One thing I noticed as my experience as a trader grew, is that I became increasingly comfortable with having a contrarian position in the markets. In fact, contrary to popular ‘wisdom’, the position that scares me the most is when I have the same trade as the majority.
When we first enter this business we tend to focus mainly on trying to figure out what everyone else is doing and jumping on board with them. Spurred on by such popular expressions as “The trend is your friend”, we believe that this is the line of least resistance. It seems to make sense to join the herd.
However, after the inevitable occasions when I (along with the herd) lost large amounts when “unforeseen” events or moves occurred, as I progressed along my trading journey I started to re-evaluate my acceptance of these well known views about positioning.
Words of Wisdom
This ‘Road to Damascus’ type moment was further encouraged by one of my trading mentors, the trader who taught me to trade options and who backed me when I first went into the LIFFE options pits.
He once said to me,
“Gary, the trades that will make you the most money are the ones where you have the opposite position to the majority”
What it doesn’t mean
It is important to first state that this does not mean that we should always take the contrarian trade.
The multiple accounts and analysts who are constantly predicting doom in equities are not skilled contrarian traders; they are just seeking clicks and exposure.
It does not mean to take positions when your contract is ‘overbought’ or ‘oversold’ according to technical analysis indicators. These are unreliable and frankly meaningless tools.
What it does mean
What this statement does mean is that we have to be able to find and then implement contrarian trades. This requires, skill, judgement, knowledge and information.
Research and Analysis
In order to find good contrarian trades we have to look for information outside of the contract we are trading. We have to understand the positioning of our market’s participants and work out what they are pricing in. Then we develop this further by looking for any information that could suggest they might be wrong or look for any imminent data that might provide that evidence.
We finally, need to estimate whether the risk/expected return profile of any trade makes sense. Typically, while we might view the potential rewards as being high, on many occasions these are low probability trades. Estimating and then actioning only on the higher probability occasions requires experience, skill and sometimes some luck too.
Those unforeseen events
When you start to weigh up market positioning and look ahead to earnings, data etc you can start to find weaknesses in how participants are positioned. What you will then find is that some of these ‘unforeseen’ events are actually not so surprising.
These events will be ‘unforeseen’ for chart traders because they haven’t occurred before on the chart and also because these traders believe that the market is ahead. They additionally tend to downplay the effect of data and other ‘fundamental’ influences.
If you look forward at what might happen rather than just look at what has happened and assume the market is ahead, then your chances of spotting ‘unforeseen’ events will increase.
Be prepared to be uncomfortable
I have also noticed that many traders/investors feel some kind of comfort if they lose money but lots of others lost too. The pain of the loss isn’t so bad if lots of people suffered the same fate.
One of the reasons why I don’t like nor take this viewpoint is that it can hinder our ability to learn from mistakes. You are essentially saying, “the trade was good, I was unlucky” or “no-one could have known this was a bad trade”. In reality you should be looking for anything you might have missed.
I feel no comfort in losing money just because others did too.
Taking contrarian trades means that you will sometimes have losses when others have profits. This will put many out of their comfort zone. But it is essential we become comfortable with acting independently; we must move out of our comfort zone.
Options
Options can be a great product to exploit these contrarian situations. The profile of a long options strategy of limited risk and potential large reward, fits the purpose of contrarian trades well. Long options trades whether outright calls/puts or spreads has been my go-to contrarian strategy for decades.
With options we can choose an expiry that fits well with our timeline.
However it is important that the contrarian possibility we are considering is not already priced into the options market. Otherwise the option trade might not offer the correct risk/reward. For example, option prices can increase ahead of earnings announcements or key data, we need to make sure the option trade still offers value.
If you want to learn more about option trading I have a free course available here
Summary
In a world where many trading accounts are offering constant claims of doom, there remains a place for genuine contrarian trades.
They are typically low probability trades but sometimes we can find trades where either there is a higher probability of a contrarian move or where an option strategy offers us such good risk/reward (expected return) that it makes sense to take the trade.
A well executed contrarian trade can return excellent profit.
New traders may feel uncomfortable taking contrarian trades however, I would suggest that with experience, most traders should become more comfortable with this style and incorporate it into their trading.
It requires the ability to think independently, seek out disconfirming information, weigh up what is being priced in and good judgement of risk/expected return.
Keep Grinding
Gary
