What is contrarian trading and investing: its advantages and disadvantages

Contrarian trading and investing is the most common strategy among traders and investors. Picking the major tops and bottoms have made legends out of the world’s best hedge fund managers and investors. In this post we are going to look at:

  1. What is contrarian trading.
  2. What are its advantages and disadvantages.
  3. How we can improve on contrarian trading’s disadvantages.

What is contrarian trading

Contrarian traders try to pick the market’s reversals (tops and bottoms).

  1. They want to buy when the market is falling because they expect the market to bottom, reverse, and rally.
  2. They want to sell when the market is rising because they expect the market to top, reverse, and fall.

Contrarian traders aren’t automatically bearish just because the market is rising. They aren’t automatically bullish just because the market is falling. Instead, they try to predict the exact moment when the market peaks and bottoms.
Unlike trend followers, contrarian traders believe that they have the ability to predict the market’s tops and bottoms using technical analysis. And unlike trend followers, contrarian traders do not have a simple stop loss strategy.

  1. Some contrarian traders will scale in as their losses grow (aka averaging in).
  2. Other contrarian traders will cut their losses if the market falls another X%.

Contrarian trading is based on a mean-reversion premise:

A market that rises “too much” must fall, and a market that falls “too much” must rise.

All contrarian traders use similar mean-reversion tools that quantify “rising too much” and “falling too much”. These tools include:

  1. Momentum indicators such as RSI and Bollinger Bands. Contrarians will buy when momentum is “oversold” and sell when momentum is “overbought”.
  2. Sentiment indicators such as AAII. Contrarians will buy when sentiment is “extremely pessimistic” and sell when sentiment is “extremely optimistic”.

Contrarian trading can be used for the short term, medium term, and long term. There are 2 kinds of contrarian traders: discretionary contrarian traders and systematic contrarian traders.
Discretionary contrarian traders
Discretionary contrarian traders use the exact same mean-reversion indicators as systematic contrarian indicators. The difference is that they don’t use a hard-and-fast rule.
For example, they don’t always buy when RSI falls below 20 and they don’t always sell when RSI rises above 80.
Instead they use discretionary thought to determine exactly where they should buy and sell. For example,

  1. If every single market is crashing right now, a contrarian trader might buy when RSI falls below 10.
  2. If this is the only market that’s crashing right now and all other markets are ok, a contrarian trader might buy when RSI falls below 20.

Systematic contrarian traders
Systematic contrarian traders combine a number of various contrarian indicators into a single quantitative model. For example, the model might say: “buy if RSI falls below 20, the market closes below its 2 standard deviation Bollinger Band, AND the market falls more than 5% in 3 days”.
Systematic contrarian strategies are generally better than discretionary contrarian strategies. You don’t know if a discretionary contrarian strategy works or not because you can’t backtest it. You can backtest a systematic contrarian strategy to see how well it works historically.

The problem with contrarian trading

Contrarian traders have MINIMUM targets and MAXIMUM targets.

  1. The market must reach its MINIMUM target before a contrarian trader can consider getting into the market. For example, the market’s RSI must fall to AT LEAST 20 before the trader can even consider going long.
  2. The trader will definitely get into the market if it reaches his MAXIMUM target. For example, the trader will definitely buy into the market if its RSI falls to 10.

The MAXIMUM target is like a worst case scenario: how far the market’s crash/spike can go in an extreme scenario.
The problem with contrarian trading is that MAXIMUM targets can vary widely.

  1. When the market is crashing, sometimes RSI will bottom at 10. Somtimes RSI will bottom at 5. The market can be much lower when RSI is at 5 than when RSI is at 10.
  2. When the market is surging, sometimes RSI will peak at 90. Somtimes RSI will peak at 95. The market can be much higher when RSI is at 95 than when RSI is at 90.

This means that there is no perfect way to catch the market’s exact tops and bottoms. This leads to a potential danger:

  1. Buying too early into a crash is akin to “catching the falling knife”: you might buy halfway into the crash. Even the market’s subsequent rally might not get back to your BUY price.
  2. Selling too early into a rally is equally dangerous if the market continues to surge. Even the market’s subsequent correction might not get back to your SELL price.

In other words, no one knows exactly how long it will be before a rally stops. No one knows exactly how long it will be before a decline ends. Being too early is very dangerous.

How to improve on contrarian trading’s disadvantages

Contrarian traders shouldn’t focus too much on finding the perfect indicator for catching tops and bottoms. There isn’t much of a difference between using e.g. RSI 9 or RSI 14.
Instead, contrarian traders should separate their indicators into bull market indicators and bear market indicators. That’s why it’s important to know if it’s a bull market or a bear market right now.
The same indicator does not mean the same thing in a bull market vs. a bear market.

  1. For example, an RSI of 20 might be a bottom indicator in a bull market, but it is not a bottom indicator in a bear market (i.e. the market and RSI can get even lower before they bottom).
  2. For example, an RSI of 80 might be the top in a bear market, but it is not the top in a bull market (i.e. the market and RSI can get even higher before they peak).

That’s why it’s important to separate bull market contrarian signals from bear market contrarian signals. The same indicator reading cannot be used for the same BUY/SELL signal in a bull market vs a bear market.
For example, weekly RSI never falls below 30 in a bull market. But weekly RSI can easily fall below 20 in a bear market. Using a one-size-fits-all “buy when weekly RSI reaches 30” rule will mean that you buy way too early in a bear market.
Here’s the S&P 500 from 2015-2017.

Here’s the S&P 500 in 2008 (bear market).

Remember that every market’s long term direction (bull or bear market) is determined by its own fundamentals.

  1. The stock market’s fundamentals is the country’s economy.
  2. Forex’s fundamentals is Money Flow.
  3. Commodities fundamentals is long term supply-demand imbalances.

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