Money Management & Contrary Opinion Trading

| | behavioral finance, sentiment

Contrary-opinion trading is perhaps the best solution to market madness and also noise in the markets; it is a “thinking-man’s” trading tool.  A Contrarian is defined as:  a person who takes an opposing view, especially one who rejects the majority opinion, as in economic matters. In a nutshell if a CTA / Money Manager is trading as a contrarian they are simply establishing positions opposite to the prevailing majority opinion, and trend in the market.

Is being a Contrarian a profitable and viable strategy?  That’s a challenging question to answer unless you have some quantitative measure to go by and compare results to.  There are many services out there that pull together “bullish sentiment”, from reading through market advisory services newsletters, or other indicators such as volatility, open-interest, Put to Call ratio’s, or any such indicator which tries to “take the psychological temperature” of the market(s).  The theory and rationale behind the notion that trading contrary to the prevailing market opinion is that, it is well known that the majority of all traders and investors lose money when they begin trading commodities or stocks, they then turn to professional sources, namely brokers and market-letter writers for advice. If one could then measure the sentiment among the respective advisory services and brokers influencing trader’s activities, one would have a pretty good idea of the psychological state of the market.  If you are able to determine that the majority, by a large percentage (over 80%)- are “bullish”, then it could stand to reason that – everyone is on the same side of the boat, and if everyone’s on the same side of the boat it will usually tip over or capsize– as there is no one left to buy.

The way a market sentiment indicator should be designed is so that it measures the “percentage” of bullish psychology surrounding a given market, as well as the bearish sentiment.  It should be broken down on a scale from 0% to 100%, and then trading rules can be designed around these percentages. Example:  If the bullish sentiment reading is above 80%, this could signal that everyone is bullish and on the same side of the boat, and a short selling opportunity could be developing.  You could also use the market sentiment indicator in confluence with other trading tools, such as trend lines, support and resistance, Fibonacci levels, etc.

In this day and age there are a number of different indicators and sources to explore, in order to come-up with your own way to determine the bullish sentiment in any given market. (And I highly recommend doing so).  Or you can subscribe to a service that specializes in determining “bullish sentiment” and gives you their opinion.  I would recommend back-testing and researching any indicator or news service thoroughly before putting your money into the markets based on taking trades contrary to the prevailing trend.  Here are a few concepts and rules to look at and use, once you have determined which bullish sentiment indicator you have faith in and are comfortable with:

 

–      There are two ways a CTA / Money Manager will use the bullish consensus indicator:  as a contrarian trend tool and also as a trend-following method.  When they take a contrarian trade they are always going “opposite” to the prevailing market trend and sentiment.  Rules of thumb:  They can place a contrarian trade whenever the Bullish consensus exceeds 80% or is less than 30%.  Between these two extremes, they may use the indicator for non-contrarian, or trend-following trades.  In short, when the consensus is at its extremes, they trade against the trend, when the consensus is mixed or hovering around the middle area, they take trades that go with the trend.

 

*** I wish to point out that there is a big difference between saying that “the majority is always wrong in the marketplace” vs. “the majority is always wrong at the major reversal points in the market”.

 

–      An overbought or oversold condition begins to occur when the sentiment exceeds 80% or is less than 30%, and the Open Interest is either stable (changing less than 4 percent per week) or is decreasing.

 

–      When the indicator is in the 60 – 80% area and a large decrease occurs (10% or more in 2 weeks’ time), a sell signal is issued.  When the consensus is in the 30 to 50% area and a large increase occurs (10 percent or more in two weeks’ time), a buy signal is issued.

 

–      Usually when CTA’s / Money Managers trade using this method they only want to trade markets that are liquid and have a large Open Interest, to work best.  These are the markets with the most participants.  A small or thin market is more easily manipulated by large trading interests and less responsive to the “emotionalism” that affects the crowd of speculators.

 

–      Only take a contrary market position that is contrary to a crowd of speculators – Not Hedgers.

 

This article serves as an introduction to the theory and concepts of how CTA’s /  Money Managers may take trades based on a contrary opinion indicator.  There are many more details and subtleties to be taken into account in order to be competent in using this methodology for trading.  If you have an interest in learning more about current CTA’s & Money Managers that use this sort of methodology feel free to click on a link below.

 

http://www.iasg.com/Groups/group/Salus-Alpha-Capital-GmbH/Program/Salus-Alpha-Directional-Markets

 

http://www.iasg.com/Groups/group/FORT-LP2/Program/Fort-Global-Contrarian

 

http://www.iasg.com/Groups/group/Piston-Trading/Program/The-Piston

 

http://www.iasg.com/Groups/group/pacific-capital-advisors/Program/vanguard-program

 

 

 

For further information please call us direct at: 312-561-3145 or email: info@iasg.com.  You can also reach us through our website at:  www.iasg.com