Contrarian trading is essentially what it sounds like: trading strategies that are based on going against the current market sentiment. However, contrarian trading strategies are more complex and nuanced than simply betting against the trend. Market trends are among the most powerful forces in finance, and it takes a deft hand to know when and how to bet against them.
That said, some of the most successful traders are contrarians and some of the greatest and most famous trades in history were the result of taking big bets against the market when everyone else was absolutely sure that the current trend would continue.
Fear and Greed: Understanding Market Sentiment
Contrarian trading is ultimately about understanding market sentiment, human psychology and herd behavior. These factors are all boiled down to the maxim of fear and greed. Contrary to most economic and financial theory, people are not perfectly rational and calculating, but rather make gut instinct decisions based on idiosyncratic factors and what the majority of the people around them are saying and doing.
This reality is evidenced by the tops of trends occurring when market sentiment is at its most bullish and the bottoms occurring at times of mass bearishness. This represents the constant swing between greed and fear that drives the market.
Contrarian trading strategies are based on recognizing the reality of market sentiment and being able to enter and exit trades when corrections to market sentiment are about to occur. While the underlying theory of contrarian trading is as simple as it sounds, the actual execution is far more complex and not for the faint of heart.
Recognizing a Turning Trend
Simply betting against current market sentiment is one of the fastest and most effective ways to lose money. Therefore, contrarian trading is all about being able to recognize when the powerful forces that drive market trends are about to turn.
Some contrarian traders rely on technical indicators to recognize turning trends. There are a number of useful indicators for identifying the tops and bottoms of trends. Other contrarian traders rely on a more holistic approach, particularly looking at what market participants are saying and doing to recognize when market sentiment has reached peak bullishness or bearishness. When uninformed retail investors start getting involved in a trade, for example, this is usually a good sign that the trend has run its course and is set for a sharp reversal.
Every contrarian trader will have their own unique trading strategy, but they will all be based on this belief that market participants are driven by fear and greed, and that it is possible to identify when these sentiments are about to turn.
A Little Contrarian In All Of Us
A healthy skepticism is a valuable attribute for any trader. Moreover, a trader who simply bases their strategy on having a cynical attitude to current market sentiment will have a hard time dealing with the fact that markets are often inexplicably buoyant or morose for extended periods, more than long enough to wipe out a trading position. Contrarian trading is about recognizing when the current market sentiment is wrong, and particularly the moment when people are going to start recognizing it.
Recognizing the sentiment that drives trends and the indicators that signal their end is useful for traders of all stripes, whether you are a committed contrarian investor, someone who dabbles in the occasional contrarian trade or a seasoned bull or bear who acknowledges that all good things must eventually come to an end.