Contrarian Trading – How to Beat the Market by Doing the Opposite

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For starters, contrarian traders are not your average traders. They are tactical, resolute and will, simply put, go against the prevailing trends.

In other words, they go against the general market consensus in their day trading activities. This defines what contrarian trading is: a method of trading that involves purchasing of assets at their worst performance and selling them at their best performance.

If most people just follow the overall market and earn the market average if they’re lucky, contrarians are looking to make a lot more. A famous example of such a trader is Kyle Bass. He made a bet against the market in 2007 and managed to become a billionaire from that bet. Yes, he was rich before, but the Big Short – as the movie about him is called, was what put him into the hall of fame of traders.

Common Basics to Observe

A contrarian trader believes that when other traders say that the markets are going up they only do so because they have fully invested and lack the power to invest anymore. This is the point where the markets are at their best, at the peak. But when they say that the markets will go down then it means that they are sold out and therefore to the contrarian trader, the market will definitely go up.

If company X which was well performing has a dip in its shares, the contrarian trader jumps in, trading against this drop in shares believing that the markets are always wrong at their very high and very lows. The strategy is to go against the viewpoint that-‘’the trend can always be your friend in trading.’’ When there is a lot of positive sentiment for a stock that is going higher and higher in the market, the contrarian trader knows that a lot of investors will be sitting on the sidelines out of pessimism.

This provides an opportunity for the contrarian trader to invest as the hope is that if the stock keeps going higher, then the pessimism and sentiment will change and the sidelined money at once will somehow flow into the market, driving stocks up albeit for a short while. In other words, you will be majorly looking for tops and highs in market shares-when the others exit, you are making an entry. So you may ask, what will be the indicators before you make a move?

Key indicators for a Contrarian Trader

Your guess is right-It is not just about precision. That would be simplistic thinking, and stock trading is definitely not a simplistic exercise. You need to have some indicators of when to make a move as markets would be at a high in a split second before cascading into an all-time low. So, you have to keep monitoring the stocks and reading about stocks to capture the sentiments and general trends. These are some of the ways you can do this:

Monitor analyst ratings:

Analysts, will always be the best source for stock market trends. For instance, they will predict a given stock and even advise on when to buy, hold or sell and this will in essence impact on the decision you make to trade in such a stock. A stock that is on a high with no ‘’buy” recommendations on it presents a great opportunity for it to be upgraded as those on the sidelines might invest in it.

A stock that falls in price must as well be monitored for changes in short interest. Such a stock will receive a lot of negative sentiment which to a contrarian trader is a signal that a lot of sideline money will be pumped in to keep the stock from falling. And that provides a great chance of investing riding on an unpopular belief.

Does Contrarian Trading Always Work?

This is a question that any trader would want to be answered. And the answer is simple: Statistically speaking, yes, it does work. In fact, it has worked for many traders and Warren Buffet leads this fray. Warren Buffet, who is one of the most successful investors of our time is fundamentally a contrarian trader who has constantly proved that this approach works.

Consider this example: Goldman Sachs, which is a premier investment bank that is highly profitable in the United States at a time when the market had tumbled saw Warren Buffet buy preferred equity stake of $5 billion, which gave him a cool 10% interest. He then bought another $5 billion stake with common shares trading at $115. This was at a time when all investors wanted nothing in the banking industry. Yet six years latter Goldman Sachs was trading at $180 per share.

The Lessons

  • Focus on quality companies- Do not just trade with any company. Keep in mind that it is important to only put your money in a stable company that has great financial records and has prospects for future growth
  • Have the foolish bottom mentality- When the markets go low, you naturally thrive as purchasing shares at that time becomes less competitive hence cheaper. The extreme highs and extreme lows are where you optimally perform
  • Always keep a long-term mindset- As a rule of thumb, always intuitively know that in the long run, you stand to gain. Short term gains might result in long-term pains.

What Must a Contrarian Trader Do To Be Successful?

As it is in any stock trading field, certain rules have to be applied for you to be a successful trader:

  • Be patient
  • Stick to your plan
  • When markets panic know it is your time
  • Be skeptical, always

Where to Find Contrarian Trading Opportunities?

  • Fundamental analysis: 
    One way is to keep your eyes open and look for listed companies that tend to be either out of favor or instead, valued at price levels that seem to be out of this world. What you would need to do is to figure out the real value of the company and initiate a trade if the difference offers a good risk/reward trading opportunity.
  • Tracking market sentiment:
    Another way is to check what the market participants are doing and try to do the opposite. The logic behind it is that if you can find a stock where the majority of the people are going long, there aren’t many people left to buy it to push the price even higher. This means that the price can either remain at current level or go down. Either way again a good risk/reward opportunity for a contrarian.

Stocks – A good site to check market sentiment from is Yahoo Finance. They show the short interest of a given stock. What this shows is how many people have taken a short position in a given company. Should you find a stock that is shorted heavily and not dropping in price, there are a lot of people that may want to bail their short positions once they realize that the drop is over or never even happened.

Forex – for currencies traders, checking market sentiment is rather easy. Most social trading sites showcase market sentiment of their traders. It is wise to choose a platform that has the biggest amount of users in order to get the best picture of what the retail traders are doing in the market. Currently the biggest social trading site is Etoro. They have over 7 million users, which enables to get a good understanding of the overall market sentiment. Now if you recognize a currency pair, where 90% of traders are long, you can make a conclusion that there aren’t many people left to go long and hence the price has a good chance of heading down.

To Sum Up

You must always remember, that stock trading or forex is not for the faint-hearted. Be ready to at times face the consequences of outsmarting yourself, being lonely in trading against the masses, and occasionally swallowing humble pie that the crowd was right. Yet even in spite of these challenges, contrarian trading can be highly rewarding.

Remember, that over time, contrarians have always outperformed other traders, proving that indeed this form of trading though not practiced by many is a great way of doing stock trading. Where the market moves on is where the contrarians move in; what the markets dismiss is where merit exists.

Sources:

• http://traderhq.com/rules-every-contrarian-investor-must-follow/
• https://financialhighway.com/five-risks-of-contrarian-investing/
• https://www.fool.com/investing/general/2014/09/05/3-things-you-need-to-know-about-contrarian-investi.aspx
• http://www.investopedia.com/university/introduction-stock-trader-types/contrarian-traders.asp
• http://www.forexmentoronline.com/the-importance-of-being-a-contrarian-in-forex-trading/
• https://beta.theglobeandmail.com/globe-investor/investment-ideas/gi-newsletter/article31503098/?ref=http://www.theglobeandmail.com&

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