Understand fatal flaws of Contrarian Trading

The idea is that the best time to buy is when the market is at its most pessimistic, the best time to sell is when the market is very optimistic. In practice, it is hard to tell when investors are very pessimistic or optimistic.

In hindsight, we know these points correspond to lows and highs, but looking forward it is harder. For every seller there is a buyer. When certain brokers advise to sell, others advise to buy. The key is in identifying marginal investors. When people who rarely invest begin to buy stocks, the market is probably at the top. When these same people are selling, the market is probably at the bottom.

Some investors play Doubling Up to take advantage of contrarian thinking. Proponents suggest that as the price of a stock falls, you purchase twice the previous size. If the price falls again, you double your purchase again. The logic here is that when the rebound occurs, you will profit handsomely as your average price would then be very low.

The fatal flaw is that price may not rebound, in fact, it may stay low, fall even further, or the stock could be delisted. You may not have the stamina and nerve to stay all the way. In many cases, you run out of funds – in which case, you could lose everything.

Example: A colleague who traded in the Eurodollar interest rate futures pit in Singapore built up his capital by filling orders for a few broker houses. Occasionally he traded spreads between longer-term and shorter-term interest rates. In mid-1989, the spreads began to widen to near the historical high so this colleague started a position. When it widened further, he took bigger positions. This happened several times, and his advisors said the trend would revert. It didn’t but instead the spread widened to way beyond previous highs. When he couldn’t top up the margin, his clearing house closed all his trades and he lost everything.

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