Is Contrarian Trading Working?
One of the greatest investors of all times, Warren Buffet, is a contrarian trader. He built his fortune betting against the Doomsday, if we can say such a thing. It means that he used each dip in the equity markets to accumulate more and more stocks, betting that the market would recover. So far, he has been right, and along the road he’s made a terrific amount of money. Of course, this is just a simplistic way of viewing Buffet’s work, as in fact there is much more going on behind the success of his Berkshire Hathaway company. Nevertheless, the above statement is very much true in general terms.
Being a Contrarian
Being a contrarian means that one questions all the time whether each move the market makes is indeed the right move, or whether it should be discounted. Forex brokers know that the clear majority of new traders lose their first deposit, and most of the brokers have a special trading department that takes advantage of this fact. In this way, the broker is a contrarian in the sense that it is betting against its clients. This is not a conflict of interest, but it shows exactly what contrarian trading is: selling when everyone is buying, or buying when everyone else is selling. Most of the time it pays to be a contrarian, even though one should consider that the market does not trend as much as people think. Having said that, it means that trends or impulsive waves are not as common as corrective waves. This makes trading a business that is predictable most of the times. However, when trends start, or when a range is broken, the violent move that follows will wipe out all the gains made when the market was ranging, and some more on top of those.
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Contrarian Technical Approach
Technical analysis deals with trading theories and indicators traders use to find out places to go long or short. The idea behind technical analysis is that market participants try to forecast future price action based on either previous patterns and historical prices, or the way an indicator is moving. Out of all the indicators, trend indicators cannot be used in contrarian trading as traders use them to follow the trend. If a trend is in place, contrarian trading is not suitable. Oscillators, on the other hand, show overbought and oversold levels, and the general understanding is that selling should be done when the oscillator shows overbought levels, and buying when the oscillator shows oversold levels. What if this is not the right thing to do? What if we should go long in overbought areas and short in oversold areas? Will this work? The right answer is that it works when the market is trending, and that is when most of the money is going to be made. Contrarian trading requires thinking out of the box, and this mean interpreting things in one’s own way. Does this make technical analysis useless? No – it means that one should use parts of it to create one’s own system.
In the long term, being a contrarian pays more than following “classical” trading rules. If succeeding in trading is so difficult, then maybe following the classical rules is not the way to trade. One thing to avoid with technical analysis is trading patterns that are too obvious. For example, every trader knows that a rising wedge falls, and a falling wedge rises. In other words, we should sell when we see a rising wedge, and buy when a falling wedge is forming. Is this correct? Is this true 100% of the time? No, it is not – especially if the pattern forms on longer time frames and looks perfect. You must imagine that all traders are watching the same pattern, there is plenty of time to interpret it, and they cannot be all right. Therefore, the market will go the other way, as this is the purest example of contrarian trading. The same is true with head and shoulders and other patterns that are too obvious on the longer time frames. A good exercise by way of example is to look for a pennant forming on the daily chart and above it, and you’ll be surprised to see that most of the time the pennant breaks the opposite way from normal.
Contrarian Fundamental Approach
Fundamental analysis is based on two things: economic news and data that is released on a constant basis, and other events that are meant to influence trading. These events may be elections, referendums, natural phenomena, wars, etc. Interpreting fundamental news is important for the trading style one has. If the time horizon for the trades is big enough, then trading based on fundamental aspects should be OK. If you’re trading with a short-term horizon in mind, buying or selling when a news item is released might not be profitable. Again, markets do not move the way they are supposed to move only because an economic piece of data was released. Trading is mostly about finding your edge, the right edge, and insisting on it. Most of the time this is related to being a contrarian, rather than following some predefined rules.
Other educational materials
- How to Use Parabolic SAR to Buy Dips or Sell Spikes
- Bollinger Bands – Profit from One of the Best Trend Indicators
- Trading with the Cloud – Use Ichimoku Cloud to Spot Reversals
- Types of Contracting Triangles
- Special Types of Triangles
- How to Trade with Gartley
Recommended further reading
- “Overreaction, delayed reaction, and contrarian profits.” Jegadeesh, Narasimhan, and Sheridan Titman. Review of Financial Studies 8, no. 4 (1995): 973-993.
- Do insider trades reflect both contrarian beliefs and superior knowledge about future cash flow realizations? Piotroski, J.D. and Roulstone, D.T., 2005.. Journal of Accounting and Economics, 39(1), pp.55-81.