In the currency market, like all other commodities markets, wealth is neither created nor destroyed. It is only transferred among the market’s participants. In other words, it’s a zero sum game. This means that winners take money at the expense of the losers. Over time, the winners are usually the minority while the losers are the majority. The reason why losers can make up a large portion of traders is because of behavioral biases to act with the crowd and also because some “losers” are actually hedgers that take losses intentionally to support outside business interests, as opposed to speculators.
If the minority profits at the expense of the majority, what do you think they need to know? They must know two things:
1. Information that the majority doesn’t know or dismisses: Surprise moves markets, because the majority of market participants price in more or less everything that they know/predict about the fundamental economics between two countries up to the current point in time. If information enters the market and differs from market expectations the market adjusts price accordingly. If you know what this information is before it’s released, you can profit, however this is very unlikely to work as a consistent strategy because chances are someone else knows this information if you do (there is really no such thing as insider trading in Forex). However, if the market has been ignoring a lot of data and something else could bring its attention back to that data, you can enter a position to profit from a correction. An example would be bad data on the US economy coming out, yet the USD rallies for several weeks. However, suddenly the Fed FOMC meeting statement shows that Bernanke and the other board members are paying attention to those bad data instead of inflation, etc. Now the market has to adjust and may take several days for institutional traders to do so. If you are a small trader you can be nimble enough to ride the trend down without affecting the market.
2. The positioning of the majority: The majority may be right during a trend, but they are wrong at the start and the end. This happens because an uptrend can only be sustained if there are sellers who can sell to the buyers who are bidding price up. Once sellers have reached a limit on how much they can sell due to rules, margin requirements and sentiment, price must adjust downward until it finds a price that buyers and sellers can deal at again. This reversal is difficult to time precisely, but it usually happens around points of extremely positive or negative sentiment. This can be gauged by COT sentiment data, judgment of media hype, and reaction of price to economic news and events.
As you can see, it’s human behavior that opens up these inefficiencies in the market that can be profited from. Crowd psychology is only one behavioral bias that traders have. Unfortunately I do not have the time at this moment to write about all of them. I plan on adding to this short article soon. In the mean time, I have longer articles with actionable strategies for trading using these methods on a weekly to monthly basis on my blog. Please have a look at it if you like the idea of using fundamental and behavioral analysis to trade Forex.