Your Comprehensive Guide to Contrarian Trading
Even if they don’t use that precise word, the majority of investors understand that taking a contrarian approach to investing is a smart idea. The cliche “buy low, sell high” is so commonplace that it’s frequently spoken with a mocking tone. Similarly, Warren Buffett’s well-known maxim to be “fearful when others are greedy, and greedy when others are fearful” has been bandied about far too often. But as rational as all that may seem in theory, most individuals find it difficult to put into reality. It is actually not that hard, and perhaps not as hazardous as you may think, given you know what to look for and how to trade such chances.
What Is Contrarian Trading?
A contrarian transaction is one that opposes a recent move in the market by going against the general consensus. That might apply to any traded asset such as futures, including the market or a specific stock. It could also allude to a movement in any direction. Here, I will limit myself to equities and long-only bets after falls for simplicity’s sake. The first thing to realize is that purchasing a stock doesn’t always make sense merely because its price has dropped significantly.
Take a look at the JC Penney (JCP) two-year chart above. It is conceivable to pinpoint several instances in which someone seeking a contrarian trade may have given in to temptation. A few of those could have been successful short-term transactions with profits of ten to fifteen percent, but considering the stock’s future course, the risk of purchasing JCP was not worth that kind of return. JCP is in serious financial trouble, which explains why the firm has been failing for some time. They accumulated so much debt that the current problem is existential because they were slow to react to the change to e-commerce and to react when things went wrong.
Comprehending the Dynamics of Contrarian Trading
It was not, and still is not, a strong choice for a contrarian trade given the unfavorable fundamental considerations in the case of the previously mentioned example, which affected the industry as a whole as well as the specific business. Being contrarian in trading involves more than just adamantly opposing every move. It involves recognizing when an action is excessive and goes much beyond its logical conclusion. Irrational dread and terror are what you are searching for, not logical, reasoned selling.
One illustration would be Equifax (EFX). In the week that followed the disclosure of a data breach, that stock fell by about 40%. Even though the company’s issues were severe, this type of response indicated a classic contrarian opportunity.
Another would be the panic sale of Chipotle (CMG) in the midst of food poisoning scandals that briefly dominated the news last year. CMG has increased by around 110% since that panic’s lowest point. However, time might still be a problem even when you spot a favorable chance. Momentum is a strong tool, and analysts’ adjustments to forecasts frequently extend out the duration of unfavorable sentiment toward a company, making an early purchase risky. However, as the aforementioned cases show, the prospective gains are frequently too attractive to ignore. Taking a cue from the traders is the best approach to handle it.
Orders known as stop loss orders are intended to close a trade and are activated when a certain loss threshold is met. If your timing is off, setting one at 5% below the entry point of a contrarian trade would assist keep losses to that level. Should the timing be in question and the initial reasoning behind the trade still holds water, you could then give it another go with a reasonable risk/reward ratio in place; similar to EFX, a 50% bounce would still give you the opportunity to make five times your possible total losses.
Having said that, most investors’ largest psychological barrier to contrarian trading may be psychological.
The Bottom Line
Everyone has a tendency to follow the crowd, so defying the crowd requires a certain level of confidence, some could even say arrogance. However, it is simpler to do so when it is a conscious approach and part of a plan. You can create such a trading strategy because you know what to look for, what to avoid, and how to manage the underlying risks. Hopefully, this will allow you to profit from being “…greedy when others are fearful.”
