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Traders have employed contrarian analysis methods for years in an effort to garner market profits. The indicators that can be employed by the contrarian have grown but the major theme has remained the same: to focus on what the majority is doing right now as well as what particular directional bias they currently possess. Contrarian analysis seeks out potential buying and selling strength by measuring investor expectations.

It is based on the notion that by the time it becomes public knowledge that a large number of people are bullish on a particular equity, a substantial amount of that stock has already been purchased. Thus, there might not be much additional demand. On the other hand, by the time everyone is bearish, the selling strength has been largely depleted and at that point even a small amount of buying can push the stock higher.

Contrarians rely on some very basic but important principles when applying their sentiment methodology. One of these principles is that the strongest contrarian implications are in place when a stock rallies with heavy bearish sentiment or declines among strong bullish sentiment. In addition, contrarians assert that bullish sentiment during rallies and bearish sentiment during declines are expected and, therefore, offer the weakest implications.

Contrarians trade counter to the prevailing trend, based upon sentiment factors that are in line with the trend, claiming they will be profitable during declines when sentiment nears a bearish extreme and during rallies when sentiment reaches a bullish zenith. They assert that that the general investing public is a very fickle group and sentiment can always become more bullish or more bearish, even if the indicators seem to have reached an extreme.

These traders use a variety of tools. Some of the more popular indicators include short interest, analyst ratings, and even the amount of popular news coverage. Some also use put/call ratios; however, most contrarians say they have to be sufficiently tweaked to be effective, such as using open interest for a particular time frame before expiration.  Short interest is defined as the total number of shares of a stock that have been sold short and not yet repurchased.

Contrarians consider rising short interest as a near-term bullish indicator because these borrowed shares must be repurchased. Short interest figures are reported once a month around the middle of the month and contrarians typically employ this indicator to signal intermediate and long-term trades. Sometimes the short interest indicator is used for even shorter-term trades when a key event like an earnings release is approaching.

They also like to closely monitor the Wall Street analysts and keep track of their buy, hold or sell ratings on a particular stock. They use it as a sentiment indicator claiming that an abundance of buy ratings can be a negative sign since there is hardly any further upgrade potential for the stock and thus can only go down from here. On the other hand, if the stock has a lot of sell ratings then any type of upgrade could be the catalyst the stock was looking for to surge to the upside.

Finally, if a stock is getting a lot of media attention and is often seen as headline news, then, according to the contrarian philosophy, this is a clear signal that the current trend is about to come to an end. Keep in mind that if attracted to contrarian analysis as a methodology, it is just another way to provide the trader with an edge but it is not foolproof.  In fact, it works best during sentiment extremes and should never be used in a vacuum.

Happy Trading.


Jeff Neal
Senior Writer & Options Strategist
Optionetics.com ~ Your Options Education Site
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