Any trader worth his salt will tell you that he thinks differently about the markets than most. This is where he gets his edge against the competition. In other words, good traders tend to be contrarian thinkers.
Although anyone can say they’re a contrarian, going against the prevailing herd mentality is not easy. In fact, it can be quite difficult. This can be directly attributed to the fact that human beings have an inherent tendency to feel most comfortable following the herd, making it hard to be an independent thinker. These common phrases depict that notion quite well; “Don’t be a party pooper” and “Don’t rock the boat”.
The same goes for the market; it’s much easier to go with the flow. To be successful in trading however, going with the plurality is not always the best course of action.
This leads us to the stark reality that the vast majority of people who attempt trading fail. If this is indeed the case, wouldn’t it make sense that fading (trading in the opposite direction) of these traders would be a profitable venture? Well, it’s not quite that simple. There are times when the herd actually does make money. Such as when markets are trending in a strong fashion. It’s knowing where the trend is likely to change that differentiates the contrarian from the herd. In trading, understanding the difference is key to being profitable.
When I got my first job as a broker back in the summer of 1987, I was fortunate enough to be around a very talented trader who taught me a great deal about contrarian thinking. He would tell me things like, “The market’s main job is to inflict the maximum amount of pain on the most people.” At first I thought, “Wow, this guy sure is cynical,” and frankly, I didn’t believe him. Later though, as I gained more experience, I began to understand exactly what he meant.
This became really evident as I witnessed first-hand, times when the market would go into states of panic selling. Since the vast majority of investors are long-only, these periods would be very painful for the majority, and as the market reached its capitulation (give up) phase, only the strong were left standing since most had to sell just to alleviate their pain. A contrarian should be able to spot this on a price chart and buy from these frightened sellers.
Fast forward to the present, the market has been range-bound for several months now and no one really knows how long this will last. One would think that because the market is at elevated prices a contrarian would be looking to short the market. This is not necessarily accurate. From a contrarian view point an interesting phenomenon has been occurring. Every time the market has even the slightest pullback, everyone jumps on the “big correction coming” band wagon. I know this because I see it in the sentiment readings that I follow. These show that traders start loading up on put options and inverse funds at every instance when the markets shows any sign of weakness. What’s also noteworthy is the amount of skepticism about the durability and quality of the rally. This leads me to believe that there are many investors that are under-invested, and at some point will end up chasing this market as they feel that they’re missing out.
In my experience, markets top when the last holdouts begrudgingly join the party and the shorts finally give up. At the time of this writing, I’m not seeing this. If we stay patient however, and look at the market objectively, the market will show us when it has topped. It is at this point that shorting may work better. Incidentally, since futures trading is a zero-sum game, being on the winning side of a trade quite often means you’re going against the short-term consensus.
Until next time, I hope everyone has a great trading week.