Contrary Trading

At the core of trading, we are all trading our own beliefs. If you are a purely technical trader, you are trading the belief that technical analysis will provide you with an edge over the market. If you are a fundamentalist, you will trade some concept of how you think the economy will unfold. There is nothing “natural” about the market place. At the end of the day, trading is undertaken in an artificial market place created by traders all over the world committing money to their beliefs. At the core of trading, we are all trading our own beliefs. If you are a purely technical trader, you are trading the belief that technical analysis will provide you with an edge over the market. If you are a fundamentalist, you will trade some concept of how you think the economy will unfold. There is nothing “natural” about the market place. At the end of the day, trading is undertaken in an artificial market place created by traders all over the world committing money to their beliefs. The strongest and most common beliefs supported by the application of significant amounts cash tend to drive the market and when some new information arrives in the market that contradicts the most popular beliefs, the market can have a major correction.

Memes
Humans are very social creatures and information can travel very quickly in communities (actually we are more like malicious gossips and bad news travels extremely fast). It is this diffusion of information coupled with vast amounts of cash that drives the markets. Mathematical models of the markets which just rely on independent agents trading a host of trading tactics tend to produce noisy synthetic price series that bear no relation to real markets and rarely display long running trends or kurtosis. Whereas, mathematical models of agents which do technical trading and share information about what their perceived value of price is with their neighbours, tend to produce synthetic time series that more closely replicate the behaviour of real markets. It is the sharing of beliefs through the community that gives us a tradeable market and it is this aspect that a trader needs to exploit.

The financial markets are nothing more than a virtual community that carries on an endless dialogue about pricing. The markets are basically like a big soap opera, with a cast of thousands all gossiping maliciously about one another. Like all good soap operas there is an underlying plot, that just repeat endless variations of old stories. Jill like Joe. Joe likes Mary. Jill kills Mary. Hedge funds like a bull run on tech stocks. The Fed dislikes bubbles. The Fed kills the equity market. The story goes on and on.

These themes are the underlying “meme” of the market. A meme is a theoretical unit of cultural information and is the building block of human culture and cultural evolution which spreads through diffusion propagating from one mind to another analogously to the way in which a gene propagates from one organism to another as a unit of genetic information and of biological evolution. Just like in high school biology, memes are subject to mutation and natural selection. Different memes in the market die out when new contradictory information backed by cash arrives in the market and active memes will often combine and mutate to produce new memes in the market. The trick to trading well is to understand the different memes that are driving the market and how they surviving the natural selection process and how they may be mutating.

John Maynard Keynes pretty well was on the money when he compared the stock market to a hypothetical news paper sponsored beauty contest in which a substantial money prize was to be awarded to the participant who guessed which of the photos was the most beautiful. It is not a case of choosing those which, to the best of one’s judgement are really the prettiest, nor those which opinion genuinely thinks is the prettiest. We have to reach the third degree where we devote our intelligence to anticipating what the average opinion expects the average opinion to be.

Contrary Trading
“Facts do not cease to exist because they are ignored” -Aldous Huxley

A trader’s edge in the market comes from places where there are systematic mis-perceptions about the market as a result of faulty memes. These places are the battle grounds of buyers and sellers. Good traders examine the evidence and place bets on what they perceive to be the winning side. They also learn to admit when they have made the wrong bet and quickly fix the situation by reversing their trade. Exploiting faulty memes is the core of contrary trading. Contrary to popular belief about contrary trading, it is not about just picking an opposite opinion to popular opinions in the market and committing to the trade.

Picking the right faulty meme to counter trade is a essential skill, because if you pick the wrong one there will be no genuine edge in your trade. To illustrate the point, if you look on the forums occasionally the topic of conversation comes up around contrary trading and some lark will post a request along the lines of “Dear beginners, please send me your trading signals so that I can do the opposite and make bucket loads of cash … Mwaa ha ha ha”. If only it was that simple. Most beginner traders are noise traders who are making their trades on irrelevant beliefs about the market and their entry is no better than random. Betting against such traders is no different from betting against a colleague in a coin tossing competition. Whether you pick the same as your colleague or do the opposite, the average outcome is still no different from a coin flip.

To be a successful contrary trader, you need to first identify the faulty memes which are driving the commitment of large amounts of cash to the market. Once you have done that, then your task is to identify when you should enter the trade. There have been numerous contrary traders that have been right, but simply entered the trade too soon and burnt up a significant amount of cash fighting a faulty meme.

At a deeper level, contrary thinking is a much more subtle and sophisticated tool. Humphrey Neil in his now classic book on The Art of Contrary Thinking wrote:

“The contrary theory is a way of thinking, but let’s not over-weigh it. It is more of an antidote to general forecasting than a system for forecasting. In a word, it is a thinking tool and not a crystal ball. It forces one to think through a given subject … I believe it is correct to say that the theory is more valuable in avoiding errors in forecasting than in employing it for definitive forecasting“

The crowd is more often right than it is wrong and the crowd tends to be wrong only at major turning points in the market. The key is to exploit the trend while it exists and use contrary thinking to help time when to lighten up your risk exposure or place contrary trades. George Soros was a master at this:

“Economic history is a never-ending series of episodes based on falsehoods and lies, non-truths. It represents the path to big money. The object is to recognize the trend whose premise is false, ride that trend, and step off before it is discredited.”- George Soros

Variant Perception
One hedge fund manager who was famous for contrary trading is Michael Steinhardt. Michael averaged over 30% annually for 30 years in his fund. In his autobiography, No Bull, he writes:

“I constructed a system that overcame the necessity of specific knowledge across a wide range of industries. In short, I asked the right questions by seeking the ‘variant perception’ inherent in each idea. A summer intern reminded me years later of the advice I had given him on his first day at work. I told him that ideally he should be able to tell me, in two minutes, four things: 1) the idea; 2) the consensus view; 3) his variant perception; and 4) a trigger event.”

Steinhardt considers that a complete understanding of market expectations to be a vital part of success and you can benefit enormously from when the gap between disparate perception and the market consensus are closed. Variant perception is not merely taking a contrarian view to that of the market, but using a high level of understanding that comes from knowing how fully a market to support a conviction and being aware of different viewpoints.

Most good traders do this instinctively. A good trader will always starts their trading day by looking for “anomalies” or variances between what is happening in different markets, differences between sentiment and the underlying fundamentals, differences between long and short term outlooks for a market, divergences in technical indicators, etc. It is in these anomalies that trading opportunities can be found. It takes time to learn to use the art of “variant perception” and learn which anomaly is a genuine opportunity and which faulty memes are just noise and will die out very quickly from natural selection.

Macrotactics is a blog devoted to recording a part time trader's journey into the world of trading currencies. In my day job I work as a manager in an Information Technology company. I live in sunny Queensland, Australia with my wife, a cat and a baby on the way. I have been banging my head on this trading thing for at least 3 years now and the deeper I dig into the topic of trading, the more I realise there is to learn. Trading for me has become... More