There is an axiom in trading that goes like this: “When one side of the boat gets too crowded, it’s time to step to the other side before it tips over.” In other words, when there’s too much bullishness (or bearishness) in the markets, it’s time to follow a contrarian trading strategy. Right now, there’s too much complacency, making it a good time to sell. On the flip side, when there’s too much fear (like back in March), it’s a good time to buy.
As I often say, nobody rings a bell at the top or bottom to let you know it’s time to sell or buy. You need to follow the indicators to understand where the sentiment lies.
When to follow a contrarian trading strategy
One of my favorite indicators is the volatility index, or the VIX. It is often the best contrarian signal out there. When fear is rising the market is often decelerating, often at a swift pace. This is exactly what happened in early 2020 when the VIX climbed an astonishing 650% in six short weeks. (To put that into perspective, it was the largest move the VIX has ever made.) With some help from the Fed and the Federal stimulus package, markets roared back and are near all-time highs today.
Back in March, how could you have known it was time to buy? Besides sky-high volatility, there were some clues out there. However, many people were shying away from the markets as they had other things on their minds (lost jobs, falling income, shuttered businesses, covid infections and family tragedies). Those who did use a contrarian trading strategy scooped up Disney, JP Morgan, Apple and Home Depot. Panic-driven selloffs of quality stocks only come around so often. You need to be ready to take advantage.
As you look back on 2020, remember these lessons: Don’t panic – opportunities arise from dark market days. Have cash available at all times so you’re ready to strike when you see a good trade. Keep your portfolio balanced and diversified with high quality names – the ones that will be around for many decades.