This applies the other way around too. During periods of extreme optimism, contrarians might become cautious. If everyone's rushing to buy a particular stock or asset class, a contrarian might see this as a sign of a bubble about to burst. They might choose to sell or hold off on buying, believing the price is inflated by hype and due for a downward correction.
When the majority is overwhelmingly positioned one way, it can leave the market vulnerable to an unexpected reversal in the opposite direction. For instance, if news or events shift perceptions, a wave of panicked short covering could propel the EUR/USD upwards at the drop of a hat. The saying "the trend is your friend" is popular for a reason, but extremes in market sentiment can signal turning points. When a substantial consensus forms, the potential for a sharp reversal grows. If something shifts to spook the bulls, a rush of sell orders could quickly overwhelm the buyers, leading to a EUR/GBP decline.
When a vast majority of traders pile onto one side of a trade, it sets the stage for potential reversals. A piece of good news for the euro – or negative stories about the yen – could set off a chain reaction. Traders betting against the common currency might be forced to buy back in, creating a flurry of short-covering. This could push EUR/JPY higher.