Contrarian Trading & Investing: A Crash Course
Why following the herd is usually the worst possible strategy.
Dean Brooke

Dean Brooke

Dean Brooke's economics & financial column brings you news, in-depth analysis, research, occasional gossip, and more. You can email him at dbrooke@rogueeconomics.net.
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Introduction

I’m honoured to have been personally referred to by Alessio Rastani as a “true contrarian” during my time in the investment and trading circles

Okay, sounds like it could have been an insult perhaps?

Actually no. It was a compliment (one which I’m pretty proud of actually) because contrarian investing is probably the smartest way to look for value for money in the marketplace.

So what do I mean by “contrarian investing”?

Lets take a look at a basic outline for how and why this works.

General Mode Of Trading

Simply put… you should always intentionally aim to deliberately do the opposite of what everyone else is doing.

Too simple? Doesn’t make sense? How can that possibly work in practice?

Allow me to explain…

Most of the traders and investors in the marketplace, frankly, have really no business being in the market because they take bad advice, don’t manage their risk properly, have no real conception of value and generally don’t look at anything except very basic price trends.

Nasty thing to say? Well sorry, but I’m not sorry. Because it’s true.

The worst advice you will get is from a layman who happens to own positions in a few of the most popular investments and presumes to know everything as a result.

At least people who are terrified of risk will stay out of the market completely (or, preferably, will defer their financial decisions to someone better-qualified). So the worst advice comes not from people who are too scared to get in, but from people who get in without having any genuine idea of what they are doing, but are also overconfident in their position for whatever reason.

This means that, contrary to suppositions that the markets are very efficient and are the pinnacle of efficiency, the markets actually tend to be irrational and fallible

Learning to take advantage of the inherent faults of the market should be one of your primary priorities because the awareness not only helps your risk management, but also allows you to identify opportunities..

This is where contrarian investment strategies come into play.

 

Why Does This Work?

Contrarian investing works because of the way the markets’ performance is structured into very natural (and often quite regular) cycles of expansion and contraction.

We refer to these as market cycles. 

Here is a rough working diagram which outlines the structure of a standard market cycle.

 

Now, lets say we wish to open a long position and maximise our potential profits.

To get the most profit possible out of our position, we have to think about when to time our entry and, the most profitable time to do this is when everyone else is simply too afraid or incredulous to do the same. I.e. during the “fear” section of the graph above.

In short yes, I am advocating for buying specifically when people are likely telling you not to buy or are dumping their holdings out of fear.

Because this “fear stage” represents the bottom of the market. 

Likewise, yes I am advocating specifically for exiting or short-selling when everyone is going all-in and insisting that you should buy.

Because this delusion stage represents the top of the market.

If we assume that the cycle of the market repeats then the long position demonstrated in the graph above would take about 150% profit assuming that you could time your entry at the best possible position at bottom of the market and time your exit at the top of the market (this would likely be when everyone was telling you to buy-in before you miss out).

The same strategy can be applied to selling (or indeed short-selling).

The best possible point to take-profit and sell your holdings would be during the “delusion” period wherein everybody is making outrageous price forecasts and ignoring reality and attempting to rationalise the idea that the markets will just keep going up forever.

Likewise, in a traditional short, you are looking to profit from the forthcoming collapse of an asset price.

Thus, the most profitable time to short-sell something is… at the very top of the market (during the “delusion” phase on our graph)

Again, this would bank about 150% gains if you could time a bet against the market so that your entry coincided with the peak of the market and your exit coincided with the bottom.

Naturally here this represents the point wherein everyone is harbouring enormous prejudice against short-sellers and due to the increasingly outrageous projections which arise during the delusion phase, short-sellers (even those who do indeed position themselves correctly so that they are short during the very top of the market) always have to put up with derision and almost universal condemnation for the perceived risk involved.

Practical Examples

Naturally this might seem too simple in practice.

Does the market really have a structure?

Absolutely yes and lets look at some examples from popular and well-known financial assets.

Here is a chart of the S&P500 from the post-war era through to the 1980s.

I picked this time-period out in particular because this period is a fantastic example of how these cycles of expansion/contraction and despair/delusion work in the market.

You can clearly see that ultimately, the market here is roughly conforming to a clear repetitive cycle of peaks and dips which are actually fairly uniform in length and are actually, reasonably predictable..

As such, if someone had actually traded the cycle which I overlaid onto this chart, by buying the cycle troughs and selling (or shorting) the cycle peaks, that trader would have had a pretty decent overall  success rate.

Conclusion

An understanding of market sentiment and a good level of psychological fortitude are thus very important attributes of a successful trader and the lesson here is ultimately that you should usually aim to do the opposite of what the majority of people in the market are doing. 

Misery thus becomes a cause for celebration because this is peak buying time. Euphoria becomes a time for wariness as this becomes peak selling time and is usually caused by “irrational exuberance”.

Likewise, when you are hunting for assets to invest in, be wary of things that are already doing well. Instead, look for things that have crashed and have already been shorted to rock bottom. This is where you will find potential bargains and value (as opposed to just price).

Most importantly, divorce your own sentiments from the sentiment of the market and think in terms of how to maximise your profit margins by doing the opposite of what the vast majority of the market is doing.

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