By Gabe Velazquez, Online Trading Academy E-minis Instructor
At first blush, you might think the title of this piece may be better suited for a Country-Western ditty, but in actuality, it's on old saying that is widely used among floor traders on the major stock and commodities exchanges. The reference is of course the contrarian point of view held by most professional traders.
One of the prominent themes I'm continuously writing about is that of being a contrarian thinker. Getting people to change their perception, and think against the grain of conventional wisdom is, in my opinion, part of being a good trading coach.
In my last newsletter, I attempted to disabuse readers of some market myths and misconceptions. In this missive, we'll explore contrarian thinking and why (although it feels more comfortable when everyone thinks the same way you do) it pays to think differently from the crowd.
For two recent examples of contrarian thinking at work, let's first look at Friday August 28. The NQ (E-mini Nasdaq 100) seen on the lower chart, gapped higher on the combination of Dell's upbeat earnings, and Intel's optimist forward guidance. The crowd, in usual fashion, took that news as very bullish and piled in on the open with little regard to risk-to-reward ratios or any other considerations that would make buying the NQ at these levels a less-than-desirable trade.
Figure 1
The contrarian trader, on the other hand, having a different mindset than the herd, sought out a potential shorting opportunity, realizing that when price is extended and approaches a strong area of resistance, the probabilities favor shorting. One would have to go back to September of last year (chart below) to find such a level.
Figure 2
As you can see from the ensuing drop, shorting (as opposed to buying) into that area turned out to be the better trade. Some readers might be thinking, "Sometimes the crowd is correct, and buying when the news is good can be profitable." My reply would be that a small percentage of the time that assumption would be correct; however, a contrarian thinker understands and uses mass psychology to improve his/her edge in the market place.
The last example I'll detail came on Tuesday, September 1st. Here we see the ES (S&P E-mini) gapping lower amid overnight weakness in the Shanghia index (a proxy for the Chinese stock market). The crowd nervously sold the pre-market because of the prevailing notion that a big correction would be imminent, and the sell-off just experienced the day before. The contrarian would have seen the market opening near a prominent support area and would have been looking to fade the gap (go long) right from the outset. In addition, the pending home sales number, and ISM manufacturing index was due for release at 7:00 a.m. PST. A contrarian trader would have been attuned to the generally positive reaction of most economic data by the market as of late, which would have added to the odds of trading on the long side early in the session.
Figure 3
After the release of the economic data and the ES filling its Friday gap (resistance), these were the headlines crossing the news ticker:
Pending Home Sales Soar to 2-Year High in July
Manufacturing Index Shows Economy Escaping Recession
The crowd of course, took this as further evidence to continue the buying spree. Conversely, the contrarian understood that the top of the gap usually acts as a resistance area and that regardless of how good the news may have been, this price level should be viewed as profit target on long trades. Additionally, a low-risk entry for selling short at this price point would also make good sense. The gap fill, as it turned out, became the genesis for the dramatic market reversal we saw on Tuesday. Anecdotally, the big sell-off, in spite of the upbeat news, had the herd quite perplexed.
All in all, human beings are herd animals; safety in numbers is part of our DNA. Perhaps it's a survival mechanism, or just that we have the need to belong to a group. It's reflected in our culture with catchphrases like, "Keeping up with Joneses", and "Misery loves company." These human traits may serve us well in other facets of life, but in the trading arena, they work against us.
In my many years of being involved in this business, one common thread I've observed among successful traders is their fierce independence. These folks are not easily swayed because in large part they do their own work and take complete responsibility for the results they produce. That can be hard to do for the majority, as it's easier to deflect the blame for ill results to other people or extraneous circumstances.
So emulate what the very few do, because in trading being unique is a great quality to possess.
Until next time, I hope everyone has a profitable week.
If you have questions or comments, please email me at gvelazquez@tradingacademy.com
- Gabe Velazquez
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