Even a freshly-minted novice trader will, before too long, come across what may be described as the "contrarian tendency".
This comprises a hardy breed of people who believe that, at any one time, the positions taken by most players in the market will be proved to have been mistaken. Therefore, they bet the other way.
A gross oversimplification, of course, but not entirely unfair. There are indeed some contrarians who trade against the trend in all circumstances and take the fact that, because the majority view is the majority view, they need no other evidence to see that it is wrong.
Baulking at contrarianism
However, most adopt a more nuanced approach, like looking for clear signs of over-buying or over-selling of a particular security or for a more general, market-wide disequilibrium that can unwind only in a disorderly manner.
True, there is always a risk that you will end up buying in close to the top, or selling out near the bottom. But this danger can be mitigated by putting time and effort into identifying when a security is nearing its peak, and thus ready to be sold, or close to a trough, meaning it is time to buy.
Even those who find the notion of momentum investing to be unsophisticated still baulk at contrarianism, for two main reasons.
One is that it is little more than a mirror image of momentum investing. Automatically trading against the trend is, they would say, the same as trading with it.
The other is that it is sheer arrogance to declare that everybody else is wrong and the contrarians are right. What gives the clique of contrarian traders a superior insight into the market denied to their everyday, unenlightened fellows?
Any defence of contrarianism should probably begin with the dictum of Robert Beckman, for years the market guru on London radio station LBC: “Markets will do whatever they have to do to ensure that most people are mostly wrong most of the time.”
Different types of contrarians
Note that he does not pour scorn on either momentum traders or the broader community of market players. He merely states that the market operates in such a way as to deny easy riches to the majority of those dealing in securities.
So, accepting that there is at least something in the notion of contrarian trading, what are the different types of contrary traders?
The first of the breed need not detain us for long. These are self-styled contrarians who boast of their maverick style while mysteriously displaying all the characteristics of momentum traders in terms of assets and strategies. They are the market equivalent of respectable middle-aged couples who insist that “we’ve always been rebels at heart”.
Much more interesting is what may be called the “correction trader”. One such who practised this style was the late British financial wizard Jim Slater. He would wait until a security, such as a company share, had deviated by a certain percentage above or below its recent average, and then buy or sell accordingly – anticipating a price correction back towards the average, or a “reversion to the mean” in trading jargon.
The basis of correction trading is that markets “over-punish” bad news regarding certain securities and “over-reward” good news, and the contrary trader can profit from it.
Key to making a success of this style is being able to distinguish between abnormal price movements that are irrational and those that have a basis in real-world events, such as the imminent bankruptcy of a company. As always, keeping a close eye on financial news outlets of all types is essential.
Bears on the prowl
Similar, but distinct, is the branch of contrarian trading that overlaps with what is known as “opportunistic” market behaviour. Here, the trader has no particular view of the rightness or otherwise of the overall market trend, up or down, but seeks out specific examples where the market seems to have mispriced a security – such as a company’s shares – and buys or sells accordingly.
At the opposite end of the spectrum are “big picture” contrarians, who wait until the market as a whole is overbought or oversold and then act accordingly, often selling or buying entire indices.
Finally, there are what may be called “permanent bear traders”. This does not, of course, mean that they simply sell, or go short on, securities haphazardly, as that would be a recipe for near-instant insolvency.
Rather, it refers to a world-view that generally assumes optimism to have the upper hand over pessimism in the markets – not least because of the stream of upbeat analysis from bankers and brokers – creating a bias towards prices that are higher than can rationally be justified.
The bearish contrarian is constantly on the alert for opportunities to profit from this in-built market distortion.
Contrarianism is also practised in the investment world, but it is especially suited to financial trading, given that this is a world in which only one party to a deal can be right. An ideal environment, in fact, for a contrarian with the courage of their convictions.