Price action: the contrarian trading strategy

contrarian trading strategy

Today's lesson is going to be about changing the way you think about trading. Instead of acting on your first market impulse, stop and think about what's REALLY going on...

Think of trading as being binary: someone wins and someone loses. When a market moves in one direction, most retail traders jump on board somewhere in the middle or towards the end of that move, when things appear safe. However, it's often at these times when it seems "safe" to enter, that the market is ready to turn. And have you ever wondered "Who's on the other side of my trades?".

It is professional traders who take the risk of the retail trader (the other side of your trades), after all, someone has to sell you something or buy something from you when you want to place a trade. The trader therefore needs the market to move in the opposite direction to what you want, in order to make a profit. So if you can learn to think ahead and think like a professional trader, you can start improving your trading results.

Taking risks on the market

Who takes the risk when you trade? The person that wants you to lose, that's who, because if you lose, they win. Therefore, he's your opponent, and since the majority of retail traders lose, that means the person offsetting your risk and turning it into profit is a professional trader.

It's obvious that you want to move from the struggling/losing trader team to the professional/winning trader team. So, you need to start thinking like a professional trader and stop thinking and behaving like an amateur.

The trading strategy of professionals is simply to compete with retail traders and compete with other professionals (opponents). They make large sums of money when other traders' speculative bets/positions go wrong and these traders end up losing when price reverses in the opposite direction.

The below chart below gives you an example of professionals offsetting the risk of amateurs. The uptrend was intact for some time before establishing a key resistance level / horizontal level. When the market retested this key resistance and tried to move above it, it was mostly a "desperation move" from all the amateurs entering near the top of the move and hoping for a breakout...even if the trend had already been there for months.

If you look closely, you will see that the uptrend was already quite weak, as it took place over several months. Professional traders were already on board and had already made their money by the time the price started to turn higher. We can then see that price failed to break above key resistance on two occasions. This was caused by amateur traders who thought the uptrend would continue and a breakout was imminent. Professionals could sense that the uptrend was coming to an end and they gladly took the risk from the more emotional and impulsive amateurs...

contrarian trading

The following example is a daily chart of Germany's stock index. Note the false breakout of the recent high, followed by another test and failure at that level, followed by a sharp drop of the market. This is yet another example of the need to closely monitor key levels for potential trend reversals, as these are the key levels where professionals typically step in to challenge the amateurs.

contrarian trading 2

Here is another great example of how to trade like a pro.

On the chart below of the S&P 500 index, you can see a false breakout/failure at the key resistance level. The market then fell dramatically, allowing those who sold short to make a lot of money. Again, it's very important to watch for false breakouts of key levels like this, as they often lead to huge moves in the other direction, which means quick profits for you, if you know how to spot these shifts before they happen.

The index then created a false breakout of key support following the huge sell-off. Successful traders know that trading is a game of anticipation.

contrarian trading 3

The contrarian strategy can go against the trend, and it can also be used within a trading range. You need to understand this concept well: "professionals are doing the opposite of what the herd does".

This doesn't mean that every time the market goes up, professionals sell, and it doesn't mean that every time the market goes down, professionals are buying. Once again, the concept we're trying to explain is a situation where a trader takes on the risk of another trader.

How to think like a professional trader

Professional traders are always thinking "What are the amateurs doing?" or "What would be the most obvious trade right now of a losing trader relying on emotions instead of logic and planning?".

Asking yourself basic questions like these before entering into a trade can sharply increase your odds of winning in the market. After all, we all know that around 90% of traders lose money over the long term, so it makes sense to try to do the opposite of what they're doing.

If a trend has already been showing for months, chances are that the pros have already made money on that trend or at least locked in a lot of the profits. So if a market has been trending for months and is approaching a key support or resistance level, you need to ask yourself if "entering here is what the pros would do or what the rookies would do".

Likewise, if a new trend has recently started and the market pulls back a bit towards a level of support or resistance, the pros are likely looking for an entry with that fresh/short-term momentum.

Amateur traders often ignore changing market dynamics until it is too late and the move is already over. Professional traders get into new trends early, they don't wait until the trend is almost over like the amateurs do.

How to trade like a professional trader

A strategy explains the reasoning behind the entry of a savvy pro into a trade - he doesn't enter randomly. He calculates, he reads the chart and he reads the emotions of the chart's market participants (via the price action). He leaps with precision, hitting his prey (the herd) with ice in his veins.

You're probably wondering what strategies can be used to trade this way. Some of the greatest traders say that all it takes is a simple horizontal line to trade the market successfully.

I'll go one step further and add price action confirmation signals (for example: pin bars, false breakouts etc. that occur on these horizontal lines).

By trading at and around these key chart levels, you can also apply tighter risk control. It is often enough to say that if one is below this level, one expects it to fall, and if one is above this level, one expects it to bounce back. As you can see, key horizontal levels allow for ideal risk management. This is often why markets reverse on these levels and at round numbers and so on. Try drawing them on your charts every day and every week and you will see for yourself how effective they are.

When you combine this price action with key levels, you'll start to look at the market like a pro does and you'll gain a significant edge over your competitors.

Conclusion

You should think of the market as a sea of competitors in which there is a group of traders, a bit like a school of fish. They will stick together, follow each other in a comfort zone, most don't know who is leading who. If you can imagine each short-term daily swing in the market as a school of lost fish following each other, you can shape reality in your favour. "What are most people doing today?" If they're likely to be wrong (most often), then I need to think logically and consider doing the opposite/being a contrarian. How can I use price action signals and key market levels to help me face my opponents and take an opposing view to the herd?

If you start using this logic, taking a step back and looking at the market from the other side (that of the pros), you'll not only be able to find excellent trading opportunities, but also avoid some bad trades.

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