Contrarian trading & investing involves spotting when the crowd has got it wrong and knowing when to go the other way.

Some of the best information I’ve come across when it comes to how to start contrarian investing and trading have come from Barry Ritzholtz via his blog:

Here’s a summary of Barry’s thoughts taken from here:

How to start contrarian trading and 6 key ideas you need to be aware of

1) You cannot be a full time contrarian. Why? The crowd is actually right most of the time. Remember, they are what moves markets, why equities go up, why a pop song becomes a number 1 hit. Indeed, the crowd is why indexing works.

2) This gets reflected in such clichés as “Don’t fight the tape” and “The Trend is your friend;” The crowd is neither right nor wrong, but instead is its own truth, a self fulfilling prophesy. This leads to some unexpected outcomes.

3) Beware extremes: The crowd will take markets much higher and much lower than they should go based on reasonable, logical common sense metrics.

4) There is safety in numbers. No one gets fired for groupthink. In every nature documentary that you have ever seen, it’s the gazelle at the edge of the herd that the lions devour. The rest of the herd is safely huddled together. That’s the anti-contrarian lesson (if your a gazelle).

5) Whenever the crowd loves or hates something, it worth noting. That’s when contrarians are the ones who will make a giant score. Think short-sellers in Enron or Tyco, or the buyers of tech stocks in late 2002.

6) Where Contrarians shine is when the crowd morphs into an angry mob. Once the bulls become convinced the market is invincible, their full throated cries will be readily apparent. So too, the bears, usually in the depths of a recession.

Contrarian Indicators

Ritholzt has also written a neat guide to the best contrarian indicators that you can use. These vary from technical indicators to more subjective things like magazine covers or TV shows. He distinguishes between two different types of contrarian indicators: ‘internal’ market signals and ‘external’ societal displays.

“Contrary Indicators are the data points, signs, and events whose actual significance to the market is the exact opposite of what their initial impression suggests. These counterintuitive signals can reveal when great masses of investors are collectively reacting emotionally to a given event or stimulus. When the herd becomes violently emotional, they typically “shoot first, and ask questions later.” This invariably results in poor investment decisions.”

Ritholtz has written a thorough guide to the world of contrarian investment here:

Internal market signals are made up of actual market activity. My favourite are the equity put/ call ratio and the VIX.

The equity put/call ratio is a measure of the amount of options traders predicting that prices will rise vs. the number predicting prices will fall. 80% of options expire as worthless so it gives you an idea that when this ratio reaches an extreme level, there’s a fair chance that many people are wrong.

The VIX options volatility index is a measure of the jumpiness of US options traders. It is also known as the ‘fear’ index because when it rises high it usually represents fear in the market. Low readings can represent complacency. Last Thursday was a great example. You can view the VIX on many charting sites like ($VIX). Last Thursday the VIX hit its lowest level since February, this indicated complacency yet the news flow continued to be poor. The next day markets were down 2%!

External signals are made up of things not directly related to the stock market. The classic is the American Association of Individual Investors sentiment survey (AAII). When AAII readers reach extreme levels or optimism and pessimism, historically it has been a good indicator of a reversal. Another more subjective external signal is the magazine cover or TV shows. When there are an extreme number of covers or media displaying an extreme message, it could be time for a reversal.

Contrarian Investing isn’t easy, but understanding some of the key ideas may help you to stay one step ahead of the crowd, at least some of the time.