How to Trade Options Like a Real Contrarian

Breaking down the contrarian approach with options guru, Bernie Schaeffer

Dec 31, 2020 at 12:45 PM
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    Profitable options trading requires traders to have an edge over everyone else in their trading. One quote that should stick with every serious options trader is from the very popular investor, Warren Buffet, who said, “In markets, be greedy when other are fearful and be fearful when others are greedy.”

    The entire ideology of acting against the crowd is based upon the theory of contrary thinking. Application of contrarian principle in options trading can be described most simply as taking positions in the market by purposefully opposing the majority’s sentiment.

    When implementing this unique ideology in options trading, traders predict, at times when the whole market is overly optimistic or pessimistic about a stock or the market in general, that a trend reversal is inevitable. A deep dive into sentiment analysis is key here.

    In this article, the team at Schaeffer’s Investment Research will provide you a detailed understanding of contrarian thinking and how we recommend utilizing it in the pursuit of huge profits from options trading with minimal risk exposure.

    Understanding the Contrarian Approach to Options Trading

    As mentioned above, the contrarian principle in trading is when a trader takes positions on a stock by going against the current overriding investor sentiment. The idea here is that when a simple saturation point is reached in a stock, whether during an uptrend or a downtrend, the stock has no other option but to reverse its pricing path.

    Therefore, if a stock has been receiving overly optimistic attention concurrent with that stock reaching an overbought position, then a contrarian would lean toward purchasing a put option on the stock to capitalize on the correction.

    On the flipside, if a stock has been receiving overly pessimistic attention concurrent with that stock also reaching an oversold position, then the contrarian would know this is the ideal time to purchase a call option to capitalize on the stock price reversal that is looming.

    A great example is the 2008 housing crisis when the market was at an all-time high and investor sentiment was over-the-top optimistic. It was the time when it was believed that the only direction market could go was up and up and up. At that moment, proficient traders who used the contrarian approach to identifying options trading opportunities began to purchase put options that bet on stock price crashing within the real estate sector. The traders who were able to capitalize on this over-the-top positivity were able to make a huge amount of profit when the housing bubble popped.

    Contrarian thinking is part of the core principles that we employ at Schaeffer’s Investment Research when implementing our Expectational Analysis ® approach to identifying trading opportunities. Our expertise in sentiment analysis, or analyzing crowd behavior, is key to our ability to completely and proficiently utilizing contrarian thinking in our trading.

    The Proper Application of Contrarian Thinking in Options Trading

    Almost all traders have had the experience of buying calls on a stock after the company outperformed expectations on quarterly earnings, and despite that positive news, the stock price continued to sink. Similarly, almost all traders have experienced buying puts on a stock that just released mediocre earnings that missed expectations and the stock price brushed off the news and continued to soar. These frustrating experiences reinforce the necessity of alternative thinking when trading, especially in the options trading space.

    We understand it is highly frustrating and confusing when something that seems like an obvious reaction goes the opposite direction. These situations can cause traders to doubt their gut instincts. But that is not the right path to go down. Think about it like this: everyone knew that the stock underperformed or outperformed on earnings, that fact alone is not going to give you an edge in your trading. A proficient option trader must understand what the majority of traders expected out of earnings and the crowd’s expectations immediately prior to the earnings release to get the full picture of the stock price’s potential future movement.

    A hidden aspect which very few consider is the Wall Street sentiment. Trading the stock market is not only about crunching numbers and correctly predicting how events will play out, but also understanding the inclination of market participants. The answer to the above examples can be easily understood by looking into the differing expectations surrounding the stocks prior to the event.

    In the case of the stock that outperformed earnings expectations, the sentiment may have been excessively bullish heading into the report, making the shares ultimately vulnerable to a drawdown correction. There may have been a build-up of call options being purchased, or a lot of anticipatory buying of the stock, which then becomes exhausted by the time earnings are reported. Such a high-expectation environment creates a heavy burden on the stock to issue a blow-out earnings report and, even if it does, the pricing for betting against the stock will be far more compelling than that of betting along with everyone else.

    For the stock that underperformed earnings expectations, there may have been a prevalent concern about a company's fundamental health and an excessive amount of put options being purchased on the underlying stock. Evaluating the sentiment associated with the underlying stock being considered for an options play is critical to trading around earnings.

    With nearly 40 years of options trading experience and proven historical trading results, Bernie Schaeffer and his team of traders at Schaeffer's Investment Research have developed a 3-tier proprietary methodology called Expectational Analysis®  which combines fundamental, technical, and sentiment analysis, providing a bulletproof approach for identifying  and timing options trading opportunities.

    The true pioneers of Expectational Analysis®, Bernie Schaeffer and the Schaeffer’ Investment Research team of analysts have tested and developed many different proprietary methods to measure investor sentiment. The distinguishing difference is that indicators used at Schaeffer's Investment Research do not reflect only the overall market, but individual sectors and stocks, specifically.


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