The contrarian trader sees what everyone else in the market is doing, and promptly does the opposite. That, in a nutshell, is the essence of a contrarian trading strategy.
Being part of a crowd, to their way of thinking, brings not safety but danger.
Their world-view was probably best summarised by the late Robert Beckman, stock-market guru on the London radio station LBC: “Markets will do whatever they have to do to ensure that most people are mostly wrong most of the time.”
A framework for forming views
A snappy formula, but is it true? Timing is everything, and you could identify entry and exit points in the market that can prove or disprove this thesis. A skilled trader may well be able to ride a wave of irrational exuberance, to use the phrase coined by former Federal Reserve chairman Alan Greenspan, with regard to a particular asset and time their exit to perfection, maximising profits and escaping the inevitable downward correction.
On the other hand, the fate of all those who failed to follow the trader’s lead before the downswing may appear to confirm the Beckman view on the wrongness of most people most of the time.
Indeed, it could be argued that this successful trader has, in part at least, followed a contrarian strategy.
Contrarian trading is of particular interest to those trading contracts for difference (CFDs). This is because CFD trading is all about forming a view on the performance of the underlying asset in question and then acting on that view. Contrarianism provides a framework within which those views can be formed.
A mechanistic approach, giving effect to this view, would be to bet against a security when it is, perhaps, 15% above its recent average price and to bet on a price rise when it is 15% below that price. Markets, in this view, not only over-shoot but they subsequently correct themselves.
The contrarian trader can, with good timing, buy or sell ahead of this correction.
Excessive punishments – and rewards
A more involved and fundamental approach, still based on the notion that markets over-shoot, would involve identifying any reason behind irrational buying or selling, confident that a cooler appraisal of this reason would lead to a price adjustment.
For example, a company’s stock may be excessively “punished” for a poor set of trading results, especially if the bad news came out of the blue and markets had expected better numbers. For the contrarian trader, this is a signal to buy, given that market players are likely, sooner rather than later, to realise they over-reacted.
Similarly, over-enthusiastic buying of a company’s stock may have been propelled by highly optimistic statements from its board members that are, on closer examination, difficult to justify. The contrarian will be betting on a price fall.
What goes for stocks goes also for currencies and commodities. Has a disappointing set of trade figures led to an excessive battering on foreign exchanges for the currency of the country concerned? Is the market pricing in unrealistic levels of demand for a particular commodity – or equally are there unrealistic constrictions on its supply?
You need to be reasonably sure that, for example, the company does not deserve its punishment, or that the commodity has been overbought.
Timing is everything
Research of a different type is called for with a third type of contrarian investing – betting not against recent movements in individual assets but in whole indices, such as the Dow Jones in the US, Britain’s FTSE 100 Index or the Nikkei 225 in Japan. This is, perhaps, the purest expression of the Beckman view that most traders and investors will be wrong-footed by the market.
How sure are you that the market as a whole is overbought or oversold? It is insufficient simply to repeat the mantra about most people being mostly wrong. Even if this is true (and non-contrarians would dispute it) the extent to which they are going to be wrong may not have surfaced by the time you trade.
A stock-market boom in 18 months’ time would be of little consolation to someone taking a long position now.
Finally, there is a type of contrarian trading that touches on other market strategies. One such is “value trading”, the search for securities that have been mispriced, for whatever reason, and which offer value in the gap between the market price and a more realistic value.
Another is the use of “behavioural finance” insights that identify irrational market behaviours, such as retaining a security for too long, that can offer opportunities for contrarian traders.
Ultimately, whether or not to adopt a contrarian strategy comes down to the temperament of the trader. But before doing so, you need to remember that there is a very strong contrary view to contrarianism, known as momentum trading and based on the view that the trend is indeed your friend.
Perhaps the most fruitful trading strategy would blend the best aspects of contrarianism, such as thinking for oneself and refusing to be stampeded into irrational behaviour, with an appreciation of the fact that there are times when most people can be mostly right.