Warren Buffett is said to be a contrarian trader. But what is a contrarian trader you ask? Put simply, a contrarian trader is someone who buys when most others are selling and sells when most others are buying. This is a part of the art of trading. That is, a trader needs to know when to take profit and when to buy into a stock. Buying while a stock is falling off a long term high is not advisable. Neither is selling at the start of an uptrend. The point is, the contrarian trader needs a means to identify “the top” and “the bottom” of a market, then to efficiently time trade entries and exits to take advantage of an up or down move.
To say one should sell on the way up and buy on the way down might sound odd, but it’s not. In fact, one of the best times to take profit on a winning trade is when the price is rising late into a long-term uptrend. There is a caveat though. Firstly, and obviously, there needs to be a profit on the table to take advantage of. Secondly and obviously again, selling as late as possible in an uptrend is ideal. But how can we know that a trend is mature and about to reverse? There is no crystal ball that can tell us when a stocks price is about to change direction. However, there are indicators that can help us see that an uptrend is mature and more likely to reverse.
A quick search on Google will reveal many articles on the Phases of the Market. There is no need to exhaustively regurgitate those articles here. Suffice it to say, stock prices and index prices follow a cycle of rising for a period of time, then slowing and moving sideways for a time, before rising again. After two or more of these cycles, the next sideways movement tends to be in the opposite direction. Search ‘Phases of the Market’ and set Google to display images to see the theory explained ad nauseam.
The point is that when a stock has been in a strong trend for a long time, buying into the stock may lead to having to sell it again when it moves into a downturn. However, if a trader tracks that downturn until the price nears the level of a prior reversal to the upside, there is a better chance of buying in “near the bottom”. This means a trader might buy while the stock is out of favour and seen in a negative light. A savvy trader will wait for a long term low price and then an see an upturn before buying into the stock. Once a position is open and assuming the stock has moved back into an uptrend, the next task is to look at the long term high and judge when the stock is likely to meet resistance to the long term high price and perhaps end its uptrend. Selling while the price is near a long term high and buying at a long term bottom is contrarian trading. The trader is using negative sentiment about a stock to capture a discount, then when the stock is popular again, the trader sells before the price moves into the next down cycle.
Of course there are many tools and techniques available to calculate where these turning points may occur. A meaningful explanation of those techniques is beyond the scope of this blog. However, keep an eye out in the blog library for more about turning points and how to read stock psychology.
One important aspect of trader psychology, is a tendency for traders to hold losing positions and sell winners. At first this might sound logical, but it often leads to losses. Traders who trade this way will hold onto losing trades because they believe the stock will come good eventually. They also believe that taking a profit while it is on the table is best. They want to capture a profit before it evaporates. However, the thinking needs to be turned around completely. Winning trades should be kept open for as long as possible, while losing trades should be closed off as soon as possible. Doing this alone will help preserve capital and improve both the traders win loss ratio and profit to loss ratio. It’s best to get rid of your losers and ride your winners.
