In the financial world of trading, there is often a general flow towards market trends. And while this looks like the most logical thing to do, there are investors who dear to think otherwise. They are known as contrarian traders. Simply put, contrarian trading is a brilliant trading technique, often employed by master traders to hit big profits. Contrarian traders always strategically going against the current market direction.
Contrarian trading works on the idea that majority of traders buy and sell at the wrong times. They normally do buying during booms and scurrying to sell the moment prices begin to plummet. In this article, you will be introduced to the world of calculated risks where daring traders go against the herd.
They buy poorly performing stocks at rock-bottom prices in the hopes of selling them off when they begin to perform well. Before you decide whether this trading strategy could suits you or not, it is important you understand the basics.
How Contrarian Trading Works
As a contrarian trader, you will have to watch out for signs of pessimism in the market and ignore them. Then watch out for trends of optimism in the market and ignore them too. This is because rising pessimism which often spreads fast actually evaluates the strength of a distressed stock far below its intrinsic value. Furthermore, a stock that most people are most optimistic about often has less value and potential than expected.
But it’s not that easy. You need to figure out if the herd is right or wrong is no guarantee that you will hit it big at all times. Just as it is with every other trading strategy, it may or not always work out fine. So, to maximize success, you need to improve your analytical skills.
Essential Analytical Skills in Contrarian Trading
Moving in an opposite direction to the crowd seems quite crazy, but not being analytical about it is outright irrational. To be a contrarian who makes consistent profits, you need the following analytical skills:
This is the first type of analysis to do. Carefully consider the previous performance of the focus stock and economic forecasts about it. You can also focus on other factors such as product portfolio, corporate management and much more.
In doing this, you have analyzed the factors that affect demand and supply of the stock. It will help you ascertain the true value and financial health of the stock you have your eyes on.
As you may have guessed, this involves getting an idea of the prevailing sentiment in the market. Which stocks are traders buying and which are they selling? Which ones are being rumored to perform well or drop in value? Beyond mere hearsays, sources like Etoro, volatility skews as well as other media outlets can help you know where the herd is headed.
Now, this is where you look at those not-too-friendly graphs and chart. Looking through these charts, you will be able to track the pricing pattern of the given stock hence have an idea of how high or low the prices could go. You will also need to understand certain concepts like strength index, volume averages, standard deviation bands, and more. As a contrarian trader, you want to study the indicators over different periods of time.
Having mastered the various forms of analysis involved in contrarian trading, you now stand a chance to enjoy the benefits of this technique. It is not without its disadvantages but we will begin with the advantages.
Pros of Contrarian Trading
When You Win, You Win Big: To be honest, this is the most attractive thing about contrarian trading. You and just a couple of other people are on the same side of the divide while the excited herd is on the other side. The herd will share little profits when they sell at the same time of boom but should the market turn around, just you and a few others will reap the profits.
You Can Win Big With Small Money: When the majority of traders condemn a given stock and say it will not do well, its value drops to a ridiculous low. For the brilliant contrarian trader, this is a time to analyze the given stock and speculate on the possibilities of recovery.
If it shows promise – even just a little – the trader can easily spare some money to buy as much as he deems okay. In the event that this same stock recovers, the trader makes several times the amount it cost him to buy them.
Determination of Market Direction is Irrelevant: As a contrarian trader, you need not hang on to your computer all day, monitoring the direction of the market. The anxiety associated with wanting to be in front of the excited crowd is absent. As you are only concerned about being in an opposite direction to them. For busy or part-time traders, this is a great bonus.
Cons of Contrarian Trading
Market Sentiments May be Misleading: Chances are that you are not the only contrarian in the financial market. Most certainly, you will not hear every rumor about every stock, especially in the Forex market. No matter how hard you try, you can’t just get every bit of information you need to make your choices.
This is because there is a clear distinction between speculations and actions; what traders speculate isn’t always what they do, and there is no way to find out what they all do. This means you could end up in the herd – trading to the tunes of the market – yet thinking you are special.
Profits Don’t Come Quickly: Buying a stock that is performing poorly in the market means you have already decided to wait for as long as it takes that stock to improve in value. If you are lucky enough, this could be in a matter of 4 hours.
Often times, however, it runs into a couple of days (for markets that last longer than a day). So, if you are looking to get rich quick in a matter of minutes, contrarian trading may not be ideal; and contrarian investing is definitely not the way to go.
Contrarian trading is a seldom-used strategy in the financial markets and is obviously a near-irrational aberration from the market trends. While it holds the potentials of making the contrarian very rich, it can be a frustrating adventure when not properly done.
However, while the contrarian hopes to buy distressed stocks which have growth potentials. You must take great care to avoid fluffy market sentiments that are far from what actually happens. This is the single biggest pitfalls of most traders who employ this strategy.
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Published on: Oct 12, 2017