Momentum and contrarian trading strategies

Contrarian Traders.

Contrarian trading is an investment style that goes against prevailing market trends by buying assets that are performing poorly and then selling when they perform well.

A contrarian trader believes that the people who say the market is going up do so only when they are fully invested and have no further purchasing power. At this point, the market is at a peak. On the other hand, when people predict a downturn, they have already sold out, at which point the market can only go up.

Contrarian investors tend to use various sentiment indicators and particularly those that emphasize out-of-favor securities with low P/E ratios.

Put simply - if you follow the herd, you will be led to the slaughterhouse. Contrarians get excited when an otherwise good company has a sharp, but undeserved drop in share price. They swim against the current, and assume the market is usually wrong at both its extreme lows and highs. The more prices swing, the more misguided they believe the rest of the market to be.

The basics of the contrarian trading strategy.

The contrarian trader’s strategy is not as simple as taking the opposite side of the public's widely held viewpoint - “the trend is your friend” theme. A stock that goes higher and higher for an extended amount of time will naturally gain a lot of positive sentiment - this does not mean that a contrarian investor immediately hates that stock. Going against the price trend is always a tough way to play. The approach is to look for stocks where the sentiment is counter to the established trend. In other words, the contrarian looks for stocks going higher despite a significant amount of pessimism.

The reason behind this strategy is that the pessimism indicates a lot of investors have been avoiding that stock, and are therefore sitting on the sidelines. If that stock continues higher, then at some point, the sentiment will change and that sideline money will (hopefully, all at once) begin to flow into that stock, thereby driving it higher in a short amount of time. The fast and furious rally is especially beneficial to those that are contrarian options traders.

Indicators for the contrarian investor.

Contrarian traders constantly monitor the markets and read about stocks, which provides a feel for the sentiment. It also helps to be able to quantify sentiment, and this can be done in a few different ways:

Analyst ratings, for example, are pretty straightforward. Analysts give a buy/hold/sell recommendation on stocks, depending on what they think investors should do. If a stock is trekking higher, but has little to no "buy" recommendations, then the potential is there for upgrades --which can influence those on the sidelines to buy the stock. Shorting a stock or buying put options are two ways for investors to profit when a stock falls in price. Therefore, monitoring the changes in short interest and the amount of put buying are ways to quantify negative sentiment on a stock. If there's a large amount of these negative bets being placed on the stock, while it's still moving higher and higher, then a contrarian trader can assume that there is significant sideline money that can still be deployed to keep the rally going.

The pendulum for success.

There is a tendency for investors to succumb to short-termism and act on their emotions rather than reason.

The pendulum of investment emotions continually swings back and forth between fear and greed, and many of these sentiment indicators are designed with the goal of capturing emotion extremes.

The concept of mass hysteria is nothing new.

Baron Rothschild, an 18th century British nobleman and member of the Rothschild banking family, is credited with saying that, "The time to buy is when there's blood in the streets."

He should know. Rothschild made a fortune buying in the panic that followed the Battle of Waterloo against Napoleon. But that's not the whole story. The original quote is believed to be, "Buy when there's blood in the streets, even if the blood is your own."

This is contrarian investing at its heart - the strongly-held belief that the worse things seem in the market, the better the opportunities are for profit.

Some contrarian sentiment indicators.

Sentiment surveys - Such as the American Association of Individual Investors weekly survey and the Advisors Sentiment Index, conducted by Investors Intelligence. Put-Call Ratio - This is a widely used ratio that measures the trading volume of bearish put options to bullish call options and is used to gauge the overall mood of the market. Volatility Index (VIX) - The VIX indicator or “Fear Gauge” calculates inputs from various call and put options to create an approximation of the S&P 500 index implied volatility for the next 30 days. Strategist sentiment indicators Short interest - The higher the amount of shares shorted, the larger the pent-up demand to buy shares becomes in the future. Fund flow data - The direction of investment dollars flowing in and out of mutual funds can provide some perspective on the psychology of the masses. The trader’s reaction - actions speak much louder than words. Indicators based on opinions, surveys, and technical analysis data can be very subjective, therefore concentration should be centered on those indicators explaining actual measurable investor behavior (i. e., Put-Call, VIX, Short Interest, Fund Flow, and other action-oriented trading metrics).

Zynga stock fell 12% from August 2012 to August 2013, experienced some wild price swings in 2013, had a late-July 2013 slide on the heels of a management shake-up which sent the stock tumbling below its 10-day moving average, and, in August 2013 the equity ran into technical resistance at its 200-day moving average. Also, analysts at Stifel Nicolaus lowered their earnings estimates for Zynga Inc. to show the weakening fundamentals of the online social gaming company based on its performance in the first half of the 2013 fiscal year.

However, from a contrarian trader’s point of view, Zynga presented a definite message that the stock will double in the following 12 months past August 2013, as it had positive points, such as:

A Groupon-like turnaround feel, Hired an 8-year veteran from Microsoft Had 65% of market cap in cash as of August 2013.

Can contrarian traders be successful?

The short answer is yes, but it requires an understanding of three things:

that opinion and action are two different things, that trends are where the money is, and that price confirmation is needed for any reversal.

Contrarian traders must realize that there can and should be a difference between opinion and action and this leads to a varying of opinions relating to the outcome of sentiment indicators. If the market is rising and they feel it will eventually collapse, they don't need to act on that opinion right now. Opinion can be separated from what is currently going on - this will allow them to profit by trading with the market right now, instead of believing their opinion should be right at this time.

Opinion and emotion can wreak havoc on trading profitability, especially when traders develop very strong opinions or emotions. This is where it becomes imperative to design a trading plan before they start trading.

Risks of contrarian trading.

There are risks to contrarian investing. While the most famous contrarian investors have put big money on the line, swam against the current of common opinion and came out on top, they also did some serious research to ensure that the crowd was indeed wrong and probably studied a great deal of sentiment indicators. So, when a stock takes a nosedive, this doesn't prompt a contrarian trader to put in an immediate buy order, but to find out what has driven the stock down, and whether the drop in price is justified.

Investor Sentiment and Momentum and Contrarian Trading Strategies: Mutual Fund Evidence.

52 Pages Posted: 17 Aug 2011.

Grant E. Cullen.

affiliation not provided to SSRN.

Dominic Gasbarro.

Gary S. Monroe.

University of New South Wales (UNSW) - Australian School of Business.

J. Kenton Zumwalt.

Colorado State University, Fort Collins - Department of Finance & Real Estate.

Date Written: August 16, 2011.

Stocks with high sentiment betas are more sensitive to investor sentiment, with more subjective valuations. We contend that sentiment beta also captures the duration of mispricing. Accordingly, stocks with high (low) sentiment betas provide opportunities for momentum (contrarian) traders. We form hypothetical zero investment portfolios of high (low) sentiment betas stocks, and show that momentum profits decompose to reveal positive (negative) serial correlation of idiosyncratic returns, that contribute to momentum (contrarian) profits. Furthermore, actual mutual funds identified as momentum (contrarian) traders hold stocks with higher (lower) sentiment betas. Additionally, funds adjust sentiment betas to enhance performance as sentiment changes.

Keywords: Investor sentiment, Momentum, Contrarian, Mutual fund.

JEL Classification: G2, G11, G14, G23.

Grant Cullen.

affiliation not provided to SSRN ( )

Dominic Gasbarro.

Murdoch University ( )

Murdoch 6150, Western Australia.

Gary Monroe (Contact Author)

University of New South Wales (UNSW) - Australian School of Business ( )

Sydney, NSW 2052.

Colorado State University, Fort Collins - Department of Finance & Real Estate ( )

Fort Collins, CO 80523.

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The mean-variance Capital Asset Pricing Model (or CAPM) developed by Sharpe (1964) and Lintner (1965) has been the most acceptable paradigm over time for determining expected return on any risky asset. The investment researchers and practitioners are, however, persistently involved in designing trading strategies that outperform the CAPM benchmark and hence provide extra-normal returns. Such extra-normal return strate - gies attempt to gain from probable stock market inefficiencies. One prominent CAPM anomaly has been addressed by De Bondt and Thaler (1985) relating to a pattern in long-term past returns. They document that stock portfolios with low long-term past returns (for the period three to five years) tend to outperform, in future, the portfolios with high long-term past returns for the US market. The investment strategies based on such a reversal in long-term past returns are commonly referred to as contrarian strategies. De Bondt and Thaler suggest that the contrarian strategy works owing to investor over-reaction to past information. Some re - searchers, however, suggest that the De Bondt and Thaler results can be explained by the systematic risk of the contrarian portfolios and the size effect (Chan, 1988; Ball and Kothari, 1989; and Zarowin, 1990).

Sanjay Sehgal is Reader in Finance at the Department of Financial Studies, University of Delhi, South Campus, Delhi, e-mail: alkasvsnl.

Jagdeesh (1990) provides evidence of return reversals over very short-term periods (say a week or a month). He, however, insists that since such strategies are transaction-intensive and based on very short-term price movements, their apparent success may reflect presence of a short-term price pressure or lack of liquidity in the market rather than over - reaction. Lo and McKinley (1990) argue that a large portion of extra-normal returns shown by Jagdeesh is attributable to delayed stock price reaction to common factors.

Although contrarian investment strategies have received a lot of attention in recent years, a parallel body of literature on market efficiency focuses on relative strength or momentum strategies. Momentum strategies are based on continuation pattern in stock returns and imply buying past winners and selling past losers. For instance, Grimblatt and Titman (1989,

The study attempts to evaluate if there are any systematic patterns in stock returns for the Indian market. The empirical findings reveal that there is a reversal in long-term returns, once the short-term momentum effect has been controlled by maintaining a one year gap between portfolio formation period and the portfolio holding period. A contrarian strategy based on long-term past returns provides moderately positive returns. Further, there is a continuation in short-term returns and a momentum strategy based on it provides significantly positive payoffs. The results in general are in conformity with those for developed capital markets such as the US.

1991) show that a variety of mutual funds examined by them have a tendency of buying stocks that have increased in price over the past quarter of an year. Jagdeesh and Titman (1993) demonstrate that stocks with high short-term past returns (based on previous 3 to 12 months portfolio formation periods) continue to perform better in future than the stocks with low short-term past returns for the US market. They propose that the evidence is consistent with delayed stock price reaction to firm specific information.

Fama and French (1996) observe that momentum profits persist even when a multi-factor asset pricing model, 1 comprising of the market, size, and book equity to market equity factors replaces Sharpe - Lintner CAPM as a performance benchmark. Jagdeesh and Titman (2001) reconfirm the continuation in short-term US stock returns over an extended sample period compared to their 1993 study. They also demonstrate that behavioural models 2 proposed by Barberis, Shleifer, and Vishny (1998), Daniel, Hirshleifer, and Subrahmanyam (1998), and Hong and Stein (1999) tend to provide a partial explanation for the momentum anomaly.

The success of both the contrarian and momen - tum strategies, supported by empirical literature, that are conflicting in nature poses an explanatory prob - lem. One possibility is that the abnormal returns realized by these trading strategies are spurious. Another possibility is that the discrepancy is due to the difference in the time horizons used in the trading rules. For instance, the contrarian investment strategy seems to work well empirically for long-term past returns and for very short-term past returns, while the momentum strategy provides strong positive results for short-term past returns. The time period classification in the investment strategy literature has been defined on the basis of the length of the portfolio formation periods. Investment strategies involving portfolio formation period of less than a month, between 3 to 12 months, and between 13 to 60 months are generally referred to as very short-term, short-

term, and long-term strategies respectively. The time specificity nature of the investment strategies is summarized in Box.

The empirical evidence on investment strategies has been mainly concentrated on matured capital markets. However, for a universal validation of these strategies, there is a need for an out of sample evidence especially relating to emerging stock mar - kets. In this paper, we examine if there is evidence of reversal effect and momentum effect for the Indian market and whether trading strategies based on these effects provide abnormal returns. The issue of sen - sitivity of contrarian and momentum strategies to the selection of time horizon has also been investigated. The evaluation of the investment strategies shall throw light on investor behaviour. For instance, if investors under-react or over-react to stock market information, then trading strategies that select stocks based on past returns will exist. This has a direct implication for the state of efficiency of a given stock market.

The empirical findings suggest that there is a weak reversal of long-term past returns in the Indian equity market, while the short-term past returns tend to exhibit a strong continuation pattern. Moreover, time-specific investment strategies based on such patterns in the stock returns do provide extra-normal returns.

\u2022 Long-term winners continue to provide higher returns than long-term losers (long-term momen tum strategy).

\u2022 Short-term winners continue to outperform short - term losers in future (short-term momentum strat - egy)-

The data comprises of month-end share prices for 364 companies that form part of the CRISIL-500 index from July 1989 to March 1999. The CRISIL-500 is a broad - based and value-weighted stock market index which gives representation to 97 industry groups. The sample companies account for a major portion of the market capitalization and trading volume for the Indian market. They are, hence, fairly representative of the general market performance.

The share price information, collected from Capital Market Line Software, has adjusted for capitalization changes such as bonus, rights, and stock splits to make the price series comparable over time. The share capitalization information is obtained from the Bombay Stock Exchange (BSE) website. More - over, the price series have been converted into monthly return series so that they are compatible for further research. The stock returns have been esti - mated using only the capital gain component. The dividend information has been consciously ignored as the stock market indices in India, including the BSE National Index used in the study, exclude dividends while computing index values. The inclu - sion of dividends in stock returns would have introduced a bias in regression results which involve stock returns and index returns as dependent and explanatory variables respectively.

The BSE National Index has been used as a surrogate for aggregate economic wealth. The BSE National Index is the broad-based and the value weighted market proxy constructed on the lines of Standard & Poor of USA. The implicit yields on the 91-day treasury bills are employed as risk-free sur - rogate, as is the common practice in investment literature. The data source for T-bills is the R e p o r t.

Generally, fairly long series of stock returns are desirable for performing evaluation of investment strategies. However, the study period has been restricted owing to the fact that continuous long-term price information for the sample companies is not available with us. Nonetheless, we feel that a 10-year sample period is sufficient to detect any visible patterns in stock returns especially in light of the thinness of trading problem in the Indian market.

In June of each year t (starting from 1992), the sample securities are ranked in an ascending order on the basis of their average returns for the past 36 months (July 1989 to June 1992 for the first time). The ranked securities are then used to form five equal portfolios. While portfolio P, contains the bottom 20 per cent securities and is called "losers' portfolio," portfolio P 5 contains the top 20 per cent securities and is termed as "winners' portfolio." The equally-weighted monthly returns are then estimated for the five portfolios from July of year t to June of t+1, and the portfolios are reformed in June of t+1 based on new rankings. The resultant portfolios represent long-term i month/j month investment strategy where i is the portfolio formation period (36 months in the present case) and j is the portfolio holding period (12 months in our case).

The mean returns for the five portfolios based on long-term past returns are shown in Table 1 (Panel A). The long-term returns seem to follow a continu - ation pattern. The simple annualized mean returns for the losers' portfolio (PJ and the winners' portfolio (P 5 ) are -0.24 per cent and 5.45 per cent respectively.

Next, the extra-normal returns for the five portfolios are estimated using the familiar market model equation,

Alpha (the intercept value) is expected to be close to zero. However, a significantly positive (negative) alpha implies superior (inferior) perform - ance. The market model results are shown in Table 1 (Panel B). The alpha differential between P 5 (winners' portfolio) and P, (losers' portfolio) is .0047 per month (t-value=4.61) which is statistically signifi - cant at 5 p'er cent level, providing support for momentum strategy in the long run. The findings for long-term past returns are in contrast with those for the US market. As mentioned earlier, De Bondt and Thaler document success of contrarian invest-

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Contrarian Vs. Momentum.

It can take longer for profits to materialize when investors take a contrarian approach.

Contrarian and momentum are two types of investment strategies. While momentum investing is a method that attempts to take advantage of the most recent market trends, contrarian investing takes the opposite approach. Market contrarians invest on the premise that the most recent market conditions aren't realistic, and therefore they make investment decisions that deviate from the general direction of the markets.

Contrarian.

Contrarian investing involves hunting for stocks that are seemingly not trading up to their value potential. While a mainstream investor sees little value in a stock or a financial security from another asset class, and consequently avoids the investment like the plague, a contrarian investor recognizes a diamond in the rough and thinks he is getting a bargain. When investing in metals produced a loss for investors in 2004 while the broader stock market produced gains of 8 percent, contrarian investors who identified an opportunity would have chosen to invest in metals. By the following year, profits for such contrarian investors were more than 30 percent.

Momentum investors aren't afraid to jump on the bandwagon and invest in the most popular securities of that time. When Internet technology stock prices were reaching new highs in the mid-1990s, the companies went year after year without earning profits. Momentum investors didn't base their decisions on the companies' profits, and instead continued to invest because Internet stocks were making investors quick money. By 2000, as soon as the ride for these stocks was ending and prices began falling, momentum investors took that cue to sell shares until the next fad came along.

Contrarian investors look for financial securities that appear to be treated unfairly by other investors. The primary risk facing contrarian investors is that they misread an investment's potential and the financial security actually has further declines ahead, not gains. For momentum investors, the greatest risk is that they enter a position too late because a financial security has already seen its best days. In that case, instead of continuing its climb the stock price would head in the opposite direction, leaving the momentum investor with a financial loss.

Warren Buffett, one of the most highly visible stock market investors, has helped to promote a contrarian investment style. One of his famous sayings is, “Be greedy when others are fearful, and be fearful when others are greedy.” Professional money manager Richard Driehaus, who started his own investment firm in 1982, helped to promote momentum investing. His strategy is the opposite of Buffett's, as Driehaus advocates buying high-priced stocks and waiting for prices to rise higher before selling for a profit.

References.

About the Author.

Geri Terzo is a business writer with more than 15 years of experience on Wall Street. Throughout her career, she has contributed to the two major cable business networks in segment production and chief-booking capacities and has reported for several major trade publications including "IDD Magazine," "Infrastructure Investor" and MandateWire of the "Financial Times." She works as a journalist who has contributed to The Motley Fool and InvestorPlace. Terzo is a graduate of Campbell University, where she earned a Bachelor of Arts in mass communication.

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