Contrarian trading is an investment style that goes against prevailing market trends by buying assets that are performing poorly and then selling when they perform well.

A contrarian trader believes that the people who say the market is going up do so only when they are fully invested and have no further purchasing power. At this point, the market is at a peak. On the other hand, when people predict a downturn, they have already sold out, at which point the market can only go up.

Contrarian investors tend to use various sentiment indicators and particularly those that emphasize out-of-favor securities with low P/E ratios.

Put simply if you follow the herd, you will be led to the slaughterhouse. Contrarians get excited when an otherwise good company has a sharp, but undeserved drop in share price. They swim against the current, and assume the market is usually wrong at both its extreme lows and highs. The more prices swing, the more misguided they believe the rest of the market to be.

The basics of the contrarian trading strategy

The contrarian trader’s strategy is not as simple as taking the opposite side of the publics widely held viewpoint “the trend is your friend” theme. A stock that goes higher and higher for an extended amount of time will naturally gain a lot of positive sentiment this does not mean that a contrarian investor immediately hates that stock. Going against the price trend is always a tough way to play. The approach is to look for stocks where the sentiment is counter to the established trend. In other words, the contrarian looks for stocks going higher despite a significant amount of pessimism.

The reason behind this strategy is that the pessimism indicates a lot of investors have been avoiding that stock, and are therefore sitting on the sidelines. If that stock continues higher, then at some point, the sentiment will change and that sideline money will (hopefully, all at once) begin to flow into that stock, thereby driving it higher in a short amount of time. The fast and furious rally is especially beneficial to those that are contrarian options traders.

Indicators for the contrarian investor

Contrarian traders constantly monitor the markets and read about stocks, which provides a feel for the sentiment. It also helps to be able to quantify sentiment, and this can be done in a few different ways:

• Analyst ratings, for example, are pretty straightforward. Analysts give a buy/hold/sell recommendation on stocks, depending on what they think investors should do. If a stock is trekking higher, but has little to no buy recommendations, then the potential is there for upgrades which can influence those on the sidelines to buy the stock.
• Shorting a stock or buying put options are two ways for investors to profit when a stock falls in price. Therefore, monitoring the changes in short interest and the amount of put buying are ways to quantify negative sentiment on a stock. If theres a large amount of these negative bets being placed on the stock, while its still moving higher and higher, then a contrarian trader can assume that there is significant sideline money that can still be deployed to keep the rally going.

The pendulum for success

There is a tendency for investors to succumb to short-termism and act on their emotions rather than reason.

The pendulum of investment emotions continually swings back and forth between fear and greed, and many of these sentiment indicators are designed with the goal of capturing emotion extremes.

The concept of mass hysteria is nothing new.

Baron Rothschild, an 18th century British nobleman and member of the Rothschild banking family, is credited with saying that, The time to buy is when theres blood in the streets.

He should know. Rothschild made a fortune buying in the panic that followed the Battle of Waterloo against Napoleon. But thats not the whole story. The original quote is believed to be, Buy when theres blood in the streets, even if the blood is your own.

This is contrarian investing at its heart the strongly-held belief that the worse things seem in the market, the better the opportunities are for profit.

Some contrarian sentiment indicators

• Sentiment surveys Such as the American Association of Individual Investors weekly survey and the Advisors Sentiment Index, conducted by Investors Intelligence.
• Put-Call Ratio This is a widely used ratio that measures the trading volume of bearish put options to bullish call options and is used to gauge the overall mood of the market.
• Volatility Index (VIX) The VIX indicator or “Fear Gauge” calculates inputs from various call and put options to create an approximation of the S&P 500 index implied volatility for the next 30 days.
• Strategist sentiment indicators
• Short interest The higher the amount of shares shorted, the larger the pent-up demand to buy shares becomes in the future.
• Fund flow data The direction of investment dollars flowing in and out of mutual funds can provide some perspective on the psychology of the masses.
• The trader’s reaction — actions speak much louder than words. Indicators based on opinions, surveys, and technical analysis data can be very subjective, therefore concentration should be centered on those indicators explaining actual measurable investor behavior (i.e. Put-Call, VIX, Short Interest, Fund Flow, and other action-oriented trading metrics).

An example of a contrarian trade Zynga Inc. (Nasdaq: ZNGA)

Zynga Negatives

Zynga stock fell 12% from August 2012 to August 2013, experienced some wild price swings in 2013, had a late-July 2013 slide on the heels of a management shake-up which sent the stock tumbling below its 10-day moving average, and, in August 2013 the equity ran into technical resistance at its 200-day moving average. Also, analysts at Stifel Nicolaus lowered their earnings estimates for Zynga Inc. to show the weakening fundamentals of the online social gaming company based on its performance in the first half of the 2013 fiscal year.

Contrarian Positives

However, from a contrarian trader’s point of view, Zynga presented a definite message that the stock will double in the following 12 months past August 2013, as it had positive points, such as:

A Groupon-like turnaround feel,

Hired an 8-year veteran from Microsoft

Had 65% of market cap in cash as of August 2013

Can contrarian traders be successful?

The short answer is yes, but it requires an understanding of three things:

• that opinion and action are two different things,
• that trends are where the money is, and
• that price confirmation is needed for any reversal.

Contrarian traders must realize that there can and should be a difference between opinion and action and this leads to a varying of opinions relating to the outcome of sentiment indicators. If the market is rising and they feel it will eventually collapse, they dont need to act on that opinion right now. Opinion can be separated from what is currently going on this will allow them to profit by trading with the market right now, instead of believing their opinion should be right at this time.

Opinion and emotion can wreak havoc on trading profitability, especially when traders develop very strong opinions or emotions. This is where it becomes imperative to design a trading plan before they start trading.

Risks of contrarian trading

There are risks to contrarian investing. While the most famous contrarian investors have put big money on the line, swam against the current of common opinion and came out on top, they also did some serious research to ensure that the crowd was indeed wrong and probably studied a great deal of sentiment indicators. So, when a stock takes a nosedive, this doesnt prompt a contrarian trader to put in an immediate buy order, but to find out what has driven the stock down, and whether the drop in price is justified.