What exactly is contrarian trading? Here’s what you should know.
Stock market investing is rapidly growing, especially in this day and age of fast technological advancements. Statistics tell the story. According to the Investment Company Institute, approximately half of adult Americans (52%) invest in stocks. This percentage is up from 49% in 2014. Advances in technology mean people can buy and sell stocks in the comfort of their homes, as long as they have a computer and good internet connection.
This kind of trading is not for the inexperienced or the faint-hearted.
While most stock investors prefer to invest according to market trends, some investors gravitate towards distressed stocks. They buy those stocks in anticipation that they will turn around and start performing well and sell them when they hit the right prices to get an impressive return on investment. This kind of trading is known as contrarian trading.
However, this kind of trading is not for the inexperienced or the faint-hearted. It requires accustomed traders who have the right set of trading skills and are able to make critical decisions when the right time comes to buy and sell distressed stocks. If you’re looking to venture into this line of stock trading, here is what you need to know:
How does contrarian trading work?
The idea behind contrarian trading is to find stocks that are on a downward spiral or underperforming and then profit by selling when they’ve started to perform better and come into favor again. Contrarian investors don’t follow the crowd. In other words, they buy stocks when other investors are panic-selling and sell when others are buying or piling in.
Contrarian trading can be done in both – long and short-term time horizons. Stock markets can move in a matter of minutes or hours. A stock can underperform in the morning but gain substantially as the day progresses.
Contrarian day traders take advantages of these daily stock movements or stock price fluctuations to buy when stocks are underperforming and sell when stocks gain substantially before the end of the trading day.
The vast majority of forex traders like the contrarian day trading model because of today’s market volatility.
Long-term contrarian investors, on the other hand, buy underperforming stocks and hold them for a longer duration (from a few weeks to many years even) and sell them when they are performing well. They can also buy well-performing stocks with the hope that the stocks’ performance will increase further and when they feel the stocks have reached the right price, they sell to make huge profits.
Forex traders can also profit from contrarian trading by buying currencies when they are spiraling down and selling them when they gain. In fact, the vast majority of forex traders like the contrarian day trading model because of today’s market volatility. Currencies fluctuate so much these days, and forex traders profit from the ever-changing prices that happen 24/5.
The big question is: How do contrarian traders know the right time to sell their stocks?
Well, they keep sharp eyes out on evidence of low cash holdings. For instance, when stock managers don’t have a lot of cash on their books, it means that they have channeled them into other investments such as shares.
A lot of activity is another indicator that the stocks are doing great. This situation is characterized by lots of confidence. Everyone is jumping in, and a lot of shares are being traded.
One good indicator that motivates contrarian investors to sell is low short interest. That means many people out there are betting for the share prices; few people are betting against the share prices. A good way to check the short interest is to check Yahoo finance or some other stock screening software that displays it. The more recent the data, the more you can trust it.
Another good indicator is complacency. In a complacent market, sentiment indicators are bullish, which means pretty much everyone is buying. Also, in a complacent market, stock prices are strong, which means a high percentage of shares are hitting 52-week highs, as opposed to 52 weeks lows. Bets on share prices are also rising in a complacent market.
Contrarian traders sell their stocks when the safe haven demand is low.
Market sentiment in itself is a very good indicator of the overall bias of the market participants. The only problem is that it’s hard to tap into this knowledge. A good way to do so is to use social trading sites like Etoro, Zulutrade or some other brokers that publicly display their user sentiment. The theory is that is a site has a good amount of users, you may get a pretty good picture of the overall sentiment of the market by monitoring a small sample group of its participants.
Also, contrarian traders sell their stocks when the safe haven demand is low. Haven demand tends to be high when a stock crisis is looming. But when the stocks are rising, there is optimism, so the safe heaven demand becomes low.
Overall you can get pretty good returns with contrarian investment when you get things right. On the other hand, the market can go greatly against you; which is why you need to know the ins and outs of the stock market and make informed decisions to prevent the possibilities of losing money.
The difference between contrarian investors and momentum investors
As we have seen above, a contrarian trader goes against the market. They don’t follow the masses. They keep eyes out on stocks that no one wants to invest in (unloved stocks).
A momentum investor, on the other hand, looks out for and buys stocks that are already on the rise (well-performing stocks). They buy higher and sell higher. They believe that once a stock price starts to rise, it will continue to rise and the greater the amount they invest in that stock, the greater the return on investment they will get when they decide to sell.
This concept usually works well in a bull market, which is characterized by lots of positive sentiment. It’s also a risky strategy, as stock traders must know when to act in order to make profits and avoid losses.
Pros and cons of contrarian trading
Potential to hit the jackpot when you get things right
Contrarian investors can hit the jackpot if they manage to find opportunities where most people are thinking the opposite. For example, American billionaire, Warren Buffet, made his fortune from investing as a contrarian. Another great example is Kyle Bass, who managed to earn 500 millions from betting on the credit crisis of 2008. Bass currently has an interesting view on the Bitcoin markets.
Contrarian traders bring balance to the market
If the stock markets were to be filled with only momentum traders, then it may have collapsed by now. In other words, individual traders and trading companies would have gone bankrupt and abandoned the market altogether if people only won. There needs to be those who bet for and against the market. Ideally, there must be winners and losers for the stock market to remain healthy. Contrarians bring diversity to the table by increasing liquidity in difficult times.
Contrarian traders can miss opportunities to make profits if the crowd’s decision prevails.
If you don’t know what you’re doing, contrarian trading can be a dangerous endeavor. Getting caught on the wrong side of the trade might really hurt your account balance. In order to stay alive in this game, you need to learn to cut your losses quickly.
It’s mentally challenging
Contrarian trading looks lucrative on paper. In actuality, it’s almost an insurmountable challenge to pull off than those traders who partake in it anticipate. Humans are social by nature and are influenced by what others think or say. Some contrarian traders can hold on to their position for a limited time. However, success in this line of work requires a level of independence and guts that, sadly, most people lack.
To be successful in contrarian trading, you must possess basic analytical skills such as fundamental analysis, technical analysis, and sentimental analysis. Fundamental analysis entails the ability to figure out a stock’s financial performance and health by keeping an eye out for financial, microeconomic, quantitative and qualitative factors. Technical analysis is the ability to predict the price pattern of the stock(s) you intend to buy. Sentimental analysis is the ability to figure out a stock’s short-term position in the investment market.
You also have to do a rigorous research before buying any stock, buy when there is rush selling, and have an additional capital in reserve to help you get through when you take a long-term investment position.