Episode 5 – Contrarian Trading Strategies ft Fear and Greed Index August 29, 2022

What is Contrarian Trading?

Contrarian trading might not be familiar to many, but one of the most well-known traders to use this strategy of Contrarian trading is Warren Buffet. “Be fearful when others are greedy, and greedy when others are fearful”, one of Warren Buffet’s most famous quotes sums up what contrarian trading is about. Simply put, you apply this strategy when you go against market trends. Contrarian traders buy when others sell and sell when others buy.

The concept behind: Fear and Greed – Understanding Market Sentiment

The concept behind contrarian trading requires one to understand market sentiment, human psychology and herd behaviour. This is because markets are subject to herd behaviour augmented by fear and greed, which results in markets being periodically over- and under-priced. Herd behaviour occurs when people react to the actions of others and follow their lead. This is similar to the way animals react in groups when they stampede in unison out of danger. Human beings are naturally prone to a herd mentality, conforming to the activities and direction of others in the way they invest. The fear of missing out on a profitable investment idea is often the driving force behind herd instinct, especially in the wake of good news or after an analyst releases a research note with a ‘Buy’ recommendation.

It is due to the natural human instinct of herding that can make those who don’t normally abide by general consensus feel distressed or fearful. If the crowd is generally going in one direction, an individual may feel that he/she is wrong when they go the opposite way, or they may fear being singled out for not jumping on the bandwagon. Based on historical data, herd behaviour has resulted in unfounded market rallies and sell-offs that are often based on a lack of fundamental support to justify either. Herd instinct is a significant driver of asset bubbles, which eventually lead to market crashes in financial markets. One prime example is the dotcom bubble of the early 2000s where this behaviour led to unsubstantiated growth resulting in a bubble that subsequently burst.

A contrarian trader however takes advantage of such market responses. The herd behaviour, which results in the over/undervaluation of stock prices, is seen as an opportunity for the contrarian trader to exploit. A contrarian trader enters the market when others feel negative about it because he/she believes the value of the market or stock is below its intrinsic value and thus represents an opportunity. In essence, an abundance of pessimism among other investors has pushed the price of the stock below what it should be, the contrarian trader will then buy that stock before the broader sentiment returns and the share prices rebound. The opposite is also true. A selling / take profit opportunity is seen in stocks that are currently heavily bought by the market.

Contrarian trading can be rewarding, but at the same time it is also a risky strategy that may take a longer period of time to pay off. Contrarian trading also requires the trader to spend a great deal of time researching stocks to find undervalued opportunities. So, how do well-known investors like Warren Buffet apply this strategy and how is contrarian trading done?

Strategies and Indicators to rely on for Contrarian Trading

By now, you would have guessed that timing plays a very big role in contrarian trading, but how do you identify when to enter and when the market is fearful? Simply betting against market sentiment is one of the fastest and most effective ways to lose money. So, here are 5 steps you can take to formulate a strategy for contrarian trading:

Step 1: Using the daily timeframe, find a stock that has been trending downward for at least three months in a row.

In this example, we will be using the Straits Time Index (STI) as it has been trending down since April 2022 as seen from the graph below.

Contrarian traders prefer a trend that has been running for at least three months as this is a timeframe long enough to start planting fear in other market participants, causing a panic. Panic in the market is actually a contrarian traders’ most favoured market condition. One of the fastest ways to look for these kinds of stocks is to search for stocks that are trading at their 52-week lows.

Another indicator that you can rely on would be the Short Interest Indicator. Short Interest is the total number of shares of a particular stock that have been sold short by investors but not yet covered or closed out. This indicator is great for traders because it allows traders to have a rough gauge on the general market sentiment towards that particular stock, since it shows what short-sellers are doing.

The short interest can be expressed as a number or as a percentage, the latter is derived by dividing the short interest over the number of shares outstanding. For example, when a particular stock’s short interest increases by 10% in one month, this could catch the attention of some traders, as such a significant shift provides a good reason for traders to find out the cause of it. At this point, it might seem natural to avoid stocks with high short-interest because the general market sentiment is poor towards the stock. Why would you want to get involved? However, this is the point where contrarian traders act. Contrarian traders use short interest as a tool to determine the direction of the market because contrarians believe that if everyone is selling, then the stock is already at its low and can only move up. Thus, a high short interest is actually bullish because, eventually, there will be significant upward pressure on the stock’s price when short-sellers have to cover their short positions.

Step 2: Draw a down-trendline and wait for a potential breakout to occur.

Contrarian traders tend to shortlist counters that have been bearish. Therefore, these traders will only construct a down-trendline and be patient until a breakout of the trendline occurs. Do note that in order to constitute a breakout, the price of that candlestick needs to close above the down-trendline. Based on the example above, there was a breakout that occurred on the day indicated by the blue arrow showing that the candle closed above the trend-line.

Step 3: Wait for sideways movement to occur.

A typical trader will enter once the breakout happens in the hope for it to go back up. However, contrarian traders do not enter when everyone else does. They will tend to wait for a sideways movement to occur before entering into a position – essentially, when others are not interested anymore, that is when the contrarian trader will strike. Based on the graph above, the STI was trading sideways for the period indicated between the 2 orange arrows. Contrarian traders draw in an intermediate resistance and support line to make it clearer to them that a sideways/consolidation movement is occurring.

Step 4: Enter when the sideways move breaks upwards.

Once the breakout of the sideways movement occurs, wait for the candle to close above the intermediate resistance line to signify that it is not a false breakout. An indicator that traders can use to help them identify a true or false breakout is by using the Moving Average Convergence Divergence (MACD). MACD is a trend-following momentum indicator that shows the relationship between two moving averages of a security’s price. This indicator can support your analysis when you are trying to spot a “breakout”. A false breakout could be supported by a small MACD histogram – indicating that momentum is low. Upon confirmation of a true breakout, contrarian traders then enter a position based on the opening price of the next day.

As a supporting analysis, traders also rely on the Relative Strength Index (RSI). Developed by J. Welles Wilder, the RSI is a momentum oscillator that measures the speed and change of price movements. The RSI oscillates between zero and 100. Between the ranges of zero to 100, the RSI indicates an “overbought” scenario when it hits 70, and an “oversold” situation when it is below 30. As a Contrarian Trader, you are looking to enter the market when the RSI is below 30 since it signals that the general market sentiments is fearful. The opposite is also true when deciding to open a short position or your take profit point. Contrarian traders tend to short or exit the position when the RSI is above 70, indicating an overbought situation.

The 30-70 bandwidth is, however, not a hard and fast rule. These levels can also be adjusted if it is necessary to better suit that particular stock’s fluctuations. For example, if that particular stock is repeatedly reaching the overbought (oversold) level of 70(30), you may want to adjust this level to 80(20).

Step 5: Setting your stop loss and taking profit.

After opening a position, the next step is to set a take profit point. With a setup as described above, contrarian traders place the stop-loss a few points below the lowest price. In this example, the lowest for the STI was at 3,072, hence traders may choose to put a stop loss at around the 3065 region. As mentioned in the first episode “Traits of a Successful Trader”, a successful trader will have a risk-reward ratio that they will adhere to. Therefore, if the trader has a 1:2 risk to reward ratio then his take profit point will be two times the range from the entry point to the stop loss point.

We hope that this sharing of contrarian trading has provided some insights that can help enhance your trading journey. At PhillipCapital, our online trading platform POEMS houses educational contents such as Market Journals, Podcasts and Webinars with the objective of giving insights to help you make smart investment decisions. Feel free to register and attend the webinars that POEMS has to offer. We also welcome you to approach our Financial Advisory Representatives / Relationship Managers in Phillip Investor Centre who can guide you along your investment journey. Contact ActiveTraders@phillip.com.sg should you have any enquiries or feedback.

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