Contrarian trading is the art of trading against the common sentiment of an asset. It rests on the idea that how people view a stock can be different from how they act on that stock. A contrarian approach can allow a trader to take advantage of the gap between perceptions and the underlying quality of an asset. On the other hand, if the timing is wrong or the trader misreads the signals, then the result will be embarrassing losses. In this post I will explain how to trade like a contrarian and why you might want to do so.
Contrarians believe that sometimes, the market participants make mistakes. Price movements might reflect an overreaction to the current news about a company, rather than reflecting the true value of the company’s future profits. Part of this comes down to paying close attention to the sources of information and reading different sources of analysis in the financial markets.
For example, if there is a lot of negative buzz around a stock, but the price is steadily rising, that is a good sign that there are some investors holding back and who are likely to join in and buy soon. That makes the stock a good purchase target because the investor sentiment can turn positive, as people see the stock is climbing despite the bad news, leading to a fresh wave of interest.Contrarian traders focus their attention on both – how an asset price is moving and how investors and analysts are discussing it. It is common for those two things to diverge, and a contrarian is willing to trust the asset price over the public opinion of the asset. This is more than just taking the opposite position of the consensus, because it requires a careful look at the difference between performance and expectations.
Risks of Contrarian Trading
On some markets, like forex, it is possible to take positions with a lot of leverage. That means borrowing money to take the position. If the bet works out, then trader can earn far more than they would have been able to do if they had only used their own money. However, this is a double-edge sword and all mistakes will be multiplied.
Leveraged trading feels even more risky when it involves betting against public opinion about an asset. Being wrong on a contrarian position might lead to fairly large losses because the market can move in the opposite direction for a while before it starts to return to it’s long term average. A famous economics professor, John Maynard Keynes has said “The markets can stay irrational for longer than you can remain solvent”. This is something that a proper contrarian has to always keep in mind. You always need to have a good exit strategy and a specific price level where you have planned ahead to stop out if the instrument does not go your way. If you’re only deciding on the go, you might not live to trade another day.
Trading as a contrarian also requires learning how to separate good information about an asset from hype and hyperbole. In today’s environment where opinions are a dime a dozen, that isn’t easy. Figuring out which characteristics of an asset matter and which are just a short-term blip is a key skill. A contrarian has to hone that skill while also mastering other day trading skills like reading charts and learning the markets.
Benefits of Contrarian Trading
With the right amount of research and knowledge, a contrarian strategy can yield attractive profits. Contrarians pride themselves on timing the market well and sorting out facts from opinions, which can work well for both a long-term and a short-term outlook. That makes the contrarian position useful for any number of investment goals.
It is a philosophy that lends itself to successfully finding the best information in any given market. That means it is not restricted to any particular asset type or market. Contrarian trading is versatile and broad in scope, so it can apply to a general market, a specific asset, a portfolio, or any mix. The world is your oyster, you can take positions in instruments ranging from bitcoin to Apple stocks and in markets from China to Brazil, but you need to know what you’re doing.
There is also the psychological element. It is rewarding and enjoyable to succeed on a trade when the consensus was pointed in the opposite direction. Eventually the analysis and research uncovers profitable positions, but contrarians tend to be ahead of the curve, and being right when others are wrong is a satisfying feeling.
That might summarize the contrarian approach. Rather than just doing the opposite of what most people do, contrarians look to get ahead of the trend and take positions that the public has not yet realized will become profitable. Getting in the door first allows for better profits.
How To Learn To Trade Like A Contrarian
It can be tough to get started on a contrarian philosophy because it runs counter to a lot of conventional wisdom about assets and trading. One idea is to spend some time learning about the basics of how to trade normally. This will give you an idea of how most investors think, what information sources they use, and how they react to news.
Being a contrarian means doing a lot of research and understanding which facts are long-term and fundamental and which are temporary. That entails deep dives into industry analytics and trends, company knowledge, and other work. Frontloading all of that effort pays off in the end, but it takes an initial investment of time.
1) Follow the Professionals
A good way to learn this skill is to study what some famous contrarians have done in the past. What positions have worked out for them and how have they come up with them. A very good example of such a trader is Kyle Bass, who was featured on the movie “The Big Short”. He made approximately $1 billion from betting on the crash of the American economy. He was down a lot at first, as he entered into the trade too soon, but after waiting it out, he managed to prove the world that he was right all along.
Kyle is a proper contrarian, he is always looking to place bets where the market is valuing something irrationally. Luckily he speaks about his ideas publicly, which provides a good learning opportunity for traders looking to learn the art of contrarian trading.
2) Study Market Sentiment
Another way to practice contrarian trading is to check the pulse of the market in a given instrument, find out the majority of traders are on the same side of the trade and only then take the opposite position. This requires you having to do some fundamental analysis if you are taking a longer term position, but can be a profitable endeavour if you are willing to put in the work.
This strategy works because if you are able to know what most of the traders are doing and you know for example that most people are long a specific stock, then you can assume that there aren’t many people left to buy that stock and push the price any higher. This means that the only way is down. If traders realise that the stock isn’t moving any higher, they will start to exit the trade one by one, which can lead to a panic sell-off. If you were short the stock, this panicking will give you a good opportunity to exit your trade with a decent profit.
Market sentiment is actually quite hard to tap into. This can be seen to some extent from Yahoo Finance. They display the short intent of a specific stock, but the information is a bit hard to read to make real trades on. Another good resource to check for market sentiment is a social trading platform called Etoro. The platform has over 6 million users and it displays social sentiment of its traders. This gives you a good opportunity to check the sentiment/opinion of a rather sizeable sample group of traders. For example, if you see that 90% of its traders are long the EUR/USD currency pair, you can assume that there aren’t too many people remaining to jump onboard this trade, while there is a large amount of people who may want to exit the trade, again giving you a good opportunity to earn a profit.
To Sum Up
The bottom line is that contrarian trading is a fascinating approach to trading forex, currencies, stocks, commodities, or any other asset. It requires a different way of thinking and hard work to master it, but can yield decent results when applied correctly. Being a contrarian means knowing when to trust trends and when to see that prices are more important than opinions. A contrarian can enter a profitable position quickly and leave it before it turns sour by paying attention to what people say and how they act about a particular asset or portfolio. It is a risky, but profitable endeavour for those who know what they’re doing.