The contrarian investment philosophy is essentially founded on a cynical outlook.
When markets are booming, contrarians wonder how much longer it will last. Accordingly, they look for opportunities to deploy positions that go against popular sentiment.
When markets are in free fall, and investors are panicking, contrarians do the opposite - they once again look for opportunities to go the other way. A strategy that has paid off handsomely for those that bought (and held) the market lows in 2008-2009.
Traders looking to learn more about this approach might find a recent episode of Best Practices particularly interesting. On this installment, the hosts outline a handful of strategies that contrarians often consider when markets are at (or near) all-time highs.
Two scenarios are run on these various strategies in order to demonstrate how each might perform under a specific set of conditions. The two scenarios tested on Best Practices include a 5% down move and a 10% down move - both of which might fit a contrarian outlook.
Before we dive into the details of that study, let's first gather more context on the current trading environment.
While we can see from a simple chart of the S&P 500 that equity prices have reached impressive levels, there is other data that can be considered as well. One popular metric often monitored by traders is the Equities and Bond ratio.
Often calculated using /ES divided by /ZB, the Equities and Bond ratio is used to measure the relative value of equities to bonds. Since 2008, this ratio has ranged between roughly 5 and 16. As you can see in the chart below, the Equities and Bond Ratio recently took out highs that were last observed in December 1999, which wasn’t long before the dot-com bubble:
For more detailed information on the Equities and Bond Ratio, we recommend watching a recent episode of Closing the Gap: Futures Edition, which covers this metric in greater detail.
The shortened version is that when the ratio gets elevated, some traders view this as an opportunity to sell equities versus buying bonds. The reverse position is established when the ratio is depressed.
For contrarians that find the current levels in the Equities and Bond Ratio intriguing, the aforementioned episode of Best Practices outlines some position structures that might be considered to express a bearish opinion, including:
Short 100 shares of SPY
Long ATM put spread
Short 30 delta call
Covered put (short SPY and short SPY put)
Short call spread
Short /ES call
The true value of this episode is revealed when each of the above strategies is put through two hypothetical scenarios - a 5% down move and a 10% down in SPY.
Traders can use the compiled results not only see how each strategy performs through a 5% and 10% down move, but also to ascertain the respective “Probability of Profit (POP)” and “Return on Capital (ROC)” of each.
One clear takeaway from the data is that as the probability of profit decreases, the potential ROC increases. This makes sense because as most tastytraders already know, high probability positions are typically deployed with the intention of capturing small, consistent returns.
Regardless of your own strategy and outlook, the information contained in this episode is extremely valuable. While you may not feel a contrarian approach is warranted at present, you’ll at least be better prepared to potentially capitalize if market conditions shift.
We encourage you to reach out with any questions regarding the contrarian strategies examined on this episode of Best Practices at any time. Please leave us a message in the space below, or reach out directly at email@example.com.
We look forward to hearing from you!
Sage Anderson has an extensive background trading equity derivatives and managing volatility-based portfolios. He has traded hundreds of thousands of contracts across the spectrum of industries in the single-stock universe.
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