The Challenge With Contrarian Trades
This video explores Contrarian trades and questions whether it’s better to just stick to the trend, and follow the money.
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We have a very interesting question here from a new subscriber as part of our January 30-day challenge who asks why we sometimes like to talk about Contrarian trades or so-called pain trades and whether it’s not better to just stick to the trend and follow the money.
This is such a fantastic question, and I think it allows us to make a few important distinctions when it comes to contrarian trading. Firstly, 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. Secondly, when talking about contrarian trading, people often jump to the conclusion that it means just randomly jumping in against the trend or against the overall market sentiment, but that’s not the case.
When we consider contrarian trade ideas it always comes from a fundamental or sentiment-based reason, and the reason is never because the market has gone up too much or gone down too much, that’s the quickest way to lose money in the markets. The popular trading axiom of “the market can remain irrational for longer than you can remain solvent” is very important when it comes to this. There are of course many retail investors and traders that would sell something because they think it can’t go any lower or can’t go any higher by just looking at the chart, but that is a sure way to lose money in the markets and that’s not how we approach possible contrarian ideas.
So, whenever we look at a potential contrarian trade idea it will always be based on additional research or analysis, fundamental analysis 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 the power of the trend and the power of consensus. There is a reason why traders say the trend is your friend, and the majority of time traders lose money by taking contrarian trades is because they base their trades on the assumption that markets operate rationally and logically, which we of course know is not the case.
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.
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 you like sitting on constant drawdowns. You see, 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.
The times when contrarian trades work the best, is when the market has reached such a 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.
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.
Probably the most important thing to keep in mind about contrarian trades is that you need to understand risk management and trading psychology before even thinking about contrarian trade ideas. If you don’t have the discipline to put solid risk management in place and 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.
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