The Importance of Contrary Opinion

Think about it. The vast majority of beginning traders (80% to 90%) fail to succeed in the first six months and give up. Of course, they don’t all take the time and the care that you are in learning to trade, so failure is quite likely. Nonetheless, what does that say about whether you should trade with the herd, or whether a contrary view might be more worthwhile?

Contrary Opinion is best described as the idea that when the vast majority of people agree on anything, they are usually wrong. I’m not suggesting that you always do the opposite of the majority, but you should certainly consider that alternative. It’s really a psychological concept, removed from the numerical constraints of fundamental and technical analysis.

Though expounded by Neil in his book ‘The Art of Contrary Thinking’ in the 1950s, it was in 1964 that Sibbet applied the principles to the futures market. He started an advisory service that polled the weekly market advisory letters for bull or bearishness, and quantified the market sentiment from them. The assumption was that many traders are influenced by the letters, so they represent the overall futures market.

The Contrary Opinion theory is really not as far-fetched as it sounds. There are reasons that it might work. Consider that traders act on the advice of the newsletters that they receive. If the letter is bullish on the future, they will adopt an aggressive attitude to their trading, and commit all they can afford. At this point, you could say that the trader is ‘overbought’, as they have no or little extra money to take up any new trades.

Now if the majority of traders take this stance, there won’t be much money left to push the market any higher. If the market can’t go higher, then it is overbought as a whole, and looking for a correction. So out of a general bullish attitude, we get a market that cannot sustain the prices. Once sentiment is strongly expressed in the market, then there isn’t enough buying or selling capacity left to sustain the trend, whether bull or bear.

Another way of looking at the philosophy of Contrary Opinion, specific to the futures market, comes from the fact that futures’ trading is a zero sum game, less any charges. This means that every contract has two sides, a long and a short. Now if 80% of traders are optimistic and on the long side, then the remaining 20% who have the short positions must be very well financed to be able to hold so many contracts. One point of view is that the smaller traders in the long seat are weaker, and if there is any turn in the prices they will be forced to liquidate their positions quickly. Once again, the sentiment of the market points to its unsustainability.

These arguments only apply when the sentiment is at an extreme, as otherwise there is scope for discretionary spending. It’s normally reckoned that the neutral sentiment point is about 55%, as there is a natural bullish bias amongst traders. This means that the extreme overbought position is when the bullish sentiment is over 90%; and t oversold condition is below about 20%. If these numbers are approached, then that is a warning for the trader who believes in Contrary Opinion. Even if the extremes are reached, it’s probably wise to wait until a break in the trend before trading against it.

You can also learn something from the open interest that has been expressed in the market. When open interest is high, contrarian positions are more likely to prove correct; however, you shouldn’t consider a contrarian trade while open interest is still rising, as that shows continued support for the current trend. I mentioned the Commitments of Traders Report in Module 5, and this breaks down the open interest by type of trader. You should check that not more than half is held by hedgers, as they are considered to be well financed and in a strong position. It’s far better to trade against a mainly speculative market.

You can get further clues on whether a contrarian stance would be worthwhile by watching the markets response to good or bad news. If the market is up and may be overbought, then a failure of prices to rise appropriately on good news is a clear sign that it really is stretched, and a reversal may be near. Conversely, if the market is down and may be oversold, and bad news does not further depress prices, then it indicates that the market has taken into account in the current price any bad news that can emerge, and the slightest bit of good news may turn the tide.

Of course, I’m not saying that you should always trade against the majority. In fact, I can’t say it too often, most of the time you will want to trade with the trend, which by definition will be with most traders. Where contrary opinion comes into play is when you can see indications that the market is reaching an extreme, and having a familiarity with these ideas should allow you to watch out for and get in early at any point of change. The sentiment of traders is what you must watch for, and be prepared to disagree with.

Prediction versus Trend

People talk about contrarian investing, cliched phrases are bandied about. Some of the most common cliches I have encountered are:-

buy when people are selling in panic and vice versa, buy low – sell high, buy high sell higher, the list goes on and on. I am not saying that these phrases are wrong. My only concerns are, when is low and when is high?

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