The Principle of Contrary Opinion in Futures
posted under
Philosophy of Technical Analysis
by ceecabolos
Oscillator analysis is the study of market extremes. One of the most widely followed theories in measuring those market extremes is the principle of Contrary Opinion. At the beginning of the book, two principal philosophies of market analysis were identified—fundamental and technical analysis. Contrary Opinion, although it is generally listed under the category of technical analysis, is more aptly described as a form of psychological analysis. Contrary Opinion adds the important third dimension to market analysis—the psychological—by determining the degree of bullishness or bearishness among participants in the various financial markets.
The principle of Contrary Opinion holds that when the vast majority of people agree on anything, they are generally wrong. A true contrarian, therefore, will first try to determine what the majority are doing and then will act in the opposite direction.
Humphrey B. Neill, considered the dean of contrary thinking, described his theories in a 1954 book entitled, The Art of Contrary Thinking. Ten years later, in 1964, James H. Sibbet began to apply Neill's principles to commodity futures trading by creating the Market Vane advisory service, which includes the Bullish Consensus numbers (Market Vane, P.O. Box 90490, Pasadena, CA 91109). Each week a poll of market letters is taken to determine the degree of bullishness or bearishness among commodity professionals. The purpose of the poll is to quantify market sentiment into a set of numbers that can be analyzed and used in the market forecasting process. The rationale behind this approach is that most futures traders are influenced to a great extent by market advisory services. By monitoring the views of the professional market letters, therefore, a reasonably accurate gauge of the attitudes of the trading public can be obtained.
Another service that provides an indication of market sentiment is the "Consensus Index of Bullish Market Opinion," published by Consensus National Commodity Futures Weekly (Consensus, Inc., 1735 McGee Street, Kansas City, MO 64108). These numbers are published each Friday and use 75% as an overbought and 25% as an oversold measurement.
Interpreting Bullish Consensus Numbers
Most traders seem to employ a fairly simple method of analyzing these weekly numbers. If the numbers are above 75%, the market is considered to be overbought and means that a top may be near. A reading below 25% is interpreted to warn of an oversold condition and the increased likelihood that a market bottom is near.
Contrary Opinion Measures Remaining Buying or Selling Power
Consider the case of an individual speculator. Assume that speculator reads his or her favorite newsletter and becomes convinced that a market is about to move substantially higher. The more bullish the forecast, the more aggressively that trader will approach the market. Once that individual speculator's funds are fully committed to that particular market, however, he or she is overbought—meaning there are no more funds to commit to the market.
Expanding this situation to include all market participants, if 80-90% of market traders are bullish on a market, it is assumed that they have already taken their market positions. Who is left to buy and push the market higher? This then is one of the keys to understanding Contrary Opinion. If the overwhelming sentiment of market traders is on one side of the market, there simply isn't enough buying or selling pressure left to continue the present trend.
Contrary Opinion Measures Strong Versus Weak Hands
A second feature of this philosophy is its ability to compare strong versus weak hands. Futures trading is a zero sum game. For every long there is also a short. If 80% of the traders are on the long side of a market, then the remaining 20% (who are holding short positions) must be well financed enough to absorb the longs held by the other 80%. The shorts, therefore, must be holding much larger positions than the longs (in this case, 4 to 1).
This means further that the shorts must be well capitalized and are considered to be strong hands. The 80%, who are holding much smaller positions per trader, are considered to be weaker hands who will be forced to liquidate those longs on any sudden turn in prices.
Some Additional Features of the Bullish Consensus Numbers
Let's consider a few additional points that should be kept in mind when using these numbers. The norm or equilibrium point is at 55%. This allows for a built-in bullish bias on the part of the general public. The upper extreme is considered to be 90% and the lower extreme, 20%. Here again, the numbers are shifted upward slightly to allow for the bullish bias.
A contrarian position can usually be considered when the bullish consensus numbers are above 90% or under 20%. Readings over 75% or under 25% are also considered warning zones and suggest that a turn may be near. However, it is generally advisable to await a change in the trend of the numbers before taking action against the trend. A change in the direction of the Bullish Consensus numbers, especially if it occurs from one of the danger zones, should be watched closely.
The Importance of Open Interest (Futures)
Open interest also plays a role in the use of Bullish Consensus numbers. In general, the higher the open interest figures are, the better the chance that the contrarian positions will prove profitable. A contrarian position should not be taken, however, while open interest is still increasing. A continued rise in open interest numbers increases the odds that the present trend will continue. Wait for the open interest numbers to begin to flatten out or to decline before taking action.
Study the Commitments of Traders Report to ensure that hedgers hold less than 50% of the open interest. Contrary Opinion works better when most of the open interest is held by speculators, who are considered to be weaker hands. It is not advisable to trade against large hedging interests.
Watch the Market's Reaction to Fundamental News
Watch the market's reaction to fundamental news very closely. The failure of prices to react to bullish news in an overbought
area is a clear warning that a turn may be near. The first adverse news is usually enough to quickly push prices in the other direction. Correspondingly, the failure of prices in an oversold area (under 25%) to react to bearish news can be taken as a warning that all the bad news has been fully discounted in the current low price. Any bullish news will push prices higher.
Combine Contrarian Opinion with Other Technical Tools
As a general rule, trade in the same direction as the trend of the consensus numbers until an extreme is reached, at which time the numbers should be monitored for a sign of a change in trend. It goes without saying that standard technical analytical tools can and should also be employed to help identify market turns at these critical times. The breaking of support or resistance levels, trendlines, or moving averages can be utilized to help confirm that the trend is in fact turning. Divergences on oscillator charts are especially useful when the Bullish Consensus numbers are overbought or oversold.
The principle of Contrary Opinion holds that when the vast majority of people agree on anything, they are generally wrong. A true contrarian, therefore, will first try to determine what the majority are doing and then will act in the opposite direction.
Humphrey B. Neill, considered the dean of contrary thinking, described his theories in a 1954 book entitled, The Art of Contrary Thinking. Ten years later, in 1964, James H. Sibbet began to apply Neill's principles to commodity futures trading by creating the Market Vane advisory service, which includes the Bullish Consensus numbers (Market Vane, P.O. Box 90490, Pasadena, CA 91109). Each week a poll of market letters is taken to determine the degree of bullishness or bearishness among commodity professionals. The purpose of the poll is to quantify market sentiment into a set of numbers that can be analyzed and used in the market forecasting process. The rationale behind this approach is that most futures traders are influenced to a great extent by market advisory services. By monitoring the views of the professional market letters, therefore, a reasonably accurate gauge of the attitudes of the trading public can be obtained.
Another service that provides an indication of market sentiment is the "Consensus Index of Bullish Market Opinion," published by Consensus National Commodity Futures Weekly (Consensus, Inc., 1735 McGee Street, Kansas City, MO 64108). These numbers are published each Friday and use 75% as an overbought and 25% as an oversold measurement.
Interpreting Bullish Consensus Numbers
Most traders seem to employ a fairly simple method of analyzing these weekly numbers. If the numbers are above 75%, the market is considered to be overbought and means that a top may be near. A reading below 25% is interpreted to warn of an oversold condition and the increased likelihood that a market bottom is near.
Contrary Opinion Measures Remaining Buying or Selling Power
Consider the case of an individual speculator. Assume that speculator reads his or her favorite newsletter and becomes convinced that a market is about to move substantially higher. The more bullish the forecast, the more aggressively that trader will approach the market. Once that individual speculator's funds are fully committed to that particular market, however, he or she is overbought—meaning there are no more funds to commit to the market.
Expanding this situation to include all market participants, if 80-90% of market traders are bullish on a market, it is assumed that they have already taken their market positions. Who is left to buy and push the market higher? This then is one of the keys to understanding Contrary Opinion. If the overwhelming sentiment of market traders is on one side of the market, there simply isn't enough buying or selling pressure left to continue the present trend.
Contrary Opinion Measures Strong Versus Weak Hands
A second feature of this philosophy is its ability to compare strong versus weak hands. Futures trading is a zero sum game. For every long there is also a short. If 80% of the traders are on the long side of a market, then the remaining 20% (who are holding short positions) must be well financed enough to absorb the longs held by the other 80%. The shorts, therefore, must be holding much larger positions than the longs (in this case, 4 to 1).
This means further that the shorts must be well capitalized and are considered to be strong hands. The 80%, who are holding much smaller positions per trader, are considered to be weaker hands who will be forced to liquidate those longs on any sudden turn in prices.
Some Additional Features of the Bullish Consensus Numbers
Let's consider a few additional points that should be kept in mind when using these numbers. The norm or equilibrium point is at 55%. This allows for a built-in bullish bias on the part of the general public. The upper extreme is considered to be 90% and the lower extreme, 20%. Here again, the numbers are shifted upward slightly to allow for the bullish bias.
A contrarian position can usually be considered when the bullish consensus numbers are above 90% or under 20%. Readings over 75% or under 25% are also considered warning zones and suggest that a turn may be near. However, it is generally advisable to await a change in the trend of the numbers before taking action against the trend. A change in the direction of the Bullish Consensus numbers, especially if it occurs from one of the danger zones, should be watched closely.
The Importance of Open Interest (Futures)
Open interest also plays a role in the use of Bullish Consensus numbers. In general, the higher the open interest figures are, the better the chance that the contrarian positions will prove profitable. A contrarian position should not be taken, however, while open interest is still increasing. A continued rise in open interest numbers increases the odds that the present trend will continue. Wait for the open interest numbers to begin to flatten out or to decline before taking action.
Study the Commitments of Traders Report to ensure that hedgers hold less than 50% of the open interest. Contrary Opinion works better when most of the open interest is held by speculators, who are considered to be weaker hands. It is not advisable to trade against large hedging interests.
Watch the Market's Reaction to Fundamental News
Watch the market's reaction to fundamental news very closely. The failure of prices to react to bullish news in an overbought
area is a clear warning that a turn may be near. The first adverse news is usually enough to quickly push prices in the other direction. Correspondingly, the failure of prices in an oversold area (under 25%) to react to bearish news can be taken as a warning that all the bad news has been fully discounted in the current low price. Any bullish news will push prices higher.
Combine Contrarian Opinion with Other Technical Tools
As a general rule, trade in the same direction as the trend of the consensus numbers until an extreme is reached, at which time the numbers should be monitored for a sign of a change in trend. It goes without saying that standard technical analytical tools can and should also be employed to help identify market turns at these critical times. The breaking of support or resistance levels, trendlines, or moving averages can be utilized to help confirm that the trend is in fact turning. Divergences on oscillator charts are especially useful when the Bullish Consensus numbers are overbought or oversold.
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