Contrary-opinion trading is perhaps the best solution to market madness and noise; it is a “thinking man’s” trading tool. A Contrarian is a person who takes an opposing view, especially one who rejects the majority opinion, as in economic matters. So, in a nutshell, if a CTA / Money Manager is trading as a contrarian, they are simply establishing positions opposite to the prevailing majority opinion and trend in the market.
Is being a Contrarian a profitable and viable strategy? That’s a challenging question to answer unless you have some quantitative measure to go by and compare results to. There are many services out there that pull together “bullish sentiment,” from reading through market advisory services newsletters or other indicators such as volatility, open-interest, Put to Call ratios, or any such indicator which tries to “take the psychological temperature” of the market(s). The theory and rationale behind the notion that trading is contrary to the prevailing market opinion are that it is well known that most traders and investors lose money when they begin trading commodities or stocks; they then turn to professional sources, namely brokers and market-letter writers, for advice. If one could then measure the sentiment among the respective advisory services and brokers influencing traders’ activities, one would have a pretty good idea of the psychological state of the market. If you can determine that the majority, by a large percentage (over 80%)- are “bullish,” then it could stand to reason that – everyone is on the same side of the boat, and if everyone’s on the same side of the boat it will usually tip over or capsize– as there is no one left to buy.
A market sentiment indicator should be designed to measure the “percentage” of bullish psychology surrounding a given market and the bearish sentiment. It should be broken down on a scale from 0% to 100%, and then trading rules can be designed around these percentages. Example: If the bullish sentiment reading is above 80%, this could signal that everyone is bullish and on the same side of the boat, and a short-selling opportunity could be developing. You could also confluence the market sentiment indicator with other trading tools, such as trend lines, support, resistance, Fibonacci levels, etc.
In this day and age, there are several different indicators and sources to explore to come up with your way to determine the bullish sentiment in any given market. (And I highly recommend doing so). Or you can subscribe to a service specializing in determining “bullish sentiment” and giving you their opinion. I recommend back-testing and thoroughly researching any indicator or news service before putting your money into the markets based on taking trades contrary to the prevailing trend. Here are a few concepts and rules to look at and use once you have determined which bullish sentiment indicator you have faith in and are comfortable with:
- There are two ways a CTA / Money Manager will use the bullish consensus indicator: as a contrarian trend tool and also as a trend-following method. When they take a contrarian trade, they are always going “opposite” to the prevailing market trend and sentiment. Rules of thumb: They can place a contrarian trade whenever the Bullish consensus exceeds 80% or is less than 30%. They may use the indicator for non-contrarian, trend-following trades between these two extremes. In short, when the consensus is at its extremes, they trade against the trend; when the consensus is mixed or hovering around the middle area, they take trades that go with the trend.
- I wish to point out that there is a big difference between saying that “the majority is always wrong in the marketplace” vs. “the majority is always wrong at the major reversal points in the market.”
- An overbought or oversold condition occurs when the sentiment exceeds 80% or is less than 30%, and the Open Interest is either stable (changing less than 4 percent per week) or decreasing.
- A sell signal is issued when the indicator is in the 60 – 80% area, and a significant decrease occurs (10% or more in 2 weeks). A buy signal is issued when the consensus is in the 30 to 50% area, and a significant increase occurs (10 percent or more in two weeks).
- Usually, when CTA’s / Money Managers trade using this method, they only want to trade markets that are liquid and have a sizeable Open Interest, to work best. These are the markets with the most participants. A small or thin market is more easily manipulated by significant trading interests and less responsive to the “emotionalism” that affects the crowd of speculators.
- Only take a contrary market position that is contrary to a crowd of speculators – Not Hedgers.
This article introduces the theory and concepts of how CTA’s / Money Managers may take trades based on a contrary opinion indicator. There are many more details and subtleties to be taken into account to be competent in using this methodology for trading.