Contrarianism

It’s a bit of a slow morning as of 7:30Am EST. I’m still in my long USDCAD trade plus a few others.

Last week I bought GBPUSD which rose smartly. On Thursday I bought USDCAD at a low. It’s currently languishing around the plus 80 pips line. One could ask, am I a contrarian? I am not. At least not most of the time. Let’s face it—if the trend is up then people are buying; if the trend is down people are selling. Sideways trading is fine if a pair isn’t trending. But one usually makes more money on any given trade when a pair starts to trend and the trader rides it up or down as the case may be. So, if there is a strong trend, one wants to buy on reactions or sell on rallies.

Most traders these days would rather undergo Chinese Water Torture than be long the USD. By the way, there’s not a lot of evidence the Chinese ever actually engaged in this. Houdini probably came up with the name—he had a trick called the Chinese Water Torture Cell. But, as I demonstrated on Friday’s chart, a trade was there and I took it. It didn’t matter to me that I was long the USD.

What is a contrarian anyway? People often believe it means one buys new lows or sells new highs, regardless of where they may occur on a chart. This is not an effective way to trade and the drain on your account over time if you do this can feel like the Chinese Water Torture or Death by a Thousand Cuts which was an ancient Chinese torture technique. Actually, the relentless drop of the USD must feel like death by a thousand cuts to some people, but never mind that.

Humphrey Neill was one of the first to write about contrarianism. He wrote that the crowd is actually correct most of the time; it’s at turning points where they’re wrong. The reason the crowd doesn’t catch turning points is because “habits push our minds into ruts—and it takes a considerable amount of force and time to get out of ruts.” Neill suggested that when everyone is saying the same thing, one should at least try to make the case in the other direction. When you do this you may come up with reasons why the crowd is wrong. Then, if you can find an entry with a tight stop, going contrary may be profitable.

That is true. Asking what could go right for the USD can be a useful exercise and one that I engaged in this weekend. But even if you can come up with reasons why the crowd is wrong, being a successful contrarian is difficult.

First, bottoming (and topping), as I’ve written frequently, is usually a process. It’s not an event. This can mean the process takes place over weeks if not months. Second, a strong, perhaps even irrational bull or bear market, can take prices beyond what seems rational. So even if there are good reasons for a change in trend, the timing can get many traders into trouble.

One reason why going contrary to a longer, prevailing trend works is once a pair has dropped precipitously and everyone has jumped on the wagon, there are few left to push the trend any further. When prices go down people sell. When everyone has sold there’s nobody left to do so. Prices can turn and go up. Trends, even strong ones, do reverse. There are also such things as a dead cat bounce.

I have no idea what the future holds for the USD. Neither does anyone else although the theories abound and the talking heads expound. But theories and talking heads don’t make money for the average trader. The questions I seek to answer are more modest, more manageable, and more profitable. That is, has the pair reached a level of support (if falling) or resistance (if rising) that has been historically significant? There are many ways to determine significance—it could be a polarity level, a confluence of Fib levels, Gann’s 50% level, etc. Note, the question is not whether price is at a new high or new low but rather is the level it is at significant? Second, are there any signs, from a technical analysis point of view, that hint a trade may be profitable in the other direction? I look for at least three, usually. This is why I got into both trades I mentioned and both have been profitable.

Again, being up 100, 200, or even 500 pips is nothing compared to what you can gain if you get in on a strong trend. But these can make for very good weeks when prevailing trends seem to have shifted sideways.

© Dianne Fecteau, 2009. No part of this material may be reproduced in any form, or referred to in any other publication, without the express written permission of the author.