Contrarian Trading Strategy — What Is It? (Backtest And Example)
Last Updated on November 19, 2022
One of Warren Buffett’s investment advice is, “Be fearful when others are greedy and greedy when others are fearful!” That basically explains the contrarian trading strategy.
The contrarian trading strategy is one that goes against the prevailing sentiment in the market. In other words, it is a trading method that seeks to trade in the opposite direction of a recent move in a market. This means that you sell when others are buying, and you buy when others are selling. We present an example of a contrarian trading strategy (with backtest).
Want to know more about the contrarian approach to trading? Let’s dive in.
Contrarian trading strategy — definition
By dictionary definition, a contrarian is a person who takes a contrary position or attitude; in the investing/trading world, it specifically refers to an investor or trader who buys shares of stock when most others are selling and sells when others are buying.
The best strategies can be found in our….
Backtested trading strategies
Thus, the contrarian investing/trading strategy is a trading style that involves bucking against existing market trends to generate profits. It is an approach whereby a trader or an investor purposefully goes against prevailing market trends by selling when others are buying or buying when most others are selling. Such a trader sees buying opportunities in stocks that are currently selling below their intrinsic value.
The idea behind the contrarian approach is that markets are subject to herding behavior due to the fear and greed of the market participants, and as a result, the markets are periodically overpriced and underpriced, providing opportunities for contrarians. The contrarian believes that when the value of the market or stock is below its intrinsic value, it represents an opportunity. In essence, an abundance of pessimism among other investors can push the price of the stock below what it should be, and that presents an opportunity to buy the stock.
Contrarians are of the view that people who say the market is going up do so only when they are fully invested and have no further purchasing power. As such, the market is already around its peak when people are crazily bullish. In a similar way, when people are overly bearish, they have already sold out, so the market can only go up at this point.
Contrarian investors often target distressed stocks and then sell them once the share price has recovered and other investors start tripping over themselves to buy the stock. However, this sentiment can lead to missing out on further gains if there is general bullish sentiment in the markets and the stocks continue to rise after contrarians have already sold their positions. Likewise, an undervalued stock targeted by contrarians as an investment opportunity may remain undervalued if the general market sentiment stays bearish.
While being a contrarian can be rewarding, it is often a risky strategy that may take a long time to pay off, as the market may keep going down after you have bought or keep going up after you have sold. Another problem with contrarian investing is the need to spend a good deal of time researching stocks to find wrongly underpriced ones.
What is an example of a contrarian trade?
Contrarian investing is built around the idea that the herd instinct, which is often a result of fear of missing out (FOMO) on a market rally or fear of losing everything during a downturn (capitulation) doesn’t make for a good investing strategy. Instead, a contrarian takes the opposite trade, knowing that what follows a capitulation is recovery and that what follows FOMO is a selloff.
The contrarian method of trading can be applied to individual stocks, but it can also be applied to an industry as a whole or even entire markets using ETFs that track them. Contrarian opportunities come when there is negative news about a stock that causes the market to wrongly underprice it. For the broad market index, contrarian opportunities arise when there is a market crisis, such as the 2008/2009 financial crisis or a market bubble like the early 2000 dotcom bubble.
A good example of a contrarian trading opportunity in a stock would be something like Equifax (EFX) in 2017. That stock lost nearly 40% in the week in September 2017 following revelations of a data breach. By January 2018, the stock had risen 39% from its September 2017 low. By December 2021, the stock has made 320%.
Another example would be the panic selling of Chipotle (CMG) between May 2017 and February 2018 following reports of food poisoning that dominated the headlines for a while. By December 2018, the stock had risen from its February low of $248 to $531 — about 114% profit. By September 2021, the stock had risen to over $1950
A good example of a contrarian trading opportunity in the broad market index, such as the S&P 500 index (SPX) would be the market decline when the Covid-19 pandemic emerged in February/March 2020. The market made a 35% decline within a space of one month, but then, it recovered very fast and broke the pre-pandemic high of 3391 before September 2020.
Famous contrarian traders and investors
There are many contrarian traders and investors in history, but the five most famous ones include the following legends:
- Warren Buffett. The oracle of Omaha, as he is fondly called, is an American investor and the CEO of Berkshire Hathaway. He is probably the most famous and most successful contrarian investor in history. His phrase “be fearful when others are greedy, and greedy when others are fearful” has been a source of motivation for investors to buy stocks during downturns.
- George Soros. He is the founder and chairman of Soros Fund Management, later named Quantum Group of Funds. He is known for betting against the Bank of England and winning them.
- Jim Rogers. He is an American investor and chairman of Rogers Holdings and Beeland Interests Inc. He is also a co-founder of Quantum Group of Funds with George Soros.
- Nassim Taleb. He is a well-known contrarian who made a lot of money in the 2008 crash, but he most likely made his career during the crash of 1987. The hedge fund he’s associated with, Universa Investments, also made a huge return during the market crash in March 2020 due to coronavirus. Taleb is most famous for tail risk hedging strategies.
- Bill Ackman. Bill is an American Investor and the founder and CEO of Pershing Square Capital. He has made a lot of money using contrarian strategies.
Contrarian trading strategy – examples
In this section of the article we’ll provide you with some examples of contrarian trading strategies, all backtested with strict rules (and settings) for buy and sell signals.
The ultimate contrarian trading strategy is mean reversion. A mean reverting trading strategy buys when the asset falls and sells when it rises. This is classic oversold and overbought signals.
Most price action on a time series study shows that the trading takes place in clusters with a few outliers. Any contrarian trading strategy would most likely buy or sell such outliers.
Contrarian trading strategy example no 1 (contrarian approach example)
The stock market is pretty mean revertive in the short term while it tends to go up in the long run because of the tailwind from inflation and productivity gains. Let’s look at a short-term strategy that is a perfect example of a contrarian trading strategy (in our opinion):
When the 3-day RSI indicator crosses below 20, we buy S&P 500. After we have bought we sell when the close is higher than yesterday’s S&P 500 value. RSI is a very good contrarian indicator.
How has this simple contrarian trading strategy performed? It turns out it has performed really well. Just look at this equity curve:
Of the 448 trades it has generated the average gain is 0.64% and the win rate is 75%. Perhaps more impressive is that it has produced the same CAGR (7.6%) as buy and hold while being invested only 30% of the time! This shows that even simple trading strategies work well in the stock market.
However, such mean reversion strategies as this one don’t work so well in other markets, like commodity markets. The most obvious reason is that commodities are prone to many other factors than stocks. We find commodity markets very hard to trade.
Contrarian trading strategy example no 2 (contrarian approach example)
Let’s flip the trading rules from above to make a short trading strategy. We make the following contrarian trading strategy:
When the 2-day RSI is above 95 we buy the S&P 500 (SPY). We sell after N-days. To do this we use the strategy optimization function in Amibroker. When we do this we get the following table:
The first column shows the trading strategy performance metrics after exiting at the close N-days after entry. Column 3 shows the average gain per trade.
The long-term average daily gain in the stock market has been 0.04% since 1993. Thus, the gains over the next ten days after the buy signal are much lower than the “normal” gains in any random period. Only after about 20 days do we see that the gains “revert to the mean”.
Contrarian trading strategy example no 3 (contrarian approach example)
Any trader or investor should love a bear market. A short-term trader can take advantage of increased volatility and the opportunity to employ short sale strategies. A long-term investor can buy at lower prices or continue dollar-cost averaging.
There are many ways you can employ a contrarian strategy so as not to fear a bear market. In a previous article, we covered four ways to make a contrarian bear market trading strategy.
Contrarian trading strategy – ending remarks
Any contrarian trading strategy might be harder to execute than many other trading strategies. The reason being is that you go against “the crowd”. This requires some kind of guts and willpower. Nevertheless, if you want to make money in the financial markets you need to have courage to enter outside the most traversed paths. Conventional thinking will most likely never reward you with alpha or outperformance. Because of this, most traders and investors are better off investing in mutual funds and “forget about it” to hold for the long term.
But for those brave enough, a contrarian trading strategy might be very profitable.