Contrarian trading strategy: Definition, how to use and examples

Do you like to go against the flow? If you are not the kind of trader who is a follower and you enjoy being a leader, then contrarian trading and a contrarian type of trading strategy may be just for you. A contrarian trade is one that goes against the general sentiment or a recent market move regarding an individual stock or anything else that is traded. It could also be an upward or downward move.

While many traders have heard of a contrarian approach to trading, they tend to fail to put it into practice. The very common expression “buy low and sell high” may be very obvious, but again, only a handful of traders practice it. Warren Buffett’s famous adage, Be “fearful when others are greedy and greedy when others are fearful,” may have become a cliché, but it couldn’t ring more true.

Definition of Contrarian trading strategy

Contrarian trading refers to trading strategies that are based on going against the current market sentiment. However, such strategies are more complex than simply going against the trend. Market trends are powerful in the financial markets, and identifying them or knowing when to go against them takes knowledge and deep understanding. Additionally, it is noteworthy that many successful traders are contrarians, and some of the most famous traders in history were those who took big bets against the market when everyone else chose the easy road and followed current trends.

Are you a contrarian?

The markets are unpredictable in nature, and being a contrarian is very difficult. If a trader is very educated, they can succeed, but even the best traders have incurred losses. So, it is hard to

follow contrarian trading strategies. These strategies tend to be used in CFD trading, as traders can follow how an underlying asset performs and act accordingly.

What is an example of a contrarian trade?

Contrarian trading revolves around the idea of herd mentality, which is the result of FOMO (fear of missing out). A contrarian will take the opposite trade, knowing that what follows a retreat is recovery and that what follows FOMO is a selloff. It can be applied to an industry, a market, or a specific stock. Traders may go after contrarian opportunities, which tend to arise when there is bad news about an asset that could lead to it being underpriced. An example of this is the 2008/2009 financial crisis or a market bubble like the early 2000 dotcom bubble.

A good example of a contrarian trading opportunity in the market index, such as the S&P 500 index (SPX), would be the market downturn during the COVID-19 pandemic, which started in February/March of 2020. The market experienced a 35% decline within just a month, but soon recovered and broke the pre-pandemic high before September 2020.

Understanding market sentiment

Contrarian trading is all about market sentiment, psychology, and herd behaviour. These factors are basically what we may call fear and greed.

Traders are not always rational and calculating, but they take decisions based on instinct and what other people around them are saying or doing. This is evident in market sentiment. When market sentiment is bullish, this can be seen in the tops of trends, whereas when market sentiment is bearish, it is exemplified by the bottoms. This reflects the constant change from greed to fear and from fear to greed that drives the market.

Contrarian trading strategies are based on identifying market sentiment and entering and exiting trades when corrections to market sentiment are about to take place. While it sounds easy, executing this is much harder.

Turning trend

Going against the current market sentiment is an easy way to lose money. Contrarian trading, then, is all about a trader’s skill to identify trends and when they are about to change. To recognise turning trends, traders may use a range of useful indicators to identify the tops and bottoms of trends. Others may look at what other traders are saying and doing so they can decide whether market sentiment has reached peak bullishness or bearishness.

Every contrarian trader may have their own unique trading strategy, but it is usually one that is based on the assumption that market participants are driven by fear and greed, and it is possible to identify when these opinions are about to turn.

Being sceptical and cautious of market sentiment is a valuable quality for a trader, and contrarian trading is all about knowing when the current market sentiment is wrong and being able to act when people are going to start recognising it.

Being able to recognise when markets are about to turn, in the short-term or long-term, is very important. 

Timing your contra moves

• Use support and resistance levels
• Make use of indicators that can show when things are about to change and can identify tops and bottoms, such as the MACD or RSI
• Look for changes in the tape at critical levels
• Catch a pullback in a trend or the top of an overall change in that trend by timing an over extension into an important level along with tape confirmation

If all of them line up at the same time, then you may have a successful contra trade.

With contrarian trading, you can catch the beginning of a change in trend, which may set you up for a great trade. But contrarian trading can be lonely and stressful, and more often than not, you may feel you’re the only one making a massive decision with too many risks. Timing contra trades is also an art form and takes time and practice, so don’t get hopeless. Start with small trades and make the most of each trade by expanding your skills and knowledge.

Key contrarian strategies in forex trading

Contrarian strategies in forex trading can be distinguished into two categories: reversal trading and fading.

Reversal

Reversal traders try to determine those moments when the market will change direction, commonly known among traders as tops and bottoms. Traders would anticipate a reversal at these two extreme points, based on the assumption that the majority’s opinion could be false. Identifying these points is difficult and challenging and requires a good understanding of technical analysis and sentiment indicators.

Fading

Fading is all about making short-term trades against the trend. A fader might sell if a currency pair is going up, anticipating a short-term price fall before the price recovers again. Fading relies on accurate timing and, for this reason, is considered a short-term strategy.

Techniques for Contrarian Trading

Contrarian traders will combine technical analysis and sentiment analysis tools, use economic indicators, and follow news events to identify trading opportunities. A successful contrarian trader will have a good understanding of market psychology and will be very disciplined with risk management.

If you want to become a contrarian trader, you can explore contrarian strategies on a demo account before moving on to live trading. When executed correctly, contrarian strategies can provide you with rewarding opportunities as long as you are willing to experience the good and the bad, the emotional stress, the changes of the market, and retain your calm against the trend.

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