How Contrarians Use Charts

A lot of people ask me if I use charts. I tell them yes and no. I do use them, but not the way most people do. As a contrarian, I tend to approach them differently.

I extensively studied technical analysis in the beginning of my career. I read everything I could about chart patterns, moving averages, stochastics, RSI, MACD, Fibonacci retracement levels, and whatever else possible there was to know. I even became a member of the Market Technicians Association.

I relied on charts and technical analysis almost exclusively for years, but I eventually found that it wasn't helping me very much. That was probably due more to my self-sabotaging behavior than to the charts, per se. However, once I started changing my self-defeating ways and making money, I mostly gave up the charts.

In articles critical of technical analysis and following the charts, I've said that such tools only show you where the markets have been and not where they are going. They're a crutch and nothing more. But I don't criticize chart followers anymore because I've come to realize that many investment approaches work and that you should choose the one that's aligned to your personality. I'm an economist and a contrarian; therefore, I use a fundamental value approach. It's what works best for me. I still use charts, too, but as I said, I use them in a different way. Let me explain further.

Wisdom from the trading floor
As a contrarian, I tend to sell during rallies and buy during weakness. Obviously, this can sometimes be a risky approach. I'm sure you heard the phrase "catching a falling knife" to describe buying on weakness, or "standing in front of a freight train" to refer to selling on a rally. Believe me, there is not an ounce of hyperbole in either of those two expressions, and anyone who has ever "bought the dip" or "sold the rally" can tell you so.

But what am I supposed to do -- stop being a contrarian because there's some risk involved? There's risk in being a momentum trader just as there is in being a trend follower. It's part of the game; it's part of life. You simply have to hone your skills, as is the case with anything you want to be good at.

When I look at charts, I like to look at significant highs and lows. That could mean the 52-week high or the 52-week low, or the high or low of the past week or month. It all depends on what my time frame is for the particular trade I'm considering.

As you might expect, I often try to sell at a significant high and buy at a significant low. Sometimes, I might do my buying or selling at a price that's just above the old high or just below the old low. That's a technique I learned very well when I was a floor trader. "Locals," or independent floor traders, as we were called, would always be playing a game we called "gunning for stops." How did we know where the stops were? Simple. We looked at a price chart and instantly got a very good idea, since most investors place buy stops just above important price highs and sell stops just below major lows.

Down in the pits, whenever the market would trade toward an important high or low, the locals would be loading up the boat and "pressing" the market in advance of it hitting that price level. As we got closer to a significant high, for instance, the floor traders would be buying like crazy. When the price got within one "tick," someone would, invariably, buy a single contract just to get a feel for whether the stops were there. This activity continued until, sooner or later, the stops were indeed hit. A flurry of buying ensued. As the buying ran its course, we liquidated our long positions into it and cleaned up every time. Not long after that, like the air coming out of a balloon, the market collapsed back down on its own weight. Sometimes we even reversed and went short into that move, playing the game on the downside.

The best of both worlds
My floor days are long gone, but I've adapted this technique to work with my current trading and investing activities. I still try to buy on dips and sell on rallies, but I always seek to limit my risk so that I don't get cut by the falling knife or mowed down by the freight train. I do that by synchronizing my buying and selling with market sentiment and the proper fundamentals.

I'll give you an example from a trade I made last year. I was watching Mittal (NYSE: MT  ) , the big global steel producer. Steel stocks were investor favorites in 2003 and 2004, but by early 2005, the bloom was falling off the rose. All you heard were concerns about overproduction. In fact, things had gotten so bad that the chairman of U.S. Steel complained that if China's steel production was not reined in, it would create a worldwide glut. Gone was all the talk of the unprecedented Chinese construction boom and the emerging economies of the world. It was as if somebody had turned off a switch.

Amid the enveloping gloom, I was quietly waiting for the right moment to pounce. Steel stocks were becoming nice and cheap. Investors were dumping them wholesale where just six months earlier they couldn't get enough of them. I wanted to buy stock in Mittal because it was the world's largest producer with a tremendous price advantage. And Mr. Market was now giving it away at bargain-basement prices. I knew it was time for me to step up with my bushel basket.

By early May 2005, Mittal's stock had dropped by more than 40%. I believed that this decline had discounted most, if not all, of the negative talk that had been swirling around since late 2004. I looked for a spot to buy and saw an important bottom around $25 that the stock had hit back in November 2004. That's where I placed my buy order for Mittal last May. Shortly thereafter, my order was filled.

Contrarian profits for the taking
Once I'm in, I have enormous patience. (Remember the four behaviors necessary for market success: patience, detachment, alignment, and discipline.) I am patient when it comes to putting on my position, and I am just as patient when I have it and am waiting for it to develop.

Here's what happened to me: Mittal's stock meandered for nearly three months, but never far from where I bought it. Then in August, it started to rally, only to fall back in October with the general market. But by December, it was off to the races, and we never looked back. The stock is now hitting new 52-week highs above $42. This represents a 68% percent return to me in a year, and now I'm starting to take profits on some of this position. Why? Because, not surprisingly, just as there was nothing but gloom in the outlook back in May 2005, the outlook has now radically changed. Consider this recent headline from Reuters: "Top U.S. Steelmakers See Bright Second Half."

The more things change, the more they stay the same.

I think you get the message: Contrarians can have fun with charts, too. Happy trading!

Mittal is aMotley Fool Inside Valueselection. For more coverage of the market's best bargain stocks, try out Inside Value free for 30 days.

Fool contributor Mike Norman is the founder and publisher of theEconomic Contrarian Update. He's also a Fox News business contributor and the host of BizRadio. Obviously, he holds shares of Mittal. The Motley Fool has a disclosure policy.


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