Traders can be divided into different groups based upon when they make their trades. Professional traders make up the groups that trade first, then come the new traders that might become professional traders one day, and then finally comes the herd.
What is the Herd?
The herd is the group of traders that make their trades after all of the other traders. The herd is composed of the majority of the buy and hold investors, along with the stock tip traders, and the general public. The herd is so called because they tend to trade as a single group, using information such as mass media news reports and the public's economic sentiment to make their trading decisions.
Where professional traders try to avoid trading based upon emotion, the herd make their trading decisions based entirely upon emotion (especially fear that they will miss out on a large price move, and greed that they could make a lot of money). As a result, the herd will only enter a trade when a price move has become so obvious that anyone (even non traders) can see it on a chart.
Why Do You Need to Avoid the Herd?
As the herd are the last group of traders to make their trades, they tend to buy at the highs and sell at the lows (the opposite of making money). The reason for this is based upon pure market dynamics. Once the herd has entered their trades there are no more traders to continue the buying or selling. Therefore, once the herd has entered their trades, the markets either reverse or consolidate (move sideways).
Professional traders often keep track of the herd, and when the herd makes a trade, the professionals will make the opposite trade. For example, when the general public starts buying Euros because of a financial news report, the professional traders will sell Euros, knowing that after the herd, there is nobody left to buy.
