How to Trade Contrarian Markets
This lesson focuses on trading techniques during periods when 1) the Spread is falling, and 2) both relative strength leaders and relative strength laggards are rising. Rising contrarian markets are nearly as prevalent as rising strength–following markets, but not, on average, as profitable. These markets are, in the main, more difficult to trade. During these periods, traders take profits in relative strength leaders and retreat to relative strength laggards. Strong stocks are sold, and weak stocks receive new support. As a result, the overall market is likely to be choppy, and durable trends in individual stocks are less likely to develop.
Here are the most important features of rising, contrarian markets:
Traders are risk averse. Traders’ preference for sold-out laggards demonstrates that confidence in the trend is weak, even though the broader market is rising.
Capital flows from strength toward weakness. Relatively strong issues are sold and capital is redirected to laggard “bargains”.
The weakest stocks and groups advance the most. On average, stocks which have a recent history of weakness advance more than stocks with a recent history of relative strength. Apart from that general observation, however, relative strength–or weakness–does not provide a reliable guide to those individual stocks most likely to do best.
These periods are often transitional. Bottoms are being made, or the broader market is consolidating, or the market may be in transition from bull to bear. Periods during which the Spread falls may set up either a new round of strength-following or a substantial correction. Review: Reading The Spread
Durable trends in individual stocks are the exception.
Characteristics of Winning Stocks
RS laggard, but with improving relative strength. Traders are picking up bargains, which means RS laggards are picking up new sponsorship. New capital flowing into such stocks will show up as improved relative strength. Look for laggards with Worm charts indicating simultaneous improvement of both offense and defense. Review the Worm chart of the Europe Group in The Worm.
Either a large base of accumulation or an extended period of consolidation under the stock. Laggard stocks which have been ignored during previous market advances may now begin to attract attention. These laggards will have built up long bases of accumulation.
Oversold. Overbought/oversold indicators can be used effectively to filter candidates for purchase. Oversold stocks on or near solid support are the best candidates. However, do not remain in oversold stocks which continue to act sluggishly or which do not show improving relative strength.
An overbought indication is a signal to stop, look, and listen. If an advancing stock exhibits climactic action or high-low compression on increased volume, reduce your position. Contrarian markets are trading markets. Take profits.
Base Hits
Rising contrarian markets are a time for base hits and bunts. With few exceptions, stocks do not trend well, but trade in short bursts. Consider shortening your grip on the bat for quicker response. If you normally trade multi-day price swings, trade intraday. If you are a position trader, used to holding your position over multiple swings, consider trading each swing independently.
Reduce leverage. The odds of success are lessened by a falling Spread. Your ratio of losing to winning trades is almost certain to rise. Throttle back on trading size to reduce potential losses.
Since the profit potential of each trade is reduced during rising contrarian markets, it makes good sense to tighten up on loss control. Play strong defense. Review: How to Lose.
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