Contrarian Trading – Strategies to Employ
March 26, 2012
This article is based on an explanation as to how you can use contrarian analysis to find out which stocks have the muscle to keep climbing in the suddenly wobbly market environment -- complete with a list of potential bullish and bearish picks.
Also included is a short summary of a contrarian trading philosophy, along with some simple indicators that can be used to determine the sentiment surrounding a stock.
Definition of Contrarian Trading
‘Contrarian’ is defined as 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 investing also emphasizes out-of-favor securities with low P/E ratios.
The Basics of the Contrarian Trading Strategy
The contrarian strategy is not as simple as taking the opposite side of the public's 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 option traders.
Indicators for the Contrarian Investor
By constantly monitoring the markets and reading about stocks or simply by reading the news and keeping an eye on other media outlets provides a feel for the sentiment. However, it 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 there's a large amount of these negative bets being placed on the stock, while it's still moving higher and higher, then you can assume that there is significant sideline money that can still be deployed to keep the rally going.
Contrarian Trading Stock Plays
Below are some stocks to keep an eye on using some of the indicators mentioned above. The following contrarian bullish stock plays were accumulated by observing stocks during the past six months and then following certain criteria:-
• despite outperforming the S&P 500 Index,
• saw fewer analyst "buy" recommendations,
• an increase in short interest, and
• more puts bought to open than calls bought to open -- Put/Call Ratio.
Using the same indicators as above, this next table shows stocks that could be compelling from the short side. In other words, these stocks have been moving lower over the last six months, but analysts and investors keep making bullish predictions. If the underperformance continues, and the bullish investors change their minds on these stocks, you might see a sudden outflow of money -- driving the prices even lower. Specifically, the table shows stocks that are lower over the previous six months, even as short interest has decreased, the percentage of analyst "buys" has increased, and there have been more call options bought compared to put options.