Contrarian Trading – How It Can Be a Lucrative Option for Investors and Traders Alike
Contrarian trading is a type of value investing whereby an investor buys distressed stocks at low price with the aim of selling them when they start performing well. Such a counter trend master plan may seem unreasonable to a novice investor who is trained to invest according to the market trends.
However, experienced traders say that contrarian investing is extremely profitable as long as the trader has the right set of trading skills. If you are planning to explore this type of investment, below is a little bit of what you ought to know.
How Contrarian Investment Works
Contrarian investment is based on the argument that mass and irrational pessimism can drive an asset’s value far below its intrinsic value. However, with time, such a stock will regain its value, and it may turn to be incredibly rewarding.
Therefore, as a contrarian trader, you will have to ignore the wrong consensus opinion and instead gauge the strength and stage of development of the particular distressed stock you are eyeing. This helps you make a rational investment decision.
Like any other investment philosophy, this type can yield good returns, and at times, it may turn against you. Therefore, you need to make informed decisions to avoid the latter outcome.
What skills do you need?
In the opinion of successful contrarian traders, you need reliable analysis skills to be able to identify situations when traders are vulnerable to start selling their stocks, or when they are likely to start buying more shares. The information will help you determine when it is time to buy or sell.
Below are the basic analytical skills that you ought to possess:
- Fundamental analysis
Fundamental analysis is a method through which you gauge a stock’s financial health and performance by looking at macroeconomic, financial, qualitative, and quantitative factors that affect supply, demand, as well as a stock’s intrinsic value.
Some of these factors include the financial condition of the company you intend to invest, economic forecasts, product recalls, corporate management, past performance, product portfolio, financial ratios, and many other factors. These factors can help you forecast a stock’s future health and performance.
- Technical Analysis
Technical analysis is a method that helps you predict the price pattern of the stock you are eyeing. Some of the indicators used in the technical analysis include chart patterns, up and down volume averages, standard deviation band, and strength index, among other indicators.
If you want to come up with a better technical analysis, business experts suggest that you consider the technical indicators across various time frames. You may also want to use forecasting technologies like genetic algorithms that provide accurate and quick predictions.
- Sentiment Analysis
Also known as opinion mining is an analysis that helps you establish a stock’s short term position in the market. Some of the factors that can help you here include investor opinions, sentiment analysis from traders (Etoro has one for traders, Yahoo finance has one for investors), media and analyst rankings, and volatility skews. As a contrarian trader, you would want to focus your interest on stocks that are moving contrary to the forex market trend.
Tips to be a Successful Contrarian Investor
- Research before you invest
Like any trading, contrarian investing is highly dependent on your prowess in stock and sector analysis. This requires that you use your analytic skill and valuable time to scrutinize the distressed stock’s past price to earnings ratio, dividend yield, price to sales, historical earnings, and any other relevant metrics.
These pieces of information will give you a reliable foresight of the stock’s financial future. So, if you find out that a distressed company has a promising future, you can lay your investment and give it patience before you start reaping the benefits.
While various trading blog sites, media rankings, and analysis sites can have this information, experts advise that you should treat the marketing opinions with caution as they are not always right.
- Buy when people are selling
An irrational market indicator like political strife, an expected change in policy, or a SEC inquiry can possibly spike an irrational sale of stocks. According to successful contrarian traders, this is the best opportunity to buy since many investors won’t take their time to substantiate the credibility or the long term effect of a market crisis. Instead, they will be disposing their shares at a low price.
Therefore, you would want to do your research and identify the irrational point at which the market has overreacted. If you find out that the crisis has a short lived effect on a company’s stock value, you should take advantage of the situation to buy as many assets as you want and later sell them off when the overreaction settles.
- Have extra capital in reserve
Sometimes, you will be forced to take an investment position with long term returns or at worst the trade may turn against you. In such cases, the financial reserve will help you push on with the trade.
- Focus on long term gains
Contrarian investors need to focus on the long- term odds of a stock instead of day trading, which is usually prone to sudden market swings and volatility that can conceal a stock’s long-term value.
As an example, Warren Buffett, one of the top contrarian traders, risked buying Goldman Sachs’ shares at a price of $115 per share during the US’s economic downturn. During this time most traders desisted from buying its shares. Six years later, Goldman Sachs’ shares trade at an estimated value of $180.
Contrarian investing is quite a new trading trend that has proved to have better returns than the traditional growth investment. Unique from the regular trading, contrarian investing entails buying distressed stocks at a low price and later selling them at a profit. Although the trade seems like a productive trading option, a contrarian trader needs to do away with misleading market commentaries and instead embark on his or her own rational analysis to determine if a particular stock is or not worth investing.