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.