Behavioural finance in forex trading

While studying the forex market, the one factor which lays special emphasis on the market pattern, is the investors’ behaviour towards the forex market. There are basically 3 main reasons which draw an investor to invest in the forex market. They are:

  • Greed for money
  • Fear of losing one’s profits, &
  • Emotional despair when caught in a wrong position.

The relationship between psychology and finance has been in existence since years now. Looking at the forex market, it can be drawn that any positive or negative trends of the market depends upon the decisions taken by human beings. Therefore, the economist, Hank Pruden postulated the science of ‘behavioural finance’ after he studied the financial market.

How does behavioural finance work?

  1. Human decisions are usually driven by psychology. The same is true for forex trading, where the investor chooses to buy or sell a product depending upon his analysis and psychological drive per se. Thus, it can be said that the forex market is influenced by major two factors- greed (of earning profits) and fear (of incurring losses).
  2. Another theory attributed to market psychology is the ‘Theory of Moral Sentiments’. This theory speculates that the individual do not circumspect while making decisions and that their decisions are rooted to the earlier decisions.
  3. The forex markets are run by the influx of money, which is basically achieved by the purchase of contracts made by traders based on their analysis. Once their signals prove correct, the market begins to gain momentum and more investors are attracted towards these signals. The existing traders then decide to pull out of the market by selling their contracts based on their presumption that the market which has already reached its peak might experience a fall.
  4. The in-depth study of the financial market and the investors trading in this market has revealed that not all the investors will make a reasonable decision while trading but their emotions are mainly governed by two factors, viz. Love of gains and fear of losses.
  5. Analysts have coined a term for such fear and it is called ‘Fear of regret’.
  6. Therefore trading in forex market and human emotions go hand-in-hand. Human psychology is difficult to understand, but there are traders who have the capability of identifying the human psychology, which results in offering gains to such traders.