Contrarian trading is one of the most common trading strategies. In this post we’re not going to look at the specific indicators that contrarian traders use. You probably already know this. It includes RSI, Bollinger Bands, distance-from-moving averages, etc. These are all commonly known mean-reversion indicators.
Instead, we are going to look at how do you know when you should go contrarian and enter a trade. We all know that there is no perfect indicator for predicting market tops and bottoms.
- When the market is “oversold”, should you buy right now or wait a little longer?
- When the market is “overbought”, should you sell right now or wait a little longer?
Here’s how to decide.
Create a list of requirements for picking tops and bottoms
*This applies to quantitative and discretionary contrarian traders.
Contrarian traders should create a list of “requirements” for picking tops and bottoms.
- For picking tops, create requirements such as “I want to see X, Y, and Z happen before I turn bearish”.
- For picking bottoms, create requirements such as “I want to see A, B, and C happen before I turn bullish”.
Then you need to divide this list into 3 groups:
- Requirements that MUST be fulfilled before you go contrarian and start a new trade. These are MINIMUM signals.
- Requirements that are nice to be met before you go contrarian and start a new trade.
- Requirements that once are met, means that you will definitely go contrarian and start a new trade. These are MAXIMUM signals.
How you employ these signals depends on whether you’re trading with the long term trend or against the long term trend.
Should you buy when the MINIMUM signals come out, or should you wait until the MAXIMUM signals come out before buying?
If you are trading with the long term trend
Let’s assume that it’s a bull market. The market is making a correction. You want to go contrarian and buy into the bottom of the correction.
You should buy when the MINIMUM signals come out because you are trading on the long term trend’s side.
This is because you never really know when counter-long term trend movements will stop. You never really know when a correction in a bull market will stop. You never really know when a rally in a bear market will stop.
If you keep on waiting for a perfect entry price, you might miss the trade all together! And because you missed a trade that was with the long term trend, you can miss out on a big profit opportunity! Rallies in bull markets can go very far, and downtrends in bear markets can go very far.
If you are trading against the long term trend
Let’s assume that it’s a bear market. The market is falling. You want to go long because you expect the market to make a bear market rally.
You should only buy IF the MAXIMUM signals come out because you are trading against the long term trend (you’re going long during a bear market).
This is because the market can fall a lot from the time the MINIMUM signals come out to the time the MAXIMUM signals come out. If you enter a trade when the MINIMUM signals come out and the market moves against you, you can lose a lot of money because the long term trend is against your trade.
Waiting for the MAXIMUM signals ensures that you won’t always take the trade. You might miss the trade because the market might bottom before the MAXIMUM signal comes out. But at least you avoid the possibility of a massive loss from going long when the MINIMUM signals come out.