Good morning! Today Troy continues about the investing for beginners series. You can check the previous posts about What are stocks and how to value them, How does Currency Trading Work, How are Currencies Traded, Investing in Commodities, What Fundamentals Affect Commodity Prices, What are ETF’s, What are Options, How are Options’ Prices Structured, Investing for Beginners Part 2 – Different Investment Strategies, When does Buy and Hold not Work, An Unconventional Approach to Buy and Hold, An Unconventional Approach to Buy and Hold Part 2, How the Investment Advisor Game is Played, An Introduction Into “Secular Investing”, Don’t Short When it Comes to Secular Investing, An Introduction into Trend Following, An Introduction into Technical Indicators, When does Trend Following Not Work, Risk Management for Trend Followers, Why Trend Following Isn’t that Useful Today, An Introduction to Contrarian Investing, Using Oscillators for Contrarian Investing, Using Magnitude Extreme vs. Time Extreme
Contrarian investing is all about extremes. When the market moves to one extreme, it will bounce back the other way. But the important question is, what is “extreme”? Extreme is a relative term, depending on your time frame. A 10% decline in one day is considered extreme, whereas a 10% decline in one month is considered normal.
Thus, there are different levels of extreme, which means that contrarian investing can be used for different time frames. A contrarian investment can have a time frame of a few days, a few weeks, a few months, or even a few years.
Multi-Year Contrarian Investing
Multi-year contrarian investing is similar to secular investing in that you’re playing the cyclical trends that each last 3-5 years. This is known as catching the falling knife, which back in my post on Secular Investing I advised against. I only advised against catching the falling knife because we didn’t talk about the tools need to catch the market bottom or peak.
Contrarian Investing Oscillators and time / magnitude extremes do this for us – they tell us when a multi-year market trend is highly oversold or overbought. Oscillators can be adjusted based on the time frame of your investment. RSI is based on the “close price”. But that close price can be adjusted. Is it the weekly close price (price as of 4pm Friday) or is it the daily close price (price as of 4 pm Monday to Friday). For multi-year contrarian investing, use the weekly close (some people even use the monthly close – the close on the last day of each month) for RSI. That’s because a shorter term RSI (e.g. daily) should not be used for making longer term investment decisions – doing so just doesn’t make sense!
Keep in mind that multi-year contrarian investing won’t allow you to be very precise with the multi-year peak or bottom. For example, RSI and magnitude / time extremes sent SELL signals in January 2007, a full half year before the market did peak. Had you gone short in January 2007, you would have experienced a half year of pain. But that’s the price longer term investors have to pay.
Similarly, RSI and magnitude / time extremes sent BUY signals in December 2008. That’s 35% away from the market bottom!
But although you can’t catch the exact bottom or top, you can get very close.
Multi-Month Contrarian Investing
Multi-month contrarian investing involves playing the monthly market waves. Investments typically last from a few months (ie 2 months) to less than a year (ie 10 months).
When a market has gone in one direction nonstop for several months, RSI and time / magnitude extremes should send signals to invest the other way. In terms of these kinds of medium term investments, it’s best to use daily close as a price input for your RSI.
Short Term Contrarian Investing
Short term contrarian investing isn’t that popular. I don’t know why, but I’ve tested this time frame out before (investments are more like trades – they last just a few days to max. a few weeks). For some reason, RSI doesn’t work very well on these shorter term frames. Maybe because there’s just too much “noise” (false price action) in the short term that renders contrarian investing useless.
All in all, I prefer using contrarian investment tactics for multi-month time frames. Long term contrarian investing means that the price you enter your investment in may be far off from the ultimate peak or bottom.
A Caveat – The Problem with RSI
RSI sometimes doesn’t work very well. Here’s an example:
- Let’s assume that the market was falling, and RSI fell to 20. Thus, a BUY signal was generated. However, RSI can back off from Oversold levels merely by the price not falling. That means, if the price doesn’t rally but it stays flat, the Oversold sign is negated. Thus, your long bullish position means nothing.
- The opposite is also true.