The Art of the Contrarian Trade

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Going against the flow is hard to do – in life and trading. In the markets, however, it can be wildly profitable.

It’s about zigging while they zag, and not following the herd mentality that is all pervasive in investing. A crowded trade is when everyone is on the same side of the market, and when that happens the market likes nothing more than to reverse and cause confusion and mayhem. Often abruptly.

Maybe it’s accumulating an unloved asset and waiting for the tide to change or perhaps it’s taking the other side of the trade when a company changes hands for silly multiples.

Simply fading a ‘fad’, which our illustrious host Chris Parry nailed to perfection with this call on ‘Pokémon Go’ also works a treat.

One of the tricks is to realize that manias and panics (which repeat themselves time and time again with alarming regularity – Tulips, anyone?) tend to overshoot in both directions, and you will need to be able to weather the storm after you take a position. Timing the trade anywhere near perfection is notoriously difficult.

Keep in mind also that long and short positions are not symmetrical. Shorting is much harder as you will generally have to maintain some type of margin if the market keeps roaring ahead before the anticipated turnaround. Positioning long will usually leave you with mounting paper losses until the crowd comes around to your way of thinking.

So take it easy on the leverage, don’t margin up and give yourself enough time to be right.

You also need to be a contrarian on both the buy and sell sides to maximize your profit potential. Buying when no one else wants to is great – prices are stable or falling. No competition. The ability to accumulate a good sized stake. When it’s time to sell don’t get swept up in the euphoria. The feeding frenzy that eventuates will have them falling over each other to buy your stake. Bids will race higher as the crowd fights to fill their positions. Meanwhile you’ll be laughing all the way to the bank.

More astute students of the market may wish to read this paper which looks at the effectiveness of magazine covers in pinpointing market turns, highlighting that the crowd is often wrong when it comes to investing.

“Consequently, we conclude that if an investor is short the stock of a company that is the
subject of a negative cover story, the publication of the story indicates it is time to cover the short position because the stock has hit bottom.”

You will need a high degree of conviction and insulate yourself to a degree from the opinions of others, whose thinking will have you second guessing yourself and your analysis.

Want some examples?

Gold

The barbarous relic. Back in the late nineties it could be had for close to $300 an ounce, but no-one could be arsed digging it out of the ground. It simply wasn’t worth it at that price. Mines were being closed and owning gold was as popular as Mel Gibson at a barmitzvar.

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Then it found it’s shine and marched on towards $2000 an ounce. You couldn’t own enough of it at that price, as the word on the street was that it was going much, much higher (Goldbugs!).

Where is it now?

Crude Oil

This beast is a traders wet dream. It trends so well that many must be shaking their heads wondering why they bother with the stock indexes at all. It blew through 100 bucks like a freight train and in March 2008 Goldman Sachs were talking it higher (hint: someone is always taking the other side of the trade.).

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Yep, that was close to the top. Then it meandered down to it’s sub $30 low earlier this year taking the economies of oil producing nations with it out to the woodshed.

Real Estate

Real Estate booms are the classic example, and one with which all Vancouverites will be well acquainted. Even if you are cashed up, is now a great time to buy?

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Notoriously hard to make profits on the short side, however, as detailed in Michael Lewis’ ‘The Big Short’ (I recommend the book over the film and his other titles are fantastic – Moneyball and Liars Poker are must reads for students of the markets.)

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All bubbles burst, eventually. Don’t be left without a chair when the music stops.

Sure you may not be able to sell the family home, but you could borrow against it’s value if mortgage free and use the money to diversify your portfolio which may help when the crap hits the fan.

What about downsizing and pocketing the change? A great option for anyone nearing retirement.

Coal

Earlier this year many were touting the ‘Death of Coal’. Everything had to be clean and green, right?

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It turns out rumors of coal’s death were greatly exaggerated, as they say. If you plonked your hard-earned into the KOL ETF back in early July this year you would now be sitting on a 30% plus return. That one trade could make a huge difference to your year.

Don’t follow the crowd

It’s been said that the best time to buy is when there’s ‘Blood in the Streets’. To see how effective the strategy can be, cast your mind back to the beginning of this year. With the exception of precious metals the price of everything else was falling into the abyss. RBS analyst Andrew Roberts sent out a client note calling for investors to abandon ship and “Sell Everything”.

Stephen Koukoulas , an Australian economist, challenged Roberts to put his money where his mouth was and structured a very favorable bet covering 11 different asset classes with an AUD 10K purse going to the winner. Here’s how that has worked out so far.

yet he seems reluctant, like many analysts, to back up their headline grabbing forecasts by putting their own money where their mouth is.

— Stephen Koukoulas

With the exception of the Nikkei index, all other assets are higher than they were on January 13th, with the average change in asset price being a healthy 18%. Nice one.

As Stephen says “In the current era of low inflation and low interest rates, that’s about 5 years return in just 8 months.

What about Roberts? Did he bite? Nah. Funny how the taking heads often aren’t prepared to back up their claims with some skin in the game. Not so here at Equity.Guru where the owner walks the walk and is nicely building his bank along with his subscribers.

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Always be on the lookout for times when the crowd is heavily positioned one way, and take the path less followed. It can be tremendously rewarding.

Is the US market topping?

No one ever rings a bell at the top, but the chart of the S&P 500 is painting a picture of a change in trend for the short term at least.

If we look at the macro events currently swirling around us, we’ve got the US Elections, the South China Sea debacle and a USA vs Russia fight worthy of a new Rocky film. Plenty of market moving fodder, not to mention any Black Swans. Game on!

Time for a fresh trade in the Russel Crowe vs The Turtle tug-of-war. To re-cap, we’ve had decent a winning trade in our GDX option play and a small profit after LAG.C disappointed after a good turn around. (we got taken out on that one with a trailing stop. It then took off without us on board. It happens.)

I’ve been sitting patiently in cash for a while waiting for something to jump out at me – trust me when I tell you that’s the hardest part. I think the signal from the US markets is pretty clear right now, and it’s telling me to get short. The simplest way to short the market is to buy a put option on one of the major ETFs, so that’s what I’m doing.

The SPY ETF tracks the S&P 500 index with one buck being the equivalent to 10 ES (futures) points. So with the futures trading at 2133 the SPY will trade 213 bucks and change. These (SPY) are actual shares, one of the most liquid ETFs on the planet.

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By the way, one graduation milestone for budding traders is when they start watching the S&P as opposed to the DOW. The former tracks 500 stocks and the latter only 30, but is still the main ‘newsworthy’ item when expressing market movements. If nothing else, I urge you to get a feeling for the S&P500 irrespective of what instrument you are trading (except maybe Palm Oil, OK you got me).

Looking at the SPY options chain a few days back I thought that the SPY161202P00212500 contract would be a good choice. This option contract (covering 100 shares of SPY) expires on 2nd December 2016 and is struck at 212.50. When I took a screen grab it could be had for $4.10 which works out at $410 per contract. I’ll take 5, and charge it to the Underhills! That’s a total outlay of $2050 which is the most that can be lost on the trade.

Now we need some type of a plan. I feel that the trade has been sized about right for the account size, and although possible, I don’t want to lose the entire amount, but I also don’t want to be shaken out of the trade by a short term gyration. This mandates that I pick a level where I’m pretty sure I’m wrong with my initial analysis. I’m going with 2158, as there should be some good overhead resistance at the 2140 level.

The reason that I am using ES futures to monitor the trade is that I am based in a different time zone than the US markets and will not be keeping a close day-to-day eye on the day session, preferring a few quick glances at the overnight market to see where I stand.

Therefore – If the SPY trades at 215.89 or above then I’ll recoup whatever time value is left in the option and move along. Why .89 and not .80 you ask? Superstition. More on that later.

As for a profit target? Reward is inherently entwined with risk, so if I’m willing to risk 38 points on the downside then I need to make a minimum of 1.5 times this so that works out at 57 points or a level of 2070. Small profits don’t help our overall objective of growing the account, they merely feed the ego. But with a ‘long’ option we don’t want to get too greedy, therefore we need to find some balance between these two objectives.

I also need a time stop with options because I am ‘short theta’ when purchasing an option outright (as opposed to writing one.) – this means time is working against me, and everyday I effectively pay a small fee for the privilege of being in the position. Just like being at the poker table, I have to ante up every time to see more hands, or in this case days.

The fewer days left until expiry, the less chance my option will be ‘in the money’ (thus having some intrinsic value). I’ll mark 11/11 down as a date that, if neither my stop or profit target are hit first, I need to walk away from the table and leave the fight to another day.

Plan the trade and trade the plan. There are now only three outcomes for this trade:

1) My initial stop is hit – ES 2158
2) My profit objective is reached – 2070
3) My time stop is hit – trade still open on 11/11/16

I can’t control what the market can do. Knowing what I will do in advance takes the emotion out of the trade and eliminates the most common destructive trading traits.

With voters heading to the polls on Tuesday November 8, I think I’ve bought the right amount of time. All things being equal I sit in the trade for the next 3 weeks and hopefully cash in my chips for a profit. We shall see.

UPDATE

The position has moved against me since entry but I’m hanging in there – bad trades are quickly taken out, and I fear this may be one of them. At the time of writing the ES is trading at 2147 only 11 points away from my stop. Make or break time in the next trading session.

You won’t always achieve the perfect entry, but I’ve found that’s it better to ‘pull the trigger’ when you’re confident in your analysis as if the market moves immediately in your favor and you waited you may be hesitant to enter at a higher price.

— Craig Amos


Credits:
Gold Historical – www.bigtrends.com
Crude Oil – http://www.macrotrends.net/
Vancouver RE – http://www.businessinsider.com/vancouver-housing-bubble-chart-august-2016-2016-8
KOL, SPY charts – Stockcharts.com

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