EMOTIONAL CONTAGION AND PATTERNS FOR TRADING FOREX

The first step in learning how to recognize patterns is to understand that the prices reflect
market psychology. The trades are signatures of human decisions that move prices
in response to market conditions. Trades, however, do not occur in isolation. Traders,
whether they are alone at their desktop or in a trading room, are really part of a virtual
neighborhood and as a result are influenced directly and indirectly. The result is the
presence of market psychology and the phenomenon of market memory.
Patterns in the past influence patterns in the future, because they are behavioral in
nature. Observing past patterns actually helps form the next pattern. Therefore, market
psychology is about group behavior and the dynamics of how trades reflect group psychology.
Market moves are often described as herding behavior because they are similar
to how herds of animals, swarms of insects, flocks of birds, and schools of fishes respond
to environmental stimuli. In all of these cases there is no real central intelligence
leading the group. Instead, patterns of behavior emerge from uncoordinated decisions
of numerous single agents. Descriptions such as emotional contagion, crowd-mind, and
cellular automaton behavior (www.automatatrading.com) are indicative forms of multiagent
behavior. The field of behavioral finance has recently emerged to study these forms
of conduct (see Table 13.1).
It is conventional wisdom that the market reflects an interaction between fear and
greed. This is simplistic because emotional responses include a much deeper gradient
of emotions. For example, there are different forms of fear. There is fear of increased
losses and fear of losing profits gained; there is fear of being left out of moves leading to
greater gains. There may be fear of spousal disapproval of trading!

Now let’s look at greed. Greed emerges in several forms when there is a significant
increase in buyers. This generates a sharp move up. Uncertainty and anxiety result in
a reluctance to trade, and therefore generate narrowing of ranges. Market enthusiasm
takes a path of trend continuation. When there is sentiment of consensus about a currency
pair, one result is a channel pattern where we see the emergence of equilibrium
between buyers and sellers. These are only some of the corresponding patterns that are
associated with each of these emotions. Once they are recognized, there are appropriate
trading strategies that can be used. Let’s explore them.
The doji is perhaps the most famous of the candlestick patterns. It means hesitation.
The interpretation of hesitation results from the fact that the opening price is the same as
the closing price. This means visually there is no body, and the appearance of a doji candle
means that the sentiment battle between the buyers and the sellers resulted during
that candle period in no clear winner. When hesitation occurs at a key support or resistance
area, it is a sign of weakness. A trader seeing a doji near a lower Bollinger band
would be reluctant to enter into a sell order. Stronger sentiment for sellers would put
show up as a candle probing the lower Bollinger band with a range around the Bollinger.
The opposite is true of doji at resistance. A stronger bull sentiment would not result in
hesitation. The market would push the price above the top of the Bollinger band. Several
consecutive dojis provide greater confirmation of hesitation. We can see the doji at the
bottom of the Bollinger band in Figure 13.1.
When the market is determined to continue a trend direction, a good pattern to trade
off is called “hugging the band.” We can see this in Figure 13.2. When candles are not
reversing after probing a Bollinger band, the trader should not wait for a retracement but should consider going along with the pattern by selling (sliding along the path) or by
buying (riding the climb up).




By ABE COFNAS