.
When the price is rising again a new profit release phase for the banks begins as shown in following diagram:
To emphasize the buying and selling activities of the banks in the market cycle once more, see the next diagram:
As you can see from the explanations in this chapter, the net position of the banks is always the counterpart of the net position of the herd. The difference between the long and the short positions of the herd is always bought from or sold to the major banks.
The 8 major banks are responsible for over 70% of the volume in the forex market. Because of their overwhelming power, the banks can define support and resistance zones. They can absorb all incoming orders from the herd in these zones and then reverse the direction of the price movement. With this power, they change the belief (the belief that the price will go up or down) within the herd.
In the next article you will see one form of the emotional roller coaster with real chart examples.