February 13, 2020

Stereotypes of the Market Crowd Behavior

Stereotypes of the Market Crowd Behavior

Bob spends much time every day sitting in front of his computer screen trying to profit from exchange rate fluctuations.

He thinks he is an advanced trader since he read a great many articles and books on trading. He even developed his own trading strategy based on the knowledge gained.

We offer you to look at one of the typical days when Bob tried to earn a profit.

The first thing which Bob does after turning his computer on is launching a trading terminal. There are many currency charts opened there – he flicks through the charts in search for any trading signals

Unfortunately, his first attempt to find a market entry point has failed.

«Why else would I have opened the terminal!» says Bob. «I need to open a trade». After setting the task Bob begins to monitor signals more carefully…

When he discovers a signal that doesn’t really exist, he opens a Buy trade and writes down his thoughts in his trading diary since he thinks himself as a solid trader:

«I’ve bought EURUSD pair by signal: there has been a sharp move to the downside following which the price hits the moving average – it indicates that the price is going to reverse». He adds the corresponding picture:

Next, Bob thinks how to take profit not to miss it anyway… «Well… why don’t I set take-profit?» Without stopping to think, he places a Take-Profit order about 20 points away from the current price.

What about stop-loss? «I don’t set stop-losses,» he says. «I’m always in front of my computer screen. I will close a trade manually or open the opposite trade if anything happens».

Well, his trade has been opened without stop-loss and the price moves neither here nor there.

«While the market is «sleeping», I’d better go and play a shooting game,» says Bob.

After half an hour has passed, he remembers that he should check out the terminal… When looks at the screen, he sees that the price has dropped by another 50 points and he has got a floating loss at $50 on his account.

Bob is wondering: «How is that? I have seen that for the first time in my life! The price will certainly not keep moving down since it has hit the long-term moving average this time. It’s 100% guaranteed reversal!» Then he buys the same amount of currency, i.e. he doubles up his position against the impulse.

After half an hour has passed, the price has bounced off slightly, and his floating loss has turned into a small profit. Inspired by the thought that things are going as he suggested, he decides to set stop-loss eventually (to protect himself against losses) at the weekly low level.

Once he has done it, strange things begin to happen in the market at once…

The price starts to move here and there surprisingly and makes Bob’s Stop-Loss order trigger at loss of $150. Bob opens his eyes wide and asks himself a question: «How’s that? By the way, the moving average is long-term…»

This is the story that happened to Bob.

Any of you might have recognized himself or herself in Bob’s behavior or it may be an already closed chapter for some of you.

The moral of the story is as follows: there are behavioral stereotypes in trading that enabled me to make a «portrait» of Bob.

Next, we’re going to switch from comical things to a bit more serious ones and consider basic stereotypes of the market crowd behavior.

We will consider the behavior that affects the market itself directly, for example: opening a trade, placing a Buy Limit order, etc. Various psychological aspects and violation of money management rules will not be taken into account.

We made a little research that enabled us to obtain the results provided below before writing the article.

So, let’s start.

Stereotypes of the Market Crowd Behavior

#1 – Most Trades are Opened Against an Impulse

In other words, they are trades against a trend or attempts to pick a reversal.

We will not dwell on the problem of trend identification. In fact, we can notice that when price moves in one direction for a long time, there are many people willing to open their trades against this move at once. Most of them don’t believe that the price will keep moving in this direction since it has already moved a very considerable distance down or up.

Consider the following situation:

On the left side, we can see the market picture at two time points; on the right side, there is a difference between these points. “Fewer trades” stands for those trades that have been closed and “More trades” stands for those trades that have been opened during this move. The given example clearly shows that there are a lot more Sell trades than Buy trades opened during this upward move.

If we think about the number of trades opened, 60% of trades are opened against a trend and only 40% of trades are opened with a trend – it is true if a trend exists.

Our desire to open trades approximately at these points – near the border of a pattern that doesn’t have an established top – underlies this stereotype.

#2 — Winning Trades are Closed About 2 Times Faster Than Losing Ones

A normal human fear is the root cause of this stereotype. We’re afraid of accepting losses but we happily take profits.

This is the reason why the average time of a winning trade is 1 hour, and that of a losing trade is more than 2 hours.

These are the data on the average time provided by Oanda broker:

The average time of a winning trade is colored in green, and that of a losing trade is colored in red on the chart.

It is also interesting that this kind of behavior of most traders always results in the increase of losing trades as compared to winning ones in the market at some point in time. To see why this should be so, you can view the percentage dynamics of winning traders with the use of this analytical tool. When you look at it, you’ll see that the percentage of winning traders rarely exceeds 40% and usually ranges from 30 to 35 percents.

By the way, it is the first and the second stereotypes that contribute to the superiority in the ratio of open positions that we apply in trading.

#3 — Stop-Loss is Set Far Less Frequently Than Take-Profit

Most newbie and more experienced traders really «suffer» from not setting stop-losses.

The reason lies in a human psychology again… We don’t know where we should set a stop-loss so that it will not be randomly triggered by price, so we prefer not to set it at all – we act just like Bob who closes all his trades manually.

As you can see, the ratio of stop-losses to take-profits roughly equals 1 to 2, i.e. only 40% of all open trades have stop-losses.

If you look at the chart below, you’ll understand why it equals exactly 40%.

#4 — Extremes are the Most Popular Levels at Which the Market Crowd Set Its Stop-Losses

Each of you might heard that stop-loss should be set above a local high or below a local low. This assertion is usually supported by the fact that if the price does hit a local high/low it will certainly move further.

Of course, there is some logic behind it… However, that was true some time ago when the market was a flock without a sheepherder. When the price was approaching the previous peak, a panic flooded traders, and the price «moved sky-high» beyond this peak… This is why the crowd picked up a habit of moving stop-loss beyond to these high and low levels.

Now the market is controlled by market-makers… The levels where stop-losses are set are of the greatest interest to them in terms of opening new trades.

Nature of the market changed, but the habit of setting stop-losses at extreme levels remains the same:

An approximate scale of the given habit: the density of stop-losses accumulation at extreme levels is twice larger than that at other price levels. It can be seen with the naked eye even in the picture above.

#5 — 80% of Trades Have Take-Profit

As against to stop-loss, take-profit is more preferably set. We are not going to repeat the reasons for it since they have been announced a bit earlier.

As we have promised, you can look now at an interesting chart:

Here is a short explanation of it:

  • 40 trades have stop-losses, and 30 of them have take-profits as well;
  • 80 trades have take-profits;
  • 10 trades have neither take-profits nor stop-losses.

This chart displays an overall picture but the figures might differ in reality.

#6 — Take-Profit is Set Almost Without Reference to Levels

Take-profit is basically set without reference to any price levels due to the fact that the variety of methods of take-profit setting is much wider than that of stop-loss setting.

Of course, we can see an accumulation of take-profits but their density is much smaller than that of stop-losses. The density implies the ratio of average trading volume at extreme levels to that beyond these levels.

Conclusion: The total mass of traders sets take-profit chaotically without any signs of the «crowd».

#7 — Most Trades are Opened Almost Randomly

If we study accumulations of trades at particular levels, we’ll see the regularity: the more time price has been at one of these levels, the larger are the volumes of open trades at this level. It must be said that it is kind of obvious. However, this leads to the conclusion that trades are evenly distributed in time… So, there are no any common entry points, and everybody enters the market whenever they want.

Consider the following example:

On the left side, we can see the market profile build on the basis of the time spent by price at every price level. The order book is displayed on the right side. Look at the areas colored in yellow. Larger trading volumes can be seen in these areas both in the market profile and the order book. If we look at the chart, we can see a ranging market in these areas.

Conclusion: Many traders like Bob trade obligatorily even when there are no signals. They just want to open a trade, and the reason to do it can always be found. The motive of such a behavior can be the absence of systematic approach or a great variety of entry signals of all kinds.

#8 — One Open Trade Accounts for 3 Pending Orders (Including Stop-Losses And Take-Profits of These Open Trades) on Average.

And the last but not less interesting stereotype is as follows.

Based on the research data, the number of pending orders is three times larger than that of open trades on average.

It sounds quite logical since one trade can have two pending orders – Stop-loss and Take-profit orders. These orders make the ratio of an open trade to pending orders equal to no more than 1:2 but the data suggests that the ratio must equal 1:3. The fact is that Buy & Sell Limit and Stop orders account for the rest volume of pending orders.

If we also take into account the previous stereotypes and the fact that not all trades have a stop-loss and a take-profit, we’ll get the following ratio of pending orders existing in the market:

  • Stop-Loss orders – 14%;
  • Stop orders – 20%;
  • Take-Profit orders – 28%;
  • Limit orders – 40%.

It was a real eye-opener for us since we suggested earlier that Limit and Stop orders constituted no more than 20% of the total mass of orders.

In principle, it doesn’t make sense to us (who trade against the crowd) what kind of order is it – Take-Profit or Limit order – since these orders are the same from the point of view of market-makers.

How not to mingle with the stereotyped crowd?

Wait! Does that make sense? The sense is that you’ll cease to be a «food» for market sharks if you eradicate a stereotyped behavior in yourself. It is exactly the crowd that feeds all the major market players. The less you resemble this crowd, the smaller is the likelihood of the fact that you’ll be «eaten away» together with the crowd.

If you have recognized yourself in some of the stereotypes, you’re at risk.

Read our recommendations on how not to mingle with the crowd:

  • Open trades in the direction of current impulse only. Never do like that.
  • Always set a stop-loss beyond round-numbered price levels and areas of highs & lows. Here you can find the best technique for stop-loss setting.
  • As for a take-profit, you can sometimes disregard it. When we predict the right market direction, the price can usually keep moving further in this direction for long.
  • If you choose to set a take-profit, you should always do it inside an accumulation of stop-losses – there are usually local extremes in this area. Imagine that all traders are crying that price always triggers their Stop-Loss orders but in your case it will regularly trigger your Take-Profit orders. It’s great, isn’t it? Learn more about this technique.
  • Enter the market only when you have really got a signal. Most our troubles come from opening trades only because we’re sitting in front of our computer screen and want to trade… After that we become angry with ourselves for having entered the market.
  • Switch your attention from profits to losses. You must ensure that the losses will always be within the limits, close your trades in time, and profits will «take care of itself».
  • • Lastly, you should enter the market using exclusively Limit orders (but not Buy/Sell Stop orders) having pre-set stop-losses and take-profits.

Many of the given recommendations are not new but now when you understand the behavior of the market crowd you are able to sort out other (not quite useful) recommendations.

Of course, blindly following the recommendations will not guarantee that you receive a profit but we can assure that it will help you to avoid losses.