Posted on 20 August 2012.
Using contrarian indicators to make stock trading decisions is a strategy that many stock market traders and investors do not pay enough attention to or ignore altogether. A contrarian is a person who takes up a position that is opposed to the position of the majority. Using contrarian indicators is a powerful trading and investing strategy that identifies extremes in stock market sentiment to assist in making decisions whether to buy or sell stocks.
The most common method of using contrarian indicators is to assess levels of market sentiment indicators to predict upcoming stock market direction moves. Although it seems counterintuitive, which is what makes it a contrarian strategy, market sentiment indicators that are skewed to the bullish side often coincide with short and long term market tops, while market sentiment indicators that are skewed to the bearish side often coincide with short and long term market bottoms.
Another common method of using contrarian indicators is monitoring weekly money flows to and from long term mutual funds (which can also apply to long term exchange traded funds). High weekly money flows into long term mutual funds indicates that individual investors are bullish. While this could push stock prices higher in the short term, it can also be a sign of excessive investor bullishness, if weekly money flows are particularly high, and could indicate a market top is forming. The opposite methodology can be utilized to identify a market bottom; when high weekly money flows out of long term mutual funds are occurring and investors appear to be giving up on stocks.
Other methods of using contrarian indicators to identify clues to market tops and bottoms and future market direction include monitoring such things as the amount of margin used to buy stocks and the put/call ratio for stock options. Market tops are often associated with times when traders and investors use excessive amounts of margin to buy stocks, because they feel so bullish about stocks. Market tops can also be indicated by put/call ratios that indicate excessive call buying and bullishness. Conversely, put/call ratios that indicate excessive put buying and bearishness are often associated with market bottoms.
Using contrarian indicators as a way to justify a bullish or bearish opinion regarding the future direction of the stock market is a mistake. Stock market traders and investors that are steadfast in their opinions regarding the future direction of the stock market, known as permabulls and permabears, often use contrarian indicators to justify their opinions. The proper method of using contrarian indicators is to try to identify stock market excesses to make trading and investment decisions ahead of changes in the stock market trend to profit from the trend change.
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