The mysterious methods behind contrarian trading

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Updated: 06 April 2020

Contrarian traders make decisions according to the idea of swimming upstream, operating with the philosophy that “the trend is not your friend”. They believe that following trends is more dangerous than beneficial, and that when a trend is noted, they should do the opposite of what everyone else is doing. The late Robert Beckman, a British stock market expert, summarized this idea perfectly by claiming that markets work hard to make sure that traders are wrong most of the time, thus indicating that trends should not be trusted.

The contrarian mindset

Whether or not this method is trustworthy depends on the trader, as many outcomes can prove this theory to be accurate or false. If well educated in this theory, a trader could turn this unpredictable method into a success story of high profits and escaping risk. However, this method has also failed many traders.

For those who follow neither the upward nor downward trends, they can be said to follow contrarian trading strategies. These strategies are used particularly in CFD trading, because of its technique of following how an underlying asset performs and acting accordingly. With the contrarian strategy, traders can form their views along with the principles of trading in CFDs. If a security was 15% above its price average, a mechanistic trader would bet against the security. If it were 15% below the average, the trader would bet on a price rise. This reveals that while markets often make mistakes or fail, they often correct their own wrongs over time.

Risks and rewards

A more fundamental approach can be used by identifying the reasons for buying or selling before making a decision. When a stock does worse than what is expected or hoped for as a result of bad trading, a contrarian trader would see it as an opportunity to buy with the idea in mind that other traders will soon revert back to the stock. In reverse, if a company’s stock is doing extremely well, a contrarian trader will predict a fall eventually and therefore bet against the stock, especially when the increase is optimistic rather than realistic. This applies to commodities and currencies, too. When applying this rule, you need to be sure that the current trend is likely to reverse due to unnecessary and momentary punishment.

It’s all about timing

Another form of contrarian investing is betting on the movements of whole indices. Dow Jones (US), FTSE 100 Index (UK) and Nikkei 225 (Japan) are all examples of such types of indices. By betting on the whole indices rather than the individual assets, you are preparing for the idea that the market will fool you. However, your predictions may not occur by the time you trade. For example, taking a long position with the hope of a stock market boom in two years will be of no benefit to you. That is why timing contributes significantly to the outcome of the trade. Along with meticulous strategies, you need to have a good understanding of how time affects your decisions and how it can bring about changes.

Value trading and behavioral finance are two other contrarian methods. Value trading looks for gaps in the market price and the idea that securities might be mispriced, which provides added value. Behavioral finance provides opportunities in irrational behaviors in the market.

Contrarian trading isn’t for every trader – it all depends on your personality. While there are many contrarian traders, there is also a strong opposition known as momentum trading which uses the opposite theories. Both strategies can be fruitful, and perhaps when joined together to suit your personal style, could be highly advantageous.