HOW TO BE A CONTRARIAN IN YOUR TRADING
there is a method to the madness

MEN THINK IN HERDS; IT WILL BE SEEN THAT THEY GO MAD IN HERDS,
WHILE THEY ONLY RECOVER THEIR SENSES SLOWLY, AND ONE BY ONE

As a general rule, it is foolish to do just what other people are doing,
because there are almost sure to be too many people doing the same thing"

People tend to act in herds. Inverstors, and traders do the same thing. The primary book written on manias and herd mentality is EXTRAORDINARY POPULAR DELUSIONS AND THE MADNESS OF CROWDS. First published in 1841 by Charles Mackay, the book is a part of my library and wonderful read. It can be found on Amazon here. Mackay's book is not only about financial manias, but includes alchemy, crusades and other "national delusions. The important thing is that it gives the reader a historical perspective on herd mentality.

Mackay describes the Mississippi Scheme, the South Sea Company and the Dutch tulip mania, where speculation on tulips was rampant (think about that....speculation on tulip growth), and futures markets were developed for tulip delivery. But there of course have been several manias since, including most recently the housing bubbles in the U.S. and worldwide, and the stock market first in Japan, then in the late 90's in the U.S.

Once the trader understands that manias and panics happen the way they do, he may feel somewhat more comfortable taking the contrary trading opinion.

It is not easy to be a contrarian. No one likes it. Life is much easier being a member of the crowd. Our minds work that way. We feel much more comfortable with any course of action as long as we know that others, preferably many others, are also following the same course of action.
WHY?
We feel comfortable not because we want everyone else to share in the profits we feel sure to reap; we feel comfortable in knowing that if we are wrong, we will not be the only ones wrong and therefore less likely to garner criticism. How pathetic. But that is who we are. That is certainly who I am. Being wrong is less important to us than being THE ONLY ONE wrong. So we go with the crowd, no matter what our instincts tell us.

A picture of a baby with a mowhawk

Humphrey B. Neill wrote a book quite relative to this subject, THE ART OF CONTRARY THINKING. He explains the difficulty of thinking differently than the herd, but advocates the value of such thinking nonetheless.

Mr. Neill wrote the following:
The art of contrary thinking consists of training your mind to ruminate in directions opposite to the general public opinions: but weigh your conclusions inlight of current events and current manifestations of human behavior

That may not surprise you but see if this next part does.

"My acquantaintanceship with Wall Street dates back to the ill-fated 1920's. I soon heard about the hundred and one technical systems then in vogue for a predicting the swings in stock prices. Losses in market operations quickly revealed that it isn't the system, but the trader or investor himself who is at fault! Take chart reading for example, one can interpret charts almost any way he wishes and read into their formations just about any result he hoped for...........with all respect for proponents of technical market analysis methods, I doubt very much if any so called technical method will ever completely enable people to overcome their inherent traits of hope, greed, pride of opinion, and similar human failings that make successful speculation one of the most difficult arts to master."

Mr. Neill decided to study market psychology. He called his work a study of human nature in finance (this was long before "behavioral economics"). He came up with some ideas for sure losses:

Elsewhere on this site I have commented on many of the same factors listed above. I know that many who have read my comments view them as little more than a nuisance, standing in the way of what they REALLY need to learn. But please think about this: These comments were written by a man who traded not in the 90's or 2000's, but in the 1920's. They were true then, and they are true now.

BE CONTRARY. Let me say that again, be contrary. Trade on your opinion, not that of the herd.

But being contrary does not mean betting against the crowd at all times. It means thinking on your own. Using your own brain. Assessing situations via your own thinking, and not simply following the herd. Mr. Neill addresses this quite clearly;

He writes: "Contrary theory is a way of thinking, but let's not overweigh it. It is.......a thinking tool, not a crystal ball. It forces one to think through a given subject......if you don't think things through, you're through thinking."

Mr. Neill comments on behavioral economics before there was such a thing. He quotes George Katona in saying "economic developments without regard to people's perceptions of them and reactions to them do not suffice for a full understanding of cyclical fluctuations." Then he follows up by saying that it is not enough for us to know the statistical setup or even the probable statistical outlook. We need more importantly to know how consumers and businessmen look upon these statistical reports and probabilities, and we then need to consider a contrary opinion on trends thus commonly accepted.

WHY IS THE IDEA OF MANIAS AND CONTRARY THINKING IMPORTANT TO TRADERS

For long term traders, the reasons to be aware of manias and to develop an individual style of assessment should be obvious. For those bright enough to recognize the stock boom in the 90's and the housing boom in the 2000s, money could be made. But they would have had to be contrary thinkers in the end. For the shorter term trader, there may seem no applicability, but most certainly there is. We see the same type of trader / investor mentality in shorter timeframes that we see with the longer term manias. It is not uncommon at all to see the futures markets trade aggressively in one direction, only to reverse. Or we might see a news report push bond prices higher intraday, and that push might be harsh and rapid and somewhat prolonged, only to stall and reverse later in the day. As traders, we must make ourselves aware of this possibility, force ourselves to think on our own, and consider contrary thinking (to what looks like an aggressive move with no end in sight) as an alternate trading strategy. This does not mean that we should reflexively trade opposite the crowd, that would be madness and lead to large losses. What we should do, however, is watch what the crowd (or trend) is doing, and not blindly get on board, but instead make our own reasonable judgements as to why the trading is occuring and whether it will continue. But the point that I specifically want to make here is that should we decide to trade in a contrary fashion, there is a right way to do so. I will get to that in one moment.

It is important to state here that are valid reasons for discounting a price move, and reasons that are anything but valid, and border on stupidity.

With time, and experience (lots of experience) a trader will learn how he or she should assess a market. He will recognize areas where reversals might occur, where a market may have moved sharply in one direction, but for good reasons he thinks it may retrace. When that happens, when and where should he put on the trade?

In January of 2000 I was plotting the markets, studying them daily, and had made a great deal of money over the preceeding few years. I saw some things that made me think that a market top would be forthcoming. I had confidence in my assessment. This was not a whim. It was a decision made after thorough efforts to assess every aspect that I thought relevant. I KNEW (you can never KNOW) that the market was likely to fall (My assessment was appropriate, but I was naive in the manner in which I acted on that assessment). With my homework done, and my confidence high I shorted the market. Not only did I short the market, I shorted the NASDAQ, and I did so with size. For a week, no move of substance occurred, and I neither made nor lost money. On that weekend, I was invited to play golf and ended up being paired with a former broker who, now retired, traded his own account. At some point in the round we began of course to talk about stocks and I explained my bearish sentiment. My confidence was boosted when I found that he agreed with my assessment. Then I told him that I had shorted the NASDAQ, and the size I had used. To this day, 11 years later, I still remember the manner in which he stopped suddenly what he was doing and peered at me with a look that suggested both curiosity and awe. For a moment he said nothing. Then he shook his head slowly and with a wisdom that comes from years of experience, and no doubt many of his own bad trades, he quietly said: "Look, I appreciate your views and find them reasonable, but I make it a point never to walk in front of a freight train, especially one moving at a high rate of speed." He then walked away. I went home that night and the next morning took my trade off.

I believe in the value of contrary thinking. I believe that those who were smart enough to question the ENRON story, saved their money and deserved to do so. I believe that John Paulson deserved the money he made shorting the mortgage markets, and that those who shorted the internet bubble in 1999, were intelligent, correct, most of all ALONE, and should have made huge returns. Here is a key though, those traders (day, intermediate, long) did not simply trade against the crowd (or move). They questioned the popular move, assessed of their own accord, and then made their own decisions. Sometimes when this happens the trader may go opposite the popular thought, maybe sometimes go with the crowd, and often likely do nothing.

Now lets move on to the point at which you have done your homework, and your believe that the popular move (the crowd) is wrong. What do you do then? As I told you, in 1999 I shorted, and I shorted the QQQ in the midst of the biggest run in its history. As it turns out, I would not have lost money had I left the trade on, but that was pure luck. As my golfing friend brought to my attention, I stepped in front of a freight train, and it was moving at high speed.

There however, is a right way to go against the crowd. You make your assessment.....(hopefully as unbiased as possible...this means with no trade on at the least)......and then once you conclude that the correct action is to go opposite the crowd, you then MUST decide the right time to put on the trade. Now this will vary. The right time for an option trade has to be sooner than the right time for trading the underlying, because liquidity, bid ask spread, price change all happens so much faster in the options market. But in equities or futures there is a right way to go opposite the crowd, and that is to asses, form your opion, and then wait for some form of confirmation that you are correct. Then and only then should you put on your trade.

Let's take my example of the bond market. You are trading it intraday on a day in which big news is to be released. You have studied the number, GDP, know the expected and also know the last few release GDP numbers which help determine if there was a recent abberation that might affect today's release. You watch for the figure, (which you can never get as fast as the market). It is positive for bond price and the market rockets up. You watch and do nothing while you discern the move, the news, your thoughts. The up move continues and hastens in price change. You realize that you have lost much money by NOT participating in the up move. But you are disciplined. You do nothing. You watch price move higher. You know your levels. You know that the news was not as bullish as price move suggests. You think that this will be a short lived rally, but you are disciplined. You watch. The market moves higher. Despite the fact that every ounce of your being wants to be long and participating in this rapid gain, you are disciplined. You are experienced. You do nothing. You wait and watch. Five minutes, ten minutes, 13 minutes, and you are wondering why you did not go long at the start because the move is still going up. But you are disciplined. You don't think this will last and you need not look to CNBC or Bloomberg to tell you. So you watch. You do NOTHING, but watch. But then, the market stalls. You see it. The price change per minute, the volume per minute have both decreased. You see your opportunity. You are anxious. How could you not be, the move has been up 20/32 of a point, and the volume is high. But you feel comfortable with your assessment and you watch a little longer, knowing that if the market sells even a little, you too will sell. It does, and so do you, but only with a clear stop at the high level just set.

What happened here? The trader did a few things right:

  1. He was prepared for the trading day and knew that news was coming
  2. He was prepared for the trading day and knew GDP would be released, and what the recent numbers had been, and whether there were abberations
  3. He watched the market action post news release
  4. He was patient
  5. He saw the market JUMP up, ......yet he did nothing as he assessed his opportunites
  6. He concluded that the move had gone TOO FAR.......yet still, he did nothing as it went higher
  7. He waited for some type of confirmation from the market ......the stall in the upmove, and retrace.....ONLY THEN DID HE SELL
  8. He had a clear stop......in case he was wrong

Every market trends. Every timeframe trends. Traders need to learn to make their own decisions, not follow a quick or sharp trend. My experience is limited. I have traded only a decade or so. But one thing I can assure all traders: NO MOVE GOES TO INFINITY.
Yet when we see a sharp, high volume up move, we all think the same thing...... I cannot miss this trade. But that trade, like all trades, will stall, and likely reverse. Patience is of utmost importance, while you think. If I am wrong, and the move does go to infinity, will it hurt to wait just a little to think about entry?

Be a contrarian trader, in thoughts if not in action. When it is time to act though. THINK IT THROUGH, and wait on some type of confirmation from the market before placing your trade. DO NOT RUSH. Do not be forced into a position you do not want by market action. Think it through. If the move is really so strong, it won't hurt to be a little late. If it is not, you will save a bundle by inaction.

GOOD LUCK.