This is a guest post by Paul Koger, founder of Foxytrades Swing Trading Blog
Due to how this style of trading is called, you may have already guessed what contrarian trading is all about. Generally, the sanest thing to do in the world of financial trading is to flow with the trend. This simply means you should sell when others are selling and buy when others are buying as this seems to be the most logical thing to do. However, the contrarian trading philosophy works the other way around, while enabling its’ practitioners to earn a handsome living for themselves.
The idea in contrarian trading is simple: one has to be at the opposite (contrary) side of the market at all times. When they win, they win big even with little money. Unlike most traders who scuttle to buy when the prices begin to rise and sell off at the slightest sign of depression, contrarians focus on buying stocks that are not currently doing well. As depressed stocks are ridiculously cheap, most buyers stay away from them, which is why they can be bought with little capital. Should they recover and get sold later on, the returns can beat the market averages by many multiples.
The Mechanism of Contrarian Trading
Contrarian trading is an advanced form of trading. If you are lazy, you’re better off following the herd of conformist traders. At least, when there is profit on the table, you get a slice of it – little as it may be; and when there is a loss, you get a little slice of it too. But to make it as a contrarian, you must be on the watch for signs of growth and depression of the stock you are targeting. You will have to buy when others are selling and sell when others are buying – this is what contrarian trading is all about.
Once more, the logic here is simple. When most people become optimistic about a given stock, they often overvalue it, and when the market loses interest in that stock, they often undervalue it. It is this mistake in valuation of stock that you will capitalize on to make your timely purchases or short-sale.
This is not an almighty assurance that you will beat the market at all times. In fact, as a contrarian, you will lose more often than you will win. This is why you are advised to invest sparingly or at least, wisely in the market. But on the occasion that you win, the return is significant. And in order to win consistently you need to possess a number of analytical skills.
Essential Analytical Skills in Contrarian Trading
Being a contrarian is crazy enough; but being a contrarian that doesn’t know what he is doing is outright madness. The following analytical skills will ensure you make informed, intelligent decisions at all times.
To start with, you need to master how to quickly run a basic analysis on any given stock. Take your time to study the previous records of the stock. This will help you identify its performance patterns. You can also do more by observing and analyzing its portfolio and management. A look at its previous economic performance, as well as what experts forecast about its future is a great way to start. In the end, you will be able to have a general understanding if the stock will grow or not.
To do this, you need to sample the opinion of traders on the stock of interest. You do not do this as to trade based on what they say. No. The crowds are often wrong, and if they are right about a given stock, it helps you turn your back on them. That is why you are a true contrarian. Over the years, media agencies and stock brokers like Etoro have been a reliable source of such information. From volatility skews to the most recent gossip, you will always have an idea of the market.
This is where you have to put in a great deal of effort. Newcomers in the industry do not find the technical details of the financial markets interesting. For instance, there are dozens of market indicators out there and studying them all takes time and effort. One way or the other, however, you have to look at those charts from time to time if you are to get an idea of the extremes of price undulations.
Other concepts you also need to be acquainted with include volume averages, standard deviation bands as well as strength indices. For the best results, it is advised you study these indicators across various time frames.
If you have mastered these three major analytical aspects of the contrarian trading philosophy, you are just about ready to reap the rewards of the market.
The Pros of Contrarian Trading
The winning trades can provide decent profits: There is no big secret here. Dying stocks you bought for peanuts will bring in a lot of profits when you sell them after they begin to perform well. In fact, the better their recovery, the higher the profit margin. Although this takes a considerably long time, it has a better profit record but only if done well. Besides, when most traders count their losses, it will be just you and a few contrarians that will be counting profits.
Small investments can yield significant returns: Depressed stocks are like rejects of the market. As the rejects they are, these stocks drop in perceived value and so does their prices. This is a time true contrarians cash in on them; buying up plenty of them at very low costs. Should these stocks rebound for the better, the profit is often way bigger than the invested amount.
No need to forecast the market direction: Contrarians have no business trying to be ahead of other traders in the financial markets. Their job is to be different; to be behind the market, in a logical way though. So, the contrarian is absolved from the mad rush to be in front of the markets, hence look at the indicators all day. What a great relief for traders on a busy schedule.
Market sentiments can’t be trusted: As a contrarian, the bulk of your decisions have to be based off what the prevailing market sentiment is. While everyone can talk about what they think of a particular stock, they often don’t do what they say. You could end up doing just what everyone is doing, thinking you are doing things differently. This is a great challenge because you want to be in the opposite direction with market trends. While you could still pull in little victories in the market; your contrarian stand is defeated.
It’s a longer term strategy: Depressed stocks don’t record tremendous improvement overnight. If you are looking to enjoy more rapid wins – and, of course losses – you are better off following market trends. But if you choose to be a contrarian, patience has to be one of your virtues.
In a Nutshell
As a contrarian trader, you are trying to make profits by an abnormal approach to buying and selling in the markets. This abnormal behavior is based mostly on market sentiments which cannot be relied on at all times. But with proper research, analysis and strategy, you will win more times than you lose – and these wins are often big.