how traders get locked into the same position
A characteristic trader behaviour is that traders tend to hold on to losing
positions but to take profits early with winning positions. Whenever
price trends occur, traders on the right side of the trend closeout their positions,
whereas the traders with the losing positions stick to their positions.
As the trend progresses, the ratio of trend followers and counter-trend
traders tends to become ever more one sided, and eventually 70 to 80
percent of the open positions are counter-trend.
This is passive herding;
the traders opened their positions for different reasons, some of them were
following technical indicators, others followed some fundamental signal,
but they now have something in common – they sit on losing positions
with an unrealized loss and the likelihood of a margin call, if the trend continues.
Whenever positions of traders are very much one-sided with only long or
short positions, the likelihood of a small price spike triggering a cascade
of closeouts increases. This is typically the case when the price has reached
a new extreme. In this situation, traders need to be careful and ready
themselves for a likely avalanche due to cascading margin calls.
The herding behaviour is even stronger when the market has been trending
strongly and then rapidly changes its direction. Many traders will then
have the false expectation that the trend will just continue.
They go on opening
positions in the direction of the previous trend oblivious to the fact that the sign of the trend has changed. They are reluctant to realize losses
and thus there is strong passive herding. This is particularly dangerous;
a minor event would be sufficient to trigger a particularly violent cascade
of margin calls affecting all the traders who have been herding. The price
will then shoot off in the new direction starting a particularly strong new trend.