Contrarian Trading: Price Action Matters

by | May 15, 2019

Trade war headlines have been the main catalysts for the volatility this week. Now, the POTUS softened his tone yesterday, causing the market to recover some of its losses from Monday. However, trade talks will be still a main catalyst, as the POTUS has until midnight Friday to decide whether the U.S. should impose car tariffs on Europe.

The market has been very news sensitive these past couple of weeks… and traders are struggling to find a clear market direction.

That said, I’ve been trying to keep clients away from danger, by laying out seven tips for trading volatile markets, as well as, some strategies that are working, like my recent contrarian trade in Weight Watchers.

In fact, I mentioned that trade to you about five days ago…

And what do you know… yesterday it was time to collect…

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Another bulls-eye!

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Now, I didn’t take profits simply because I felt like it or was happy with the returns. You see, there was something very odd that I saw in the price action that made me bail on the position. It’s an important lesson, and something you need to be aware of as you further develop as a trader.


Price Action is Key With Contrarian Trading


If you read my post about contrarian trading, you probably remember I was in Weight Watchers (WW) for a contrarian trade. Now, I want to walk you through that trade again because I’ve been getting questions about my thought process in it.

The reason: I sold the rest of my options… even though the market was strong yesterday.

More specifically, traders were asking me why I sold and didn’t let it ride because I did take 100%+ gains on a portion of the trade earlier.

Well, it’s simple.

With this market environment, you don’t want to hold onto positions too long, especially since stocks have been very sensitive to trade war headlines.

That said, let’s walk through this trade once more and the reasoning why I sold yesterday despite the market bouncing right below the $280 level (something I talked about in my post the other day).


Weight Watchers (WW) Contrarian Trade Case Study


Remember, with a contrarian trading strategy, we’re looking to go against the trend. In other words, if a stock has been beaten down, we’re looking to buy calls or shares in the stock. On the other hand, if a stock has been running up, but hit a resistance level, we might look to buy put options in the name.

That said, WW has been down over 50% since November 2018.

Keep in mind, we’re not trying to buy the stock as its falling. In other words, we’re not trying to play around with falling knives here. I’m looking for areas where the stock has found some support to buy calls or stock, or selling to open put options to express my bullish outlook on a stock.

For example, here’s a look at the thesis on the WW trade that I sent out to clients.

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Now, there were some catalysts in play (earnings and Oprah’s ads running). Remember, holding options into earnings is very risky… so make sure you can stomach the risk and size your positions in a way that won’t wipe out your account. That means you should be comfortable with the amount you could lose.

Remember this chart?

That’s what WW did after its earnings announcement. I sold most of my position for a 100% gain… but I was still long some call options and letting them ride. It was more or less a risk-free trade because I really couldn’t lose money on the entire trade… I was practically playing with house money.

You see, WW finally broke above the gap at $22, and it had room to the $30 area… so I figured it was a good risk-reward to let the rest ride.


Relative Weakness and Strength


Well, here’s the reason I sold the rest of my call options.

If you look at the chart above, you can see WW getting back into the gap. Well, my thinking was… since it broke below $22, it could fill the gap up from its earnings… and then it could test that $18 level again.

Additionally, when you compare WW to the SPDR S&P 500 ETF (SPY) – a market-tracking exchange-traded fund (ETF) – it was relatively weak. In other words, despite SPY was trending higher pretty much all day yesterday… WW didn’t continue higher… in fact, it was trending lower all of yesterday.

Now, compare that hourly chart in SPY to this hourly chart in WW (below).

As you can see, while the market was trending up… WW was trending down all day.

Now, there are multiple ways to see whether a stock is relatively strong or weak. For example, I compared WW to the overall market, but I could compare it to its competitors or the industry. However, with the market affecting all stocks with recent headlines… I figured it made more sense to compare WW to SPY.

So here’s what you need to remember about relative weakness. If the overall market or industry is trending up… while the stock is trending lower… it means the stock is relatively weak. If you’re long, it’s time to look for an exit.

On the other hand, if the overall market or industry is trending lower, while the stock is trending up, that means the stock is relatively strong… if you’re long, it’s probably okay to stay in your position. However, if you’re short the stock or long put options, it signals it’s time to cover the short or close out those put options.

Now, once I saw that throughout the day… I alerted clients about my moves in WW.

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The whole idea about contrarian trading is to catch bounces in the stock. However, I always respect the overall trend. For example, WW still hasn’t broken out of the downtrend… and with the stock being relatively weak in relation to the market yesterday… that signaled this stock could continue lower. Now, I’ll still keep WW on my watchlist if it pulls back to an area of support.

If you’d like to keep up with some of my trades and how I’m trading in this market, make sure to follow me on TwitterInstagramFacebook, and Youtube.


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