Contrarian Ripple Trading, My Take

Posted by Dan Hung

June 26, 2008

In my last post reviewing Contrarian Ripple Trading, I mentioned that I would attempt to contribute my own take on a so-called contrarian ripple trading strategy which might act as an addendum or clarification on the views presented in the book. I don’t want to give away the authors’ entire strategy so I’m only going to lay out a quick summary before I go into my extension on their technique. If you’re interested in this strategy, I suggest you read their book for more details (though be sure to take some of the claims with a grain of salt). Let me remind you that this isn’t necessarily a strategy I would follow myself, but I do find it interesting from an academic point of view. If anyone else who has attempted to trade “ripples” has anything else to offer, please do leave a comment.

Contrarian Ripple Trading as a strategy is a trading strategy built around the idea of mean reversion. Basically, the investor starts by looking for stocks trading at their 52-week low (or some other relative low). As with most mean reversion strategies, the safest course of action is to focus on large cap stocks that have a more or less established baseline value. Mean reversion strategies also make sense for use when the investor has a particular knowledge of a company and believes that a recent decline in stock price is unwarranted (but this begins to verge on value investing and leaves the scope of our trading strategy).

Upon identifying stock trading at a relative low, the investor then looks to take a position in the stock as the stock bottoms. This is based on the general principles outlined in Dow Theory which predict that a stock will trade randomly (a.k.a. ripples) in a tight lateral range after a big move down during periods described by market sentiment as despair and accumulation. What I believe the authors fail to warn the reader of is that it’s not enough just to identify a stock falling to its 52-week lows, but also to ascertain that there is things will not keep getting worse. The authors address this tangentially by warning readers only to purchase the stock of large cap companies or companies that they have particular knowledge of, but this isn’t really enough to protect person looking to make short-term profits in a stock.

Moving on from the identification of a bottom base comes the most interesting part of this startegy and an area where the authors of Contrarian Ripple Trading are either geniuses or simply very, very lucky. The reason it is advised that traders and investors avoid periods of lateral trading is that “ripples” are characterized by essentially random movement. It is difficult to time in and out of these trades and make money regularly. The only way to do so is with a very precise sell strategy. Here, waiting just a bit too long to sell can ruin the trade and force the investor to hold the position much longer than is worthwhile. This is outlined by the fact that the authors of Contrarian Ripple Trading, while supposedly never realizing any losses have managed to hold positions in excess of 2 or 3 years without any real return. That being said, the authors’ of the book choose a seemingly minimal target for nominal gain (read the book to find out or read the reader reviews on Amazon.com) and, for reasons unknown, it is successful in the majority of their trades. For someone looking to extend this strategy or turn it into a true algorithmic trading strategy, some research into how big “ripple” movements during a basing period tend to be could prove quite lucrative.

An Example of Contrarian Ripple Trade

Let me walk you through, what I believe would be a classic application of Contrarian Ripple Trading. Microsoft, a large cap stock with strong competitive position and in an indespensible industry, fell into a trading range near its 52-week lows in the last six months. This, in and of itself should be enough to warrant consideration for trading the stock at these levels, but let’s add in the fact that we know at least part of the fall was due to a dilutitive (and questionable) merger offer which (at the time) was not very likely to go through (and subsequently fell apart).

Looking at the chart, it is not enough simply to begin buying shares of the stock as it hits its 52-week low. Instead, one has to ascertain some amount of buying support at this level. Here, we must wait for a bounce off to establish a possible trading range/bottom base. This is identified in the a bove chart by the support line created by the previous 52-week low and the subsequent bounce back to the top of the gap-down identified by the first green circle. Now, as no contrarian would buy on a bounceback rally, we must wait for the stock to approach support level once again. Here, one would begin the first of his ripple trades. Buying as the stock approaches support and selling at some predetermined profit taking level. The stock loses its appeal once it breaks past its resistance level and we move onto another stock. In the case of Microsoft, the stock seemingly broke out but quickly moved back into the previously identified trading range. It’s hard to say whether or not one should buy the next test of support, but given that the stock holds on its support line for 4 trading periods, it would seem tempting enough and would have rewarded the trader with quick pop within a day or two.

Now, while playing this ripple trading game, one cannot simply assume that support will always hold. Sometimes, as is the case with Bank of America’s stock over the last few months (and much to my dismay), the stock will bounce around its 52-week low before plummeting through support. Buying here is not contrarian, but simply catching a falling knife. How does one avoid riding the ripples too long? It’s hard to say, but some tell tale signs can be found. The two most tell tale would be that ripple rallies only ascend to lower and lower highs and selling volume increases with each downward test of support. If this begins happening during your ripple trades, move onto the next target.

All-in-all, this strategy would seem to have a chance of working, but is likely best suited for people with a lot of money to invest. In the example of Microsoft, ripple rallies moved no more than $1.50 per share and there’s no guaranteeing that you will buy the absolute bottom of a support test and absolutely no way to time the top of the rally. Instead, you must be able to buy enough shares so that a small per share gain will yield a satisfactory nominal gain. This is akin to the way merger arbitrageurs often play by investing large sums to capture small changes in price in a stock. If your interested in how you might be able to do this at home, the authors of Contrarian Ripple Trading present a crude and unscientific way of doing it. But, I think most of the savvy readers of this blog might be able to come up a few of their own ideas.