Some among us are perpetual contrarians. When the market is going up, they think it should be heading down before long. When the market is going down, they think it should go up soon. However, for each transaction there must be a buyer and a seller, so one party is always a contrarian based on the prevailing trend. The question becomes whether or not it's possible to make money while always believing the market will reverse its course.
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The short answer is yes, but it requires an understanding of three things: that opinion and action are two different things, that trends are where the money is and that price confirmation is needed for any reversal.
Opinion and Action Are Different Things
If you find that your natural tendency is to be a contrarian, you must realize that there can and should be a difference between opinion and action. If the market is rising and you feel it will eventually collapse, you don't need to act on that opinion right now. Opinion can be separated from what is currently going on – this will allow you to profit by trading with the market right now, instead of believing your opinion should be right at this time.
For more on indicators that contrarians monitor, check out Why is the disparity index indicator important to contrarian investors?
Opinion and emotion can wreak havoc on trading profitability, especially when traders develop very strong opinions or emotions. This is where it becomes imperative to design a trading plan before you start trading. This will allow you to act in a way that is aligned with your trading methods despite opinion or emotion. Trading on opinion can be very costly - the market can be "wrong" a lot longer than a trader can afford to be "right." A trader can design such a trading plan any way they wish, whether by trading with the trend, or watching for high probability reversal points. The key is that contrarians must not act only on opinion, but must take other factors such as actual price movement into account.
Trade With the Trend Even if You Don't Believe It
The development of trends is what allows the majority of traders to make money over time. A contrarian can trade in the direction of a trend, even if he or she feels it will reverse at some point. A trend will always reverse simply because prices do not move in one direction forever.
But just because a trader has an opinion about what the market will do, doesn't mean he or she has to act on it. Trading with the trend will allow the trader to capitalize on market moves while they are occurring instead of always waiting for a reversal. While markets do reverse, trends can last for a long time, even in the face of information that indicates otherwise. Since most individual traders can enter and exit the market with relative ease to due to their position sizes, trading against current price movements does not need to occur. (For more, see Keep It Simple – Trade With The Trend.)
An uptrend is defined as higher highs and higher lows, while a downtrend is defined as lower highs and lower lows. Therefore, all traders have a guide as to when trends are present. A trader can draw lines on a chart, called trendlines, along the price lows and price highs to give themselves a visual representation of the current trend. The current direction of the trend is where trades should be placed. When the trend actually appears to be in jeopardy based on price action, then the trader can begin looking for reversal trades that fit their contrarian view.
Trends occur on multiple time frames, therefore it is also important that a trader have a time frame for any given trade. For example, a one-minute time frame would not provide the relevant trend information for a long-term investor, just as a weekly chart is unlikely to help a day trader move in and out of positions. Analyzing multiple time frames can aid all traders in finding high-probability entry and exit points. For example, a pullback on a smaller time frame can often provide a valid entry for a longer term trend. (To learn more about this strategy, check out Multiple Time Frames Can Multiply Returns.)
Watch for Prices that Indicate Reversal
If the market is going lower and a trader feels it should go higher, he or she should trade with the trend. That said, a trader cannot get too attached to the trend, and must remain nimble and able to act when the trend appears to be reversing according to the his or her suspicions – and this turn is evidenced by actual price action.
Therefore, traders must trade in the direction of the trend if they wish to make money during that time frame, but if they feel that the trend could reverse they must have a price point that will tell them when this is actually occurring. One way to do this is to simply use the definition of a trend. For example, an uptrend is no longer an uptrend if it fails to make higher highs and/or makes a lower low on a pullback. It is possible that price may resume a higher path at some point, but a lower low is a valid signal that the uptrend is in jeopardy. This is when a trader who is looking for a contrarian reversal could step into the market. (To learn more, see Retracement Or Reversal: Know The Difference.)
In the case of a downtrend, a higher low or a higher high is a signal the downtrend is in jeopardy. There are many potential reversal signals that can be used, including trendline breaks, candlestick patterns, chart patterns or indicator levels. No matter what the method, it is best to wait for prices to confirm all reversal indicators and signals.
By watching for such reversal signals a trader can trade with the trend until it is in jeopardy; it is at that point that the contrary opinion is given credibility and the trader can act on that opinion.
Traders can make money despite being perpetual contrarians, provided they control their opinions and realize that they do not need to act on them. Contrarians can also capitalize on the current trend by trading with it, and should only act on their contrarian opinions when the trend shows signs that it is in jeopardy. After all, if you try to buck the current trend, you could be left with an empty account, even if the market eventually takes the turn you predicted. (For more on contrarian trading, see Buy When There's Blood In The Streets.)
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