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Chapter 4- Explain the Day Trading Strategy Known as Contrarian Investing

Day Trading As a Contrarian Investor

Contrarian investors that day trade are primarily looking for inflection points on a given security or investment. These inflection points are points in time in which the market price momentum on a position quickly stops and reverses course. In short, contrarian investors observe the direction the market price is currently heading in and bet against that momentum in order to gain when the market reverses course. The key for contrarian investors is to identify these inflection points in order to maximize short-term profit.

Contrarian investing can be a particularly profitable way of day trading as securities can often be purchased at amounts significantly below what their fair value truly is. This is best detailed in an example. If a stock is currently dropping in value, a contrarian investor would be more likely to bullish on this stock. To maximize their profit, the contrarian investor would attempt to identify the point where the stock is at its lowest. A good way to profit off of this trade would be to buy a call option on this stock that is short-term in nature. By being a contrarian investor, the investor would be purchasing the call option at a price that is significantly below the value that it was earlier in the day or week. As the stock bounced back from its lows, the contrarian day trading investor could possibly realize a significant return from the trade.

Due to the short-term nature of day trading an investor is attempting to identify clues regarding when these inflection points are likely to occur. As it can be difficult to pinpoint the exact moment when these moments occur, day trading in a contrarian manner is wrought with risk. There are certain common strategies and trends that contrarian day trader investors look for when attempting to identify inflection points in stocks. A contrarian day trader often trades more based upon chart analysis rather than company fundamentals, though sometimes both are at play in their analysis.

Having said that, contrarian trading is not as risky as it may seem. This can be shown through an example as well. If a stock has dropped ten percent and you are a contrarian investor, you will bet that it will reverse course and increase. Many investors advise against this and call doing so “catching a falling knife”. While this can be risky, at least in the short-term day trading model, there is a limit to how far a stock can drop. As you have already missed part of the drop, your risk is now limited even if you were to predict the incorrect movement in the stock.

Volume is one of the common triggers of inflection points. Significant volume spikes are often an indicator of a coming inflection point in a stock. This is because during significant increases in volume, anyone who is looking to purchase (if the stock’s momentum is up) or sell (if the stock is decreasing) is likely to doing so. If you are bullish on a stock you are less likely to be bullish after the stock increases. All those who are interested in buying the stock effectively do so at this point and the market runs out of buyers. This is called stock exhaustion. Once a stock is exhausted the price tends to reverse course. Contrarian investors search for volume spikes and compare them to significant stock movements. This strategy is often used in conjunction with other factors to anticipate when a stock’s momentum will reverse and a contrarian investor can therefore profit.

Trend lines are another tool used by contrarian investors to determine when a stock will likely turn. Common examples of trend lines that can be useful are moving average lines. 50 day moving average trend lines are effectively regression lines that track the past stock price for a position. These lines form either resistance for the stock price if they are above a stock’s current price, or support if the moving average line is below the current stock price. If a stock price is currently plummeting with high volume, a contrarian investor would likely utilize this moving average trend line to determine if a stock price is likely to reverse.

In addition to chart analysis, contrarian day traders will also use news and fundamental analysis to identify inflection points that symbolize a turn in the stock price. For example, if a company were to announce solid earnings and the price were to skyrocket upwards as a result of this news, a contrarian investor would wait for the momentum of the stock to wane, and then short the stock, purchase put options on the stock, or sell call options. Effectively, a contrarian investor is the theoretic opposite of a momentum trader. Identifying when the momentum on an investment will wane is the risky part of contrarian trading.