The Secret To Contrarian Trading
We have a very interesting question here from a new subscriber as part of our January 30-day challenge. The question refers to why we sometimes like to talk about Contrarian trades ( or so-called pain trades). Is it better to just stick to the trend and follow the money?
Recommended Reading Relating To This Contrarian Trading Question:
It’s More Than Simply “Going Against The Trend”
This fantastic question allows us to make a few important distinctions when it comes to contrarian trading.
It’s important to know that we are not married to contrarian trades. Some of our trade ideas might be contrarian but it’s only a fraction of our trades.
When talking about contrarian trading, people often jump to the conclusions. They think it means just randomly jumping in against the trend or against the overall market sentiment. But this is really not the case.
Fundamental Sentiment Based Reason
When we consider contrarian trade ideas it always comes from a fundamental or sentiment-based reason. The reason is never because the market has gone up too much or gone down too much. Because that’s the quickest way to lose money in the markets.
The popular trading axiom: “the market can remain irrational for longer than you can remain solvent”. This is very important to remember. There are many traders that think price can’t go any lower or higher just by just looking at the chart. But that is a sure way to lose money in the markets. That is not how we approach possible contrarian ideas.
The Trend Is Your Friend
So, whenever we look at a potential contrarian trade, it will be based on additional research or sentiment analysis. It won’t be just based on price levels for an example. The one area where trader or investors often get stuck on contrarian ideas is that they forget something important. They forget the power of the trend and the power of consensus.
There is a reason why traders say the trend is your friend. The majority of traders lose money by taking contrarian trades. This is because they base their trades on the assumption that markets operate rationally and logically. But this we of course know is not the case.
The Difference Between Conviction & Arrogance
The reason why traders usually like the alure of contrarian trade ideas. They like it because they see the potential risk to reward payoff usually associated with contrarian trades. They like the idea of buying the bottom or selling the top, and probably to some extent it’s a pride thing, being able to say that they outsmarted the market etc. So, looking at contrarian trading through these type of pitfalls is a sure way to lose money because the market can go much higher or lower than we think.
Caution And Thorough Analysis Is Key To Contrarian Trades
But there is a better way to approach contrarian trade ideas. Firstly, always with caution knowing that you need to be more accurate with your timing. Unless, of course, you like sitting on constant drawdowns.
An important premise of having a contrarian idea is that you are trying to benefit from complacency in the market. You are trying to profit from extreme exuberance or extreme fear. And the danger with trying to do that is that betting against a well-established trend is like trying to catch a falling knife. So, caution is always required when even thinking about a contrarian trade idea.
Contrarian trades work the best when the market has reached an overly bullish sentiment on an asset that they no longer think it can go down. Or when the market has reached such an overly bearish sentiment on an asset that they no longer think it can go up.
Good examples of this was the stock market crash after the covid crisis, where yours truly didn’t think the market upside in April and May would be sustained. But it was, and the contrarian buyers of that dip is laughing all the way to the bank. Or similarly back in 2018, everybody and their dog was thinking that the ECB will hike rates and that the EURUSD would push higher.
But what actually happened was the exact opposite. The EURUSD started a two-year downtrend after failing at the April 2018 highs. The one thing that was very interesting during April and May was how many market participants, even investment banks, were caught completely off guard by the move as consensus expected the EURUSD to push higher.
Now, the challenge with this is twofold.
Firstly. Even if you catch the initial turn in the market, you are likely not going to have the nerve to ride the trend for what it’s worth.
Secondly, if you jump in at the wrong time you could be losing more than what you could potentially make if you time the market incorrectly.
Always Two Sides To The Coin In A Contrarian Trade
So, the way that I prefer to look at contrarian trade ideas is understanding both sides of the argument. If you are selling something consensus thinks is going higher, make sure you understand the reasons why. And make sure you weigh the reasons for both.
If you want to buy something everyone thinks is going lower, make sure you understand the reason why. And then evaluate whether your reasons for wanting to sell or buy against the crowd is justified. Does it makes sense from both a sentiment and macro fundamental point of view.
Risk Management & Trading Psychology
This is probably the most important thing to keep in mind about contrarian trades. You need to understand risk management and trading psychology before even thinking about contrarian trade ideas.
You need to have the discipline to put solid risk management in place. If you don’t have the experience and mental fortitude to accept when you are wrong, then it’s going to be a way too dangerous avenue to explore.
So, I hope that helps with your question, and please let us know if you have any other questions.