What is a Fade?
A fade is an investment strategy devoted to doing the opposite of the prevailing wisdom. In the brokerage sector, it also refers to a dealer's inability or refusal to fill an order at the prevailing bid/ask spread the dealer has published (that is, the dealer 'fades' from trading).
How Does a Fade Work?
Fade investors love to do what's out of favor. They tend to buy when everyone else is selling, sell when everyone else is buying, and wait when everyone else is active. The result is that the contrarian often buys a cheap security that everyone else is calling a dog and sells a security that everyone else is clamoring to get into.
Fade investors often look for stocks with low price-to-earnings ratios. When the market goes up, they sometimes prefer value stocks to growth stocks; when the market goes down, they often favor growth stocks over value stocks.
The Dogs of the Dow strategy is a popular fade strategy whereby investors purchase the highest-yielding stocks in the Dow Jones Industrial Average. Remember, a stock has to pay a relatively high dividend and have a relatively low stock price to have a high dividend yield. When any of the investor's stocks rise in price so much that they are no longer one of the ten highest dividend-yield stocks, he sells them, capturing the gain and reinvesting the proceeds in the newest 'dog.'
Why Does a Fade Matter?
Fade investors zig when everyone else zags. They have strong stomachs, a sense of independence, and an ability to resist the temptations of going with the crowd. That can mean picking up a few dogs, and that can mean sticking with a stock if it has become a dog. Fade investors are not always right, but the philosophy has attracted many happy investors over the years. Even Burton Malkiel, who developed the random walk theory, which says there is no reliable way to beat the market in the long run, acknowledges that contrarian strategies can be successful. They tend to outperform other trading strategies because market reversals are often based on economic facts rather than investor psychology.
It is important to note that fade investing often works best for investors who have thoroughly analyzed the fundamentals of the companies they invest in. Companies with solid management teams, innovative products, efficient processes and good profit margins can often weather being unpopular with the crowd.