When most people think of investing, they think of buying stocks that are going up. After all, who wouldn't want to make money by riding the wave of a stock's increasing value?
But what about buying stocks that are declining? Is there value in that too? The answer is yes, and it's called contrarian investing. If you're the type of person who likes to go against the grain, this may be the perfect strategy for you.
Contrarian investors look for undervalued stocks whose prices have been beaten down. By identifying and buying these stocks, they hope to achieve outsized returns by taking advantage of other investors' pessimism and going against the herd. It's a strategy that can be high-risk, but it can also have large rewards.
There are many reasons why you might consider contrarian investing. It can help you avoid losses in a down market because while the overall market may be falling, some stocks will actually rise, so you may be able to avoid the worst of a market decline.
Another reason to consider contrarian investing is that it can help you capitalize on other investors' irrationality. When other investors sell in a panic, they may be selling valuable stocks. You can take advantage of this and buy quality stocks at a discount.
How to be a contrarian investor
If you're interested, there are a few things you need to know. First, you need to be able to identify undervalued stocks. This can be difficult, as there is no sure-fire way to do it. A good place to start is to look for stocks that have been downgraded by analysts or underperformed the market.
You also need to have a contrarian mindset. This means you must withstand short-term losses and be patient for long-term gains.
Finally, you need to have a good understanding of the companies you're investing in. Just because a stock is undervalued doesn't mean it's a good investment. You need to do your research to make sure you're buying a quality company at a bargain price.
In addition to being able to identify undervalued stocks, investors also look for what are known as "contrarian indicators." These are signals that a stock's price may be ready to change direction.
The put/call ratio is a popular contrarian indicator. This is the ratio of put options to call options. A high put/call ratio means there are more puts than calls, which is often seen as a sign that investors are bearish on the market. Investors may use this as a sign to buy, as they believe the market is about to turn around.
The Commitments of Traders (COT) report is published weekly and discloses positions held by institutional investors in various markets. The sentiment could be faded as a strategy.
Contrarians may also look at the "smart money flow index." This is a measure of how much "smart money" (i.e., institutional investors) flows into or out of a stock.
When the smart money flow index is below 50, more smart money is flowing out of the stock than is flowing in. This is seen as a bearish sign, and contrarians may use it to identify stocks that are about to go down.