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The theory of reflexivity is based upon circular relationships between cause and effect and has it’s roots in the work of sociologist William Thomas, Robert K Merton, and later on, philosopher Karl Popper.

As it turns out, Karl Popper, was a tutor to a young George Soros while working at the London School of Economics. Soros is one of the greatest currency traders of all time and he attributes much of his success to his belief in the theory of reflexivity.

A Guest Post by  FXTM

Principles

As mentioned, reflexivity describes a circular relationship between cause and effect. At it’s most basic, it describes how the occurrence of an event can directly influence future events. That those situations are bidirectional, able to ‘bend back’ on each other, or that they be self-perpetuating.

In economics, or in this case, in forex, the implications are relatively clear. A significant market event or movement can drive future events or cause new trends to develop.

The perfect example can be seen in any financial bubble or crash. In the case of a bubble, rising prices attract more and more buyers into the market. This drives prices higher and higher in a self-perpetuating motion until the market becomes unsustainable.

In the same way but in reverse, when markets start to drop sharply, more and more sellers come to the market, and people begin to liquidate their positions out of fear. This causes a much more significant drop than was first foreseen.

It’s a theory that is also seen clearly in macroeconomics. Namely, when consumers become too pessimistic that pessimism can lead to a vicious cycle of reduced spending, and a spiralling downturn can occur.

Taking advantage of reflexivity

Legendary trader George Soros is known to be a fan of reflexivity and he feels that the theory has helped him to beat the markets over the years.

Since the theory describes markets as having a circular relationship between cause and effect, it is important to maintain a very flexible approach to the markets.

The theory of reflexivity states that markets are completely dynamic, that new trends can influence policies and economics just as much as the other way around.

It is essential then, to keep a completely open mind when trading. To not get too attached to any one trade and to move with the flow of the markets.

Since one big trend or market move can cause self-perpetuating consequences, it would seem natural to abide by the old market wisdom of cutting loses quickly and letting winners run.

Further reading:  5 most predictable currency pairs

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