3 Keys to Successful Contrarian Trading

While many traders focus on fundamental and technical research, here at Schaeffer's we add another very important flavor to the mix: sentiment analysis. Bernie Schaeffer's proprietary Expectational Analysis^® methodology gives us a critical, contrarian edge over the teeming masses on Wall Street. Read on to learn the three pillars of EA.

Fundamental Analysis

Simply defined, fundamental analysis is the study of specific factors that influence supply and demand and (consequently) prices in the marketplace. On a corporate basis, fundamental analysis can be chalked up to the company's bones.

This sort of analysis typically looks at numerous factors including, but not limited to: financial ratios, earnings, dividends, and economic forecasts. These are usually longer-term indicators, but some useful fundamental indicators for option players (who focus on short-to-intermediate-term trends) are: earnings (momentum, history, and surprises), corporate news (restructuring, new CEOs, and other management changes), new products, product recalls, stock buybacks, and stock splits.

Past performance is obviously not a foolproof indicator of future performance, but it would be nonetheless foolish to disregard that data. No matter how short-term your trading horizon is, it helps to know whether the company's making money, or losing it.

Technical Analysis

Another key to successful option trading that we use here at Schaeffer's is technical analysis -- or, simply speaking, charts. Under this umbrella: moving averages, standard deviation bands, and other price and volume indicators to identify and predict an equity's trajectory. 

Drilling down on one of the most popular technical indicators, moving averages soften out the directional trend of the stock. They can also act as support and resistance. It's important to look at lots of different trendlines (10-, 20-, 32-, 80-, and 200-unit, for example) across various time frames (daily, weekly, monthly) to find ones that have signaled buying or selling opportunities in the past.

Round numbers can also emerge as layers of support or potential speed bumps. So can other various price points, like year-to-date breakeven levels, bull or bear gap sites, former highs and lows, and so on.

Sentiment Analysis

The final key to successful option trading is sentiment analysis. In the simplest terms, sentiment analysis is taking Wall Street's temperature. As contrarians, we like to find a stock moving against the grain. For instance, if an uptrending stock is plagued by pessimism, there's still room on the bullish bandwagon, and vice versa for downtrending stocks surrounded by optimism.

At Schaeffer's, we measure sentiment among options traders, analysts, short sellers, mutual fund traders, and watch a number of different sentiment surveys (weekly surveys from Investors Intelligence and the American Association of Individual Investors [AAII] are among the most popular). We also look at magazine cover stories and other media sentiment, analyst rankings, implied volatility skews, and more.

For instance, let's assume stock XYZ is in rally mode, yet most analysts are bearish and there's still lots of shares sold short. Should the equity continue to edge higher, a round of upgrades and/or a short squeeze could act as catalysts even higher.

On the flip side, let's assume stock ZYX has been struggling on and off the charts. However, Wall Street remains enamored, with analysts in the "buy" camp and option traders call-heavy -- as evidenced by various indicators like the Schaeffer's put/call open interest ratio (SOIR) and buy-to-open data from the major options exchanges. A flood of downgrades or a mass exodus of option bulls could exacerbate the stock's losses.

Of course, there will be times when prevailing sentiment is right in line with the stock's price action. There's no real contrarian takeaway in this scenario -- we would expect to see optimism on a strong stock, as well as pessimism on an underperforming issue. However, by applying this Expectational Analysis^® methodology to your trading, you can get ahead of the crowd.