Confusion exists between the definitions of contrarian and bear. A contrarian tends to act opposite the majority view of the moment, whereas a bear believes that markets are in a long-term downtrend.
A true contrarian is not concerned so much with whether the current circumstances are typical of bull or bear markets. Instead, a contrarian investor or trader does not always go along with the majority view, but observes that the majority often is wrong. With this in mind, the contrarian strategy is to take the opposite action to that of majority opinion – not always, but often. It is not just the automatic contrary action that defines this type of investor, but the questioning of consensus opinion and convention wisdom typified in crowd behavior. A contrarian sees majority opinion leading to overreaction to short-term news; as a consequence, price moves too quickly in one direction or the other, and is likely to adjust in the near future. So when a stock’s price rises many points in response to slight earnings disappointments, a contrarian is likely to sell a covered call or buy a put – two examples of behavior moving against the majority view. In other words, the contrarian makes trades for reasons contrary to the majority, and not just to be, well contrary.
The same applies when prices fall. When most investors sell stock to avoid further losses, a contrarian questions whether the decline in price is rational given the news or conditions that led to the decline. A likely action would be to buy stock after a sharp drop, or to buy calls in the belief that prices will rebound, reversing at least part of the decline.
Some confusion comes into the picture because some contrarians are also permanently bearish. No matter how good the news and no matter how much prices move upward, the bear contrarian predicts catastrophic market declines and perhaps even complete collapse. However, the permanent bear contrarian is not a true contrarian because this opinion works only in one direction. A “pure” contrarian recognizes that the majority of traders are often wrong and prices are driven too far in one direction or the other, and usually correct in the coming two or three sessions. In fact, being bearish all of the time is just as myopic as being bullish all of the time. It does not always work.
So bears and contrarians are by no means the same. A bear has a permanent view of impending collapse in market values or, often rightly so, acknowledges that a falling market is also a long-term bear market. A contrarian sees opportunities in all sudden and substantial moves in either direction, knowing that in the short term, price levels tend to constantly correct such movements. Most swing traders are contrarians in the sense that they time decisions based on entry and exist signals rather than on emotions. This is the key to the contrarian approach – acting out of analysis and logic, and not out of emotion.
The dominant market emotions, contrarians observe, are greed and fear. Greed comes into the picture when prices move up. Traders jump in to get a piece of the action, so that buying activity is often found to be at its peak right as prices top out. Fear is seen at or near price bottoms, when those with long positions sell in the belief that prices will move lower. So the contrarian truly does follow the advice to “buy low and sell high.” The great secret contrarians know is that most traders do the opposite.
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