If a trader possesses a contrarian opinion, it is said that he believes the market will move in the opposite direction of what most investors believe. A contrarian attempts to profit by investing in a manner that differs from the crowd, when the consensus opinion appears to be wrong. The contrarian will buy and sell, when others are doing the reverse.
A contrarian believes that certain crowd behavior among investors can lead to exploitable mispricings in the market. For example, widespread pessimism about a stock can drive share price so low that it overstates the company’s risks, and understates its potential to return to profitability. Identifying and purchasing distressed stocks, then selling them upon recovery, can lead to excellent returns. Conversely, widespread optimism can result in unjustifiably high valuations that will eventually decline, when those high expectations don’t pan out. Contrarian investors will short sell these over-hyped securities, in order to profit on the decline. Hype is a common factor when trading stocks, and a contrarian should be able to work against it.
A large proportion of stock investors bet on the market being bullish and hope to make money when the price of a stock increases. Although this is the general trend, a contrarian opinion would suggest it is a good idea to try and play the market when it is bearish. Some contrarians have a permanent bear market view, while the majority of investors bet on the market going up. It is important to note, that a contrarian does not usually have a negative view of the overall stock market, nor does he have to believe that everything is overvalued, or that conventional wisdom is always incorrect. Rather, a contrarian seeks opportunities to buy or sell specific investments when the majority of investors appear to be doing the opposite, to the point where that investment has become mispriced. Typically, more “buy” candidates are found during market declines, and vice versa.
Contrarian investing isn’t merely guesswork, as it can be predicted by using some indicators in unconventional ways. Contrarians attempt to exploit the principles of behavioral finance. For example, studies have shown that investors as a group tend to overweigh recent trends when predicting the future. Therefore, a poorly performing stock will remain bad, and a strong performer will remain strong. This is why the contrarian believes that investments may drop to unjustifiably low levels during periods of negative news, due to incorrect assumptions by other investors on the long-term prospects for the company. When this happens its value can be mispriced and this is an opportunity which can be taken advantage of.