The word contrarian itself implies the preference for taking a position against the majority. These types of people swim against the current and do not generally conform to socialite norms. When referring to the stock market, contrarian holds a similar connotation.
Contrarian trading is an investment style where the investor spots the end of a trend and trades against it. In other words, contrarian investors buy stocks that have dropped in value and then sell once the value increases.
The logic behind contrarian trading is that nothing goes up forever, and nothing falls forever. A contrarian investor looks to buy assets that have been falling in price, and they prefer to sell assets that have been rising in price. The purpose is not to buy cheap or sell high, but rather to sell what seems to be overpriced and buy what seems to be a bargain.
The base of contrarian trading strategy is to go against the market trends, looking for stocks where the sentiment is counter to the established trend. Contrarian investors will generally keep note of what most market letters recommend.
The idea is that market letters often reflect when it is a good time to buy a stock, so the best things to do is the exact opposite of the recommendation. The higher the recommendation is to buy a stock, the more likely it is that a contrarian investor is to sell, and vice versa.
Some believe that the majority is generally wrong and tend to get carried away during a boom, causing a panic. As a result, they tend to buy and sell at the wrong times. The appeal to contrarian trading is by simply doing to opposite of everyone else, one will know the right time to buy and sell.
Pros of Contrarian Trading
While some view contrarian trading as risky, it can be an extremely rewarding experience. When individuals begin to panic about a dropping stock, they begin selling their shares. A levelheaded investor can take advantage of this situation and make good money while following the philosophy of contrarian investing.
Contrarian investing also helps balance out the market by purchasing in large amounts while everyone else is selling. Similarly, when everyone begins purchasing a promising stock, contrarian investors will offload their shares.
Cons of Contrarian Trading
While the saying “No risk, No reward” can apply to contrarian trading, blindly following this method can backfire. There could be a multitude of reasons why stock prices are fluctuating, and investors are jumping ship. Being pro-active in conducting research can aid in the success of a contrarian investor. Investors should understand the underlying reasons behind the fluctuation in pricing.
The rise and fall of stock prices should be closely monitored, as there may be instances when the prices do not match what is reported in the news. Evaluating the market and the events that may cause fluctuation require expertise that has been gained from trading for an extensive period of time. Going against market trends can be a risky move for any investor. Therefore, contrarian trading may not be suitable for those with little to no experience.
Indicators for Contrarian Investors
Contrarian investors use a variety of indicators, particularly those that emphasize out-of-favor securities, to determine which stocks are worth investing in. However, the most effective and widely popular indicator is market sentiment.
Although many investors would like to perceive their decisions as rational, most have purchased due to fear of losing out on gains and sold due to fear of further losses. This herd behavior is called market sentiment. However, the market will often move against the sentiment of the majority.
Many investors use market sentiment as an indication to buy when the sentiment is pessimistic and sell when the sentiment is optimistic. Therefore, if you follow the herd, you will be led to the slaughterhouse.
One of the most powerful tools for a contrarian investor is the variety of websites that provide indicators of investor sentiment.
The CBOE Volatility Index is also referred to as the fear gauge. Essentially, the prices of stock will increase if more fear, or volatility, is present. Therefore, the CBOE Volatility Index will jump when there is more fear, or an expectation of fear, in the market.
The Put-Call Ratio is a good tool to indicate low investor sentiment. Investors can purchase puts, which protects themselves against a market downturn, or purchase calls, to possibly gain from a market rally. A large number of calls, when compared to puts, shows a high investor sentiment, and vice versa.
From a contrarian standpoint, negative cash flow from long-term mutual funds is considered a bullish indicator. This means investors believe that a stock or the overall market will increase. A positive cash flow is considered a bearish indicator and may mean a stock or the overall market is believed to decrease. This is monitored by Mutual Fund Money Flows, which allows investors to determine which way money is flowing.
One way to view the percentage of individuals who are bullish, bearish, or neutral is the AAII Sentiment Survey. The survey is open to all AAII members, who tend to be individual investors nearing retirement age, with a substantial portfolio. This indicator has proven to be surprisingly accurate over the years.
Another great way to check the market sentiment is to check the sentiment ratio from Etoro. Etoro is a peer trading site, mainly focused on currencies, but also covering main commodities and stocks. The site shows whether most of its users are long or short an instrument. If over 90% of its users are buying a stock, then it could be good place for a contrarian investor or trader to use this information to their advantage.
The final indicator is the margin debt, which is a measure of how much investors are buying on margin. Generally, an increase in margin debt indicates a rise in stock price, and a decrease indicates a drop in stock price. Using margins can be much riskier than buying with available cash, as a small loss can force investors to close out positions and cover margins.
Contrarian investors are constantly fighting the trend, but it can occasionally work against them. This style of trading favors those who know the market inside and out and requires experienced traders who aren’t afraid to take a risk every now and then. Those who use this strategy hold the belief that the worse things seem in the market, the better the opportunities are for profit.
Contrarian traders who use this strategy wisely tend to be bargain hunters during their everyday lives as well. They are the ones who use coupons when they come in the mail, sell their homes if the market is hot, and know how to spot a good sale. They understand the value of something and use it to their benefit.