Contrarian investing and
why it works
What is a contrarian?
Definition
A Contrarian makes decisions for different
reasons than most traders.
Contrarian – a
trader whose
reasons for making
trade decisions are
based on logic and
analysis and not on
emotional reaction.
The majority buy out of greed and sell out of
panic. As a result, the tendency is to make
the wrong decisions.
A contrarian does not simply act contrary to
most traders, but tends to not follow the
majority if indicators favor the opposite
decision.
Trading tendencies and market behavior
How most traders trade
Everyone has heard the advice to “Buy low and sell
high.”
This sounds easy, and most traders do exactly the
opposite. They buy high (greed) and sell low (panic).
A contrarian attempts to “buy low and sell high” by
observing how market prices over-react to news.
The contrarian observation
A contrarian will observe that:
- most traders follow the majority
- the majority is often wrong
- as prices rise, a growing number of people tend to
buy, and the higher the price, the more buyers
- as prices fall, a growing number of people tend to
sell, and the lower the price, the more sellers
The contrarian ideal
A contrarian will attempt to:
- make decisions in spite of what the majority does
- make a wise decision more often than not, based on
analysis and reading of signals
- buy when prices are depressed, especially if reversal
signals indicate a coming uptrend
- sell when prices rise to new heights, especially if reversal
signals indicate a coming downtrend
Timing a buy or sell decision
A contrarian not only employs logic and analysis, but also times trades
based on:
- strong reversal signals found in price patterns, candlestick
indicators, volume spikes and momentum oscillators
- confirmation of reversals, using the same signals and indicators as
reversals; and the stronger the confirmation, the more confidence
the contrarian has
- avoiding placing too much capital into any single trade, to
minimize losses and to avoid large losses
- risk reduction methods through hedging and diversification
Price reversal signals
A contrarian will watch trends and look for reversals in the
following indicators:
- traditional price reversal patterns like the head and shoulders, double
tops or bottoms, and price gaps – especially when these appear at or
near resistance or support
- volume indicators as well as volume spikes, a one-day or two-day
exceptionally high number of trades
- momentum oscillators, indicators designed to reveal how quickly
trends develop, when they begin to slow down, and when a stock is
overbought (a bearish signal) or oversold (a bullish signal)
Contrarians and the efficient market
hypothesis
The efficient market hypothesis
Definition
Contrarians believe that prices can be
predicted to a degree, based on the Efficient market
logical and analytical study of market hypothesis – the belief
that all current prices
behavior and of the news.
are based on the
accumulation of all
This idea is disputed by EMH, which
known facts and news
assumes that the market is efficient about the company,
and that all information is factored
meaning that all
into the price of a stock.
prices are currently
fair and efficient.
Problems with EMH
If markets were efficient, prices would react in the
same manner to all news, such as earnings or
merger announcements.
Based on EMH, reaction to earnings surprises
should be measured and precise, and not subject
to correction.
EMH fails to recognize the elements of market
behavior, which may be the most influential
aspect of stock market investing and trading.
A view contrary to EMH
A contrarian has observed how irrationally price
behaves, and how price tends to overreact to all
unexpected news.
In these conditions, contrarians believe the market
is quite inefficient.
If that is true, then exaggerated one-day price
movement presents an opportunity to exploit
inefficiency.
Contrarians and the random walk theory
The random walk theory
Definition
Contrarians also reject the random
walk theory, because the
contrarian believes that price
movement can be predicted –
based on market behavior and on
fundamental analysis.
If the random walk theory is true,
then all forms of analysis are
useless. The contrarian rejects the
theory for that reason.
Random walk theory
– a theory about the
market stating that it
is impossible to predict
the direction of price
movement, and that
any price today has a
50% chance of rising
or falling.
Problems with the random walk theory
If all prices were 50/50 bets, it would not matter which
stock was selected; half would rise and half would fall.
Under the random walk, you must reject the effects of
high revenue and earnings in one company, versus low
results in an other.
You also would have to reject reputation, competitive
success, and exceptional management. None of this
would matter because price movement would occur
apart from these influences.
Contrarians and the Dow Theory
The Dow Theory
Contrarians accept the basis of the
Dow Theory over the long term,
while also recognizing that shortterm price behavior tends to be
chaotic and irrational.
The contrarian views the Dow
Theory as an organizing principle
of technical analysis, while also
observing how volatile short-term
price movement and market
behavior present trading
opportunities.
Definition
Dow Theory – a series
of “rules” about
market trends and
how they are set and
reversed. The theory is
based on the
teachings of Charles
Dow, one of the two
founders of the Dow
Jones Company.
The tenets of the Dow Theory
1. The market consists of three movements:
primary, secondary and short-term.
2. Trends consist of three phases: accumulation,
public participation, and distribution.
3. The market tends to discount all news very
quickly.
The tenets of the Dow Theory
4. Stock averages must confirm each other
before a reversal is recognized.
5. Volume confirms trends.
6. Trends continue until a contrary signal is
recognized and confirmed.
Is the Dow Theory in conflict with
contrarian investing?
Many have pointed to the tenet that the market
discounts news, to support the efficient market
hypothesis.
It is true that the market behaves in this manner, but it
often takes several days for the discounting to go into
effect.
Contrarians are strong proponents of the Dow Theory
over the long term, and recognize that the core of
trend analysis rests with recognition of reversal and
confirmation.
Conclusion
Contrarians do not act opposite the majority, but make
decisions for different reasons than most – employing logic
and analysis rather than emotion.
The efficient market hypothesis assumes that all prices are
correct because they contain all known news.
The random walk theory assumes that prices cannot be
predicted, and that all analysis is useless because of the
random nature of markets.
The Dow Theory is the basis for technical analysis, and
contrarians are strong proponents of its tenets.