This article on Contrarian Trading was written by a guy called Mike, who was mentoring the original poster on Forex Factory. I thought it may be of benefit for readers of the blog. Thanks to the OP for allowing me to share this. Enjoy…
Why Contrarian Trading Works
The basic idea behind contrarian trading is that when a large percentage of traders/analysts are bullish, anyone who wanted to be long has already bought, leaving the market with no more buyers; therefore, the price must go down. The opposite is true for the sell side. For sake of brevity, I’ll explain the forthcoming ideas only in relation to the bullish case.
We are raised from childhood to believe that good decision-making entails collecting all the pertinent data and weighing that evidence which supports our hypothesis against that which doesn’t. The best decisions are those that have overwhelming supporting evidence relative to the conflicting evidence. Unfortunately, this strategy doesn’t work in financial markets because, paradoxically, as soon as supporting evidence becomes available, it is no longer pertinent. It’s no longer pertinent (once it becomes widely available) because to whatever extent it contributes to the bullish case, people will have already bought. If you can acquire and act on the evidence before it becomes available to others, then it is still pertinent, but don’t plan on having such a chance.
Everyone has different criterion as to what constitutes “proof” that a market is going higher. Here’s an example: After a long bearish trend in the dollar, Itsukawa Importer sees that, because of the cheaper dollar, the price of widgets from US exporters is cheaper relative to his current supplier in the UK who wishes to be paid in Pound Sterling. Itsukawa decides to switch his sourcing to the US. He doesn’t know anything about the foreign exchange market; he just knows he needs to buy dollars to do business so he tells his bank to buy dollars at the market with his current yen denominated account. It just so happens that on this day a US trade number is released indicating that the trade gap is getting worse. But, since Itsukawa and his ilk are buying dollars, they soak up all the selling and the price doesn’t go down any further.
Steve Smartmoney doesn’t know why the price isn’t going down but figures if it can’t go down on bad news; it’s a good buy. The market’s not moving lower on bad news is proof enough for him. He buys, bidding the price up which causes some shorts to cover sending the price up further.
Tammy Technical doesn’t know why the market is going up either but she’s run tests indicating that, in the past, when the market has made 20-day highs it typically goes higher. She buys. More shorts cover.
Itsukawa’s bank sees the price going higher and calls him saying that if he’s content with the margin of profit he is currently getting from the price of widgets as they are, perhaps he should buy all the dollars he’ll need for the next year now so he can lock in this price and be assured of his current profit margin. Itsukawa agrees and buys more dollars. This happens to be on a day that a slightly bearish revision of the previous trade number is released, but Itsukawa and his ilk’s buying has eclipsed the selling from the bearish news and the market actually trades higher.
Steve Smartmoney likes this reaction to the news and buys a little more.
Carl Connected runs a hedge fund and is a big customer of the bank’s fx department. The dealer/salesmen lets him know that he’s seeing importers coming in for the first time in quite a while and Carl takes that information, along with the recent up move, to mean that the downtrend is over. He buys.
The next set of trade figures is released showing that Itsukawa and his ilk have been importing from the US. The dollar goes ballistic from Francine’s Fundamental Fund and her kind who needed some supporting economic reason before they began buying dollars. Sam Subscriber thinks this news is probably bullish but decides to wait for his weekly recommendation from Andy Analyst before buying. Elmer Economist doesn’t consider one month of trade figures enough to prove that the trend has turned and so stays on the sidelines.
Three months later, after the third set of bullish trade figures, Elmer Economist writes up an article for the Wall Street Journal, describing how this current up trend in the dollar will go on for the foreseeable future. More buying. Now there is so much proof that the dollar is going higher that even Otto Overlycautious buys.
This same overwhelming proof says to Steve Smartmoney that everyone who wanted to buy has already bought and therefore sells his long position to people like Otto. Meanwhile, Japanese goods are starting to seem attractive to US importers because of the strong dollar and so Independence Importers decides to begin buying Robot Dogs from Japan. They call their bank and buy Yen. Lo and behold, this just happens to be on the day the trade numbers are announced revealing the most bullish dollar numbers yet. Tommy Toptick, who knew he should have been buying all along and has watched all his friends get rich being long the dollar, finally places a buy order after the number. The problem is Carl, Fran, Andy, Sam, Elmer, Otto and anyone else who would consider buying have all already bought and the US importers are actually selling. Nobody knows why the market would go down on such a bullish number. But Steve Smart money doesn’t care…and the cycle continues in reverse.
Notice that every person described above needed different levels of proof before buying. The importers don’t need any. Steve just needs to see the market acting counter to the news. Tammy doesn’t need any fundamental reason to buy but she does wants to see price break a certain level. Carl likes the technicals but needs some sort of reason for it to be going higher which he gets from his FX dealer who saw the importers buy. Fran needed to wait for some fundamental data confirming the trend. Sam needed to hear that the fundmental data really did confirm the trend. Elmer needed more proof than Fran but less than Otto. For Tommy Toptick, reason and proof weren’t even an issue; he was buying out of panic of being left behind.
The more proof any of the above traders required, the higher the price they had to pay. The greater the proof, the greater the number of people to have already cast their vote that the case has been made for buying. Furthermore, the older information helping to make the case had already been acted upon, making such proof irrelevant to the bull case. This information was relevant, however, to the bear case, because it represented the pricing in of expectations and the existence of long speculative positions that were vulnerable to any contradictory data.
The contrarian doesn’t need any proof other than the existence of overwhelming bullishness and perhaps price action that suggests that all the potential bulls have bought. The benefit they get from being willing to buy when there is virtually no proof for the bull case is a cheap price. If you want a good price you have to be willing to give up on proof. If you want proof you’re going to have to be willing to give up a better price.