The Contrarian Approach To Trading

Accountancy Resources

The Contrarian Approach To Trading

Investing Author: Admin


Whether you consider yourself an investor or a trader, a second question you need to answer is whether you are going to employ strategies in a contrarian manner.

A contrarian approach is based on the belief that the majority is usually wrong. Accordingly, by buying when everyone else is selling, and selling when everyone else is buying, the logic follows that your experience will be better than average.

This oversimplifies the strategy to a degree.

The majority is often wrong, but the belief that most traders are always wrong is not accurate. As a general rule, following the investing and trading crowd is a mistake; by the time a trend or opportunity is recognized by everyone, it has usually passed. In that case, jumping in is a matter of poor timing. Contrarians recognize that most buying activity peaks at the top of an uptrend and most selling appears at the bottom.

Key Point

The contrarian is not simply contradictory; he or she just realizes that timing of trade decisions is likely to be wrong.

This is true. It gives profound context to the old advice, ‘Buy low and sell high.’ That sounds easy assuming you know where ‘low’ and ‘high’ are located. The contrarian approach is based on the realization that the majority (not everyone, but the majority) tends to do the opposite, to buy high and sell low.

The Contrarian Concept: Why Go against the Market?

The value of contrarian investing is anything but settled science. It is controversial. If you believe that the market’s conventional wisdom is often wrong, then contrarian strategies will be appealing and potentially more profitable than following the crowd beliefs. History, whether of market activity or science, has demonstrated that the consensus is easily wrong more than right. So a contrarian relies on the tendency of the majority to time entry and exit poorly, and for that same majority to follow rather than to lead.

Within the market, contrarian investing and trading is a popular approach but it is not always easy to apply.

When prices of a stock are rising rapidly, it is difficult to resist the temptation to jump in and take advantage of the trend. When prices are falling, it is equally difficult to resist the temptation to get out before prices fall even more.

Key Point

The hardest part of the contrarian strategy is having the discipline to go against what the majority thinks.

As a contrarian, you need to put aside the emotional and natural impulses to act in the same manner as everyone else, and to be willing to sell when prices have risen too quickly or buy when prices have declined and when everyone else is fearful.

This is counterintuitive to the way that most people naturally think and act. This is due to what most people perceive about how to act either individually or collectively. As social beings, people know that collective action is powerful and convincing. This has both positive and negative aspects for investors and traders. If the crowd psychology of the market is to believe that a company is going to grow rapidly, then the collective demand for stock will drive up prices. But how far will that go? If you are one of the early believers in this supply-and-demand trend, then you can profit well from taking up positions. However, at some point the crowd psychology can convert into a more mindless form and revert to mob mentality. In this phase, people are likely to act irrationally and take comfort in the collective action itself rather than analyzing the opportunity rationally and logically.

Investors and traders have to overcome crowd psychology in order to act and behave as a contrarian, and it is against human nature to do so. Sigmund Freud wrote that people acting within a crowd majority tend to act differently toward people thinking outside of the crowd’s belief. In other words, a majority does not easily accept contradiction offered by individuals. Most people instinctively want to be accepted as part of the crowd, or ‘tribe’ of people thinking alike, in the belief that the collective belief provides safety and protection. However, contrarians are aware that as a crowd’s beliefs are made uniform, each individual within the crowd is likely to become less aware of their actions as individuals. It gets easier to go along with the majority.

Whether a crowd becomes a mindless mob with an anonymous and comforting personality, or is simply a group of like-minded individuals, is controversial. No one can identify conclusively why crowds act as they do, but the tendency is a reality. For anyone acting as a contrarian, the most difficult aspect is ignoring the desire to be a part of the crowd.

Key Point

It is human nature to want to be accepted, which is why most people cannot successfully apply contrarian theories to their timing.

The issue is complex. Under the belief of convergence theory, crowd behavior is not an automatic response of crowd thinking, but is created by individuals who bring the thinking into the crowd. This ‘contagion’ grows from a crowd of like-minded people. This makes a certain degree of sense when applied to markets. For example, when several people are prone to believe that a particular stock is likely to increase in value, one influential individual acts by buying stock, and is imitated by others who share the point of view. They converge into thinking in the same manner.

In convergence theory, an individual who buys or sells shares of stock may influence others based on a shared belief in the conditions of the market, inherent risks or opportunities, or the tendency to go along with people in similar circumstances. So in a work or social setting, a respected investor or trader can hold a great deal of influence over his or her peers and when that individual makes entry or exit decisions, the convergence of thought may easily lead to a duplication of the action.

A contrarian, however, recognizes convergence theory and resists it. The recognition of the tendency gives a contrarian great power, because that contrarian has insight not only into the crowd’s mentality to act together, but into why the crowd does so.

Putting this another way, a contrarian recognizes how crowd behavior works as a predictable force in the market and is able to exploit it. The convergence of many individuals creates price movement in the market that inevitably creates mispricing. So when there is good news, the price is driven too high and has to correct in subsequent sessions, and on bad news, the crowd drives the price lower than the news justifies, meaning the price corrects in the following sessions. This endless overreaction of price is the key to successful swing trading, but it also points to the short-term advantages that all contrarian traders and investors hold. By not going along with the crowd thinking, they are able to recognize overreaction and act accordingly.

Key Point

Contrarians tend to be astute observers of human behavior, and are able to recognize moments when the majority belief is likely to be wrong.

This applies not only to the very short-term price swings that occur on a daily basis, but also to longer-term trends. A general belief in a company’s potential for growth may lead to exaggerated price appreciation (reflected in the P/E ratio rising quickly, for example), and the same kind of crowd-based belief that a company is not a sound investment may easily depress its stock’s value. Both of these conditions create opportunities for contrarian investors.

Contrarians may act on their observations about price movement by buying depressed stock, short-selling stock that is overpriced or using options on either side to exploit the very short-term price swings that may occur. For long-term investing, the use of price declines to oversold conditions can be used to identify a bargain price level and to buy shares in carefully selected companies. This is a strategy used by value investors. The concept requires prequalifying a company based on a few sound fundamental principles and then seeking a bargain price as the entry point.

Contrarians and the Permanent Bear or Bull Mentality

There is an important difference between a bear mentality and the contrarian trader or investor. A trader with a permanent bear mentality believes that market trends are always downward, even in bull markets. While the view is contrarian, it is unyielding. The permanent bear is right only half of the time.

An equally common problem is found in the overly optimistic permanent bull approach. Like the bear, the bull is right only half of the time and during bear markets, the bull trader is acting in a contrarian manner.

A true contrarian is more flexible than either a permanent bear or a permanent bull.

The contrarian should constantly be in ‘evaluation mode’ about overall markets as well as individual stocks. All market trends are cyclical, meaning prices rise and prices fall. As a matter of improved timing, a contrarian questions the crowd mentality that follows trends, when the timing is invariably improved if you lead rather than follow. A contrarian is not by definition either a bull or a bear, but rather observes the market direction. The key is to identify the direction properly and to note when trading sentiment is moving in the wrong direction. This is most likely to occur at or near the top of uptrends and the bottom of downtrends.

Key Point

Unlike the permanent bull or bear, a contrarian recognizes that opportunities are most likely to occur at the top of an uptrend and at the bottom of a downtrend.

The advice to ‘buy low and sell high’ has great significance, but only contrarians are able to act on the advice. Because buying activity accelerates as prices top out, and selling activity accelerates when prices bottom out, contrarians have to be able to step back from the emotional investment in a market position, and to make rational observations. By doing so, timing is vastly improved and the contrarian learns to ignore the human instinct to go along with the majority.

Contrarians belong to neither the bear nor the bull camp because they have specific traits:

  • They are able to think and act independently. Perhaps the most difficult character trait to develop is thinking independently, especially when the majority holds an opposite view. The independence of thought that contrarians work to create in themselves requires self-discipline and demands that you ignore impulse and gut reaction. The gut reaction that arises when you are tempted to go along with the majority is most likely to occur at the wrong point in the price cycle to buy at the top and sell at the bottom and this is where the contrarian philosophy is based.
  • Contrarians are not invested in price direction. Many traders and investors are personally invested in a fixed belief about the market. Either they are optimistic and believe that prices are always about to turn upward, or they are pessimistic and believe that the market is about to crash. A contrarian refuses to adopt a fixed philosophy or to give in to social pressure to act on beliefs that can only be correct for a small period of time.
  • A default assumption is that the majority is more likely to be wrong than to be right. It is not fair to say that the crowd is always wrong, but it is equally false to assume that the crowd is always right. When in doubt, a contrarian will choose to go with the belief that the majority is more often wrong than right. If you track trading volume along with price trends, you often see rises and even spikes in volume right before a price reversal at the end of the trend. In fact, swing traders look for volume spikes as one of the strongest reversal signals, primarily because the majority acts within the crowd mentality, with accelerated buying at the top and selling at the bottom.

Value Investing and the Contrarian Approach

Distinctions are made between the philosophy of investing and trading (like the contrarian approach) and the kinds of investments themselves (like value or growth investments, for example). However, the contrarian approach contains some elements that make it compatible with value investing.

So you can be a value investor, seeking companies with excellent management, competitive position, and fundamentals, and at the same time act as a contrarian in how and when you buy shares. In a widespread market price decline, for example, many excellent value companies will experience dips in their stock price, which from a value investment point of view is the best time to buy.

At such times, though, many investors and traders are fearful of further declines so they do not act.

Key Point

Value investors often are also contrarians, because they recognize bargain prices at the moment when most people have an unfavorable view of a company.

Even if a stock’s price could fall more, the value investing ideal is to buy shares when they are priced at bargain levels. Even if they decline further, they are still bargains. A mispriced stock is valuable because the market as a whole, with its tendency to exaggerate price movement, has driven the price unreasonably low. Value investors tend to rely on metrics to measure bargain pricing, among which the P/E ratio is prominent. The relationship between market value and book value is an additional test. In the most extreme market declines, it is possible for a stock to fall temporarily below reported book value, meaning it is selling at less than the actual net value of the company’s balance.

Book value includes intangible assets, so a conservative adjustment to book value is to remove intangible assets and calculate the tangible book value per share. Stock prices rarely fall below a company’s book value, but extremely bad news can cause this. The news may relate to the company specifically, to a sector, or to the market as a whole.

A value investor seeks bargain pricing based on the fundamentals and a contrarian looks for price disparity above or below fair value to time entry or exit.

The primary difference between value investing and the contrarian philosophy of investing is one of the indicators that are used. A value investor relies on the metrics, and a contrarian is more attuned to market sentiment at the moment. The ideal value investment is purchased at a discount from its tangible book value (or from a calculated intrinsic value based on measurements like P/E, for example). The ideal contrarian move takes place whenever a stock’s price is well above or below fair value based on sentiment. The common sentiment is either greed on the way up, or fear on the way down; a contrarian exploits the market’s tendency to exaggerate these temporary opinions and reactions, buying when everyone else is selling and selling when the ‘crowd’ is buying.

Key Point

Value investors rely on fundamental indicators to pick companies, and contrarians rely more on market sentiment and exaggerated price movements.

Valuable Strategies

A contrarian approach can be as simple as the technical observations of price swings made in a swing trading or day trading strategy, or far more complicated based on volatility indexing or trends in options trading.

The swing approach relies on charting patterns. The most popular among these are the short-term trend, narrow-range day, and volume spike. When these occur along with a clear reversal day, the swing trader defies the popular sentiment and makes a contrarian move. Swing traders are the ultimate technical contrarians.

Measuring volatility is a method preferred by traders who have observed a correlation between market trends and options trading. The Chicago Board Options Exchange Volatility Index (VIX) has been used since 1993 to measure market volatility. It is based on trends in the implied volatility of options on stocks in the S&P 500 index.

The VIX is a predictive index often called the ‘fear index’ because it measures market uncertainty. High implied volatility is viewed as a measurement of traders’ fears about marketwide trends and the potential for increased risk over the next 30 days.

VIX valuation is derived from weighted price blending for a range of options on stocks of the S&P 500. However, in addition to serving as a measurement of current volatility, the VIX has also become a speculative market instrument in its own right. As of 2006, VIX options contracts were first traded directly; these are literally options on an index tracking options volatility. The VIX also is traded in the futures market and as an ETF that tracks futures performance levels. As a result, traders can speculate on increases or decreases in market risk based on changes in the implied volatility of options.

Before the VIX, an older volatility index, the VXO, was used. This was a calculation of 30-day implied volatility, but only for at-the-money options (the condition when the strike price is identical to the market value of the underlying stock).

Because volatility is one of the important elements used to calculate the overall premium value of options, using options to measure market volatility makes sense. The broad options market has become an important market indicator as a result. While a segment of the investing and trading world continues to think of options as highly speculative, intangible ‘side bets’ on the market and on the direction of price movement, they provide more valuable functions as well. Contrarians with advanced knowledge and experience are likely to track VIX to help time and confirm other indicators to time entry and exit.

Key Point

The VIX is called the ‘fear index’ because it measures not the volatility of the market, but the perception of volatility.

Contrarians are aware of the significance of VIX as a ‘fear index’ that can provide valuable insight. Many people view VIX as a specific measurement of volatility, thinking that a high VIX level translates to a bearish stock market. However, this is not the case. A high VIX measures the fear of volatility, which can mean the market is perceived as volatile in either a bullish or bearish direction. This distinction is important. The activity in the speculative side of the options market is quantified within the VIX, and this is translated to a percentage value. It is not just the percentage that conclusively determines volatility, but the change in the VIX percentage over time. As the percentage rises, it means the perception of volatility is rising as well. It measures how options traders perceive the market by how willing they are to trade in options over the next 30 days. Likewise, when traders think the risk levels are low, the VIX will fall to reflect that perception.

Contrarians are not limited to the VIX to time their trading decisions. They use a variety of measurements. Among these is a strategy called dogs of the Dow. The theory underlying this is that investors tend to pick the 10 DJIA stocks whose dividend is the highest percentage of the current price per share. The theory states that companies offering the highest dividend levels are likely to outperform the overall DJIA stock index.

The dogs of the Dow are so-called because a higher dividend yield is likely to result from a decline in the market price of shares. This occurs because dividends are fixed for the current year even while stock prices move. So when a company’s stock price loses value, the dividend yield increases. For example, consider what happens to a company that started the year with shares at $50, and declaring a dividend of $1.00 per share. What happens when the stock price falls to $40 per share, or to $30?

Price per Share Dividend Dividend Yield
$50 $1.00 2.0%
$45 $1.00 2.2%
$40 $1.00 2.5%
$35 $1.00 2.8%
$30 $1.00 3.3%

The lower the price, the higher the yield. According to the contrarian model, the 10 Dow stocks with the highest yield are also most likely to be at the bottom of their price cycle. If this does truly identify stocks that are oversold, it makes sense to go long in the dogs of the Dow. In addition to the benefit of buying at the bottom of the price cycle, the contrarian using this method also gets a higher-than-average dividend yield. In the example above, the stock at $30 per share yields 3.3 percent, but when the same stock was at $50, the dividend yield was only 2.0 percent.

Key Point

Declining stock prices result in higher dividend yield, making a depressed stock more profitable on the dividend side. For contrarians, this can also be used to find bargain-priced stocks.

To critics of the theory, the highest-yielding stocks may also be the most distressed among the 30 industrials. However, the distressed situation may refer only to a price cycle and not necessarily to an economic or business cycle. Because of this, a contrarian may use the dogs as one of several indicators pointing to smart timing, but also check other indicators to avoid buying shares in companies losing their value investment status as well. The dogs of the Dow are also useful in the timing of sales. As prices rise and stocks are no longer in the grouping of 10 stocks, it can signal the time to sell. For contrarians, this means selling shares after prices have risen, clearly a contrarian move. At such times, it is more likely that traders will be buying up shares based on strong upward movement.

These 10 stocks are called ‘dogs’ because the bargain pricing and attractive dividend yield appear when the stocks are out of favor. And so contrarians move in and buy at that moment. When the market once again likes those companies (meaning they are no longer dogs), the contrarian takes the change as a sell signal.

Merging Technical and Fundamental in a Contrarian Strategy

A contrarian does not have to be strictly an investor or a trader. The two philosophies can be merged into a single contrarian strategy. A good way to understand contrarian thinking is to equate it with the tendency within the market for people to (a) act impulsively, (b) overreact to virtually all news, good and bad, and (c) follow rather than lead.

These attributes make a majority of investors and traders more likely to time their decisions poorly. Impulsive behavior includes trading in stock based on today’s news, meaning they trade at the ‘exaggeration point’ of the stock’s price. For example, an earnings report is released and the reported earnings are far above expectations. As a result, the stock’s price jumps by four points. An impulsive decision would be to buy shares right away, in the belief that the good news is only the beginning of a spectacular uptrend. However, a contrarian is going to recognize that the four-point jump is an overreaction to the good news, and that it is likely that the price will decline in coming sessions to a more realistic level, perhaps giving back half of the four-point rise.

Key Point

Reacting to news, either positive or negative, and trading as a result, means timing is likely to be poor. That news is probably already reflected in the stock’s price, so the opportunity has been lost.

Overreaction to all news works in both directions. The decision to buy on good news or to sell on bad news overlooks an important fact: The news, once known to everyone, is probably already reflected in the current price and, of course, that is likely to be exaggerated. So just as buying after good news means you will probably overpay, selling just after bad news means you are giving up stock at a price that is too low and will probably rebound in the next day or two.

The tendency to follow rather than to lead is very common. Following is easier and it feels safer, but it also means that many trading decisions are going to be made at the worst possible times. It is the primary attribute of the expensive but widespread ‘buy high and sell low’ approach to the market.

Contrarians recognize all of these tendencies, which is why they have a more profitable experience by going against the intuitive or impulsive decisions that most people make. As a group, investors and traders tend to think that the latest trend is a permanent condition. So a stock that has lost value is always going to perform badly, and a stock that has outperformed the market is always going to perform above average. This view of the market is very common; it is also the key to contrarian success. However, to succeed as a contrarian, you have to be able to time trades in exactly the opposite direction of the majority. This means you have to move in when everyone else is fearful, and step back when everyone else is euphoric. This advice is easier to give than to follow, so contrarians are not just good at timing. They also are highly disciplined and able to set and follow rules for themselves that fly in the face of what the majority thinks.

Contrarian Views in Perspective

The tendency for investors and traders to go along with the crowd mentality is reinforced within the market itself. If you watch financial shows on television, you will notice a tendency to follow the trend. If the market has a huge drop in a single day, featured stories will include ‘Is this the correction we have been expecting?’ or ‘Is this the start of a bear market?’ If the market jumps several hundred points, the opposite features are likely.

Stories on topics like ‘The new bull market’ or ‘The end of the recession’ are quite likely. Financial journalism, like all forms of journalism, caters to majority thinking. With this in mind, contrarian thinkers can take a contrarian clue from the financial news programs. It may be wise to act in opposition to journalist ‘expert’ advice.

A cultural tendency is to go along with what most people believe. If most people think the market is going to rise, declaring yourself a bear makes you an outsider and perhaps even an oddity. The nonconformist (another word for contrarian) is shunned and even ridiculed by the majority and their spokespeople. So being a contrarian is not the easiest path, although it is often the most profitable.

Key Point

People tend to want to be accepted, so acting as a contrarian is counterintuitive. Few people seek out nonconformity as a style of behavior, although in the market it may be more profitable.

A true contrarian does not act in a contrary manner for its own sake and will not always decide against the majority. There have been many famous market experts who called markets incorrectly and lost all credibility as a result. For example, Joseph Granville was a famous market forecaster in the 1970s and 1980s. Between 1979 and 1981 his predictions in his newsletter (Granville Market Letter) were virtually perfect. But that is not what he is remembered for. In 1982, Granville predicted that the market was going to decline significantly. However, the moment of his prediction turned out to be the beginning of one of the strongest historical long-term bull markets. He remained bearish all the way to 1996.

Granville is remembered not for his amazing ability to call market trends between 1979 and 1981, but for his refusal to turn away from his bearish prediction for 15 years of mostly rising markets. This made Granville an object of ridicule despite his record of past successes. It also gave contrarian investing a black eye. If Granville was the ultimate contrarian from 1981 to 1996 by insisting a bear market was on the horizon, then contrary investing is simply a form of inflexibility.

This was not a typical contrarian story. In fact, Granville’s reputation as a permanent bear even in a long-term bull market is contradicted by the principles of contrarian investing. Because he was so invested in being right about his bearish call, he refused to pay attention to subsequent signals. A true contrarian would be able to get over a poorly timed call and start fresh by analyzing the current market based on what the signs provided.

With the many attributes of contrarian investing (buying at bargain price levels or preferring to go against the majority, for example), the real meaning of the strategy is more. A contrarian does not simply defy the majority, but is analytical in how the majority thinking gets interpreted. The consensus view should always be suspect, and there is great historical precedent for this. In science, for example, many of the greatest advances have been made by individuals willing to go against the majority. A famous example is that of Galileo, who proved through observation that the earth rotated around the sun and not the other way around. The power of the day, the Church in Rome, threatened Galileo through the Inquisition because his beliefs contradicted biblical passages. Galileo was a scientific contrarian who was forced to retract his claims under threat of death and ended his life in house arrest. Yet his views were correct, even though contrary to the commonly held beliefs of the day.

The same reality applies in the market, though with less severe consequences than those Galileo faced. For investors and traders, taking on the majority is daunting. However, a successful contrarian is also likely to be more analytical and methodical than the typical investor. Most people are simply impulsive and act too quickly and on too little hard evidence. A contrarian might end up drawing the same conclusion or a different one, but the real meaning of contrary investing is not ‘doing the opposite’ in each and every case. Its most profound application is in the tendency to review the evidence carefully before making a trade. So it is contrary to act after studying the facts rather than to jump aboard because the majority has made a decision. Most noncontrarians will make fast decisions because they fear losing an opportunity (to get in before prices go higher or to get out before they go lower). A contrarian refuses to act quickly just because that is what almost everyone else is doing.

Key Point

History is full of examples of contrarians being shunned, and even imprisoned or worse. This bolsters the human tendency to want to remain silent and go along with the crowd.

This raises an interesting rhetorical question: If contrary investing and trading makes such sense, why isn’t everyone a contrarian? This is a paradox, of course, because if everyone acted as a contrarian, it would create a new herd mentality.

There is a greater reason for most people not to act as contrarians. It comes down to the question of conformity and fear. Most people know that it is a very uncomfortable matter to act contrary to the majority and also to be proven wrong. This fear is a compelling force for most people, causing them to prefer the illusion of safety in the crowd to the potential for profitability by acting in the opposite manner. The social belief that the majority is always right is such a democratic ideal that it becomes accepted truth, even when in fact the majority is simply wrong. A contrarian in a democratic society is a minority, a troublemaker, or even an eccentric.

People also tend not to act as contrarians because they want the efficient market theory to be true. Investors and traders are continually seeking certainty in the market, even though the market by definition is very uncertain (and inefficient). If the majority acts in a particular way, it must be in response to efficiency within the market. In other words, a stock will rise or fall because the majority believes it. A contrarian recognizes that group thinking does not create (or even respond to) efficiency, but tends to disprove the efficient market theory. This is ironic because it defies logic. If there were such a thing as an efficient market, it would be a relatively easy matter to buy and sell at the right moment, because emerging trends would be obvious. Lacking this efficiency, investors and traders tend to substitute majority opinion for what they seek, and to assume that the majority opinion is in fact a reflection of market efficiency.

A contrarian approach works well for individuals, given all of the complexities of timing investment and trading decisions. The conclusion most obviously reached is that following the crowd is not a successful method for profiting in the market. Because known information is normally factored into price, reacting to what others do is a poor way to time entry and exit effectively. It is more likely to lead to ill-timed decisions.

Mixing speculation and investing within a contrarian philosophy is one of the best ways to diversify capital, with some capital left to grow in long-term value companies selected with fundamental analysis, and another portion used to play short-term price swings and based on a largely technical approach. Using both forms of analysis and diversifying between speculation and investing is the topic of Mixing Speculation and Investing.