How to trade a bear market

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A bear market is probably the greatest fear for stock traders. We all remember the images from investors or traders in 1973–1975, 2000–2002 and 2008 who just lost half of their money or worse. Although bear markets occur much less than bull markets it might be good idea to be prepared for the worst, since strong market corrections always happen when you least expect it.  

What is a bear market?

A bear market is when stock prices are declining and market sentiment is pessimistic. Generally, a bear market occurs when a broad market index falls by 20% or more over at least a two-month period.

Since 1930 there have been many market corrections but only eight bear markets. Historically, bear markets last shorter than bull markets as shown on the chart below.

bear market

〉〉 The average bull market period lasted 9.1 years with an average cumulative return of 476%.
〉〉 The average bear market period lasted 1.4 years with an average cumulative loss of -41%.

Many investors prefer to look at the S&P500 index as to warn them if markets are turning bearish.

 

What are the other types of downward markets?

There are four types of a downward market, and this is how they differ from a bear market.

Market pullbacks or retracements. This is a temporary reversal in the movement of share prices. A downtrend can be seen when a share price moves lower following a recent uptrend. A retracement doesn’t mean much since it happens all the time. It can be profit taking or covering a long or short position. There are technical indicators to determine whether it is a reversal or the start of something more.

Reversals. A reversal is a turnaround in the price movement of a share or other asset, when an uptrend becomes a downtrend. The period of decline is longer than a market pull back.

Market corrections. This is a 10% decline in the price of a share or index from a 52-week high. It is called a correction because it is sign that companies are currently overvalued, mostly due to speculation. A market correction is considered a good thing, since it releases market pressure and reduces the “hype”.

Recession. A recession is a complete economic decline that takes place over a six-month period or longer. During a recession stock prices will suffer too as businesses earnings are impacted.

 

How to spot if a market correction turns into a bear market?

Below some of the indicators that Bank of America uses to spot if the market trend turns bearish.

  1. Federal Reserve raising interest rates
  2. Tightening credit conditions
  3. Minimum returns in the last 12 months of a bull market have been 11%
  4. Minimum returns in the last 24 months of a bull market have been 30%
  5. Low quality stocks outperform high quality stocks (over six months)
  6. Momentum stocks outperforming (over six to 12 months)
  7. Growth stocks outperforming (over six to 12 months)
  8. 5% pullback in stocks over the last year
  9. Stocks with low price-to-earnings ratio underperform
  10. Conference Board’s consumer confidence level has not hit 100 within 24 months
  11. Conference Board’s percentage expecting stocks go higher
  12. Lack of reward for earnings beats
  13. Sell side indicator, a contrarian measure of sell side equity optimism
  14. Bank of America Fund Manger Survey shows high levels of cash
  15. Inverted yield curve
  16. Change in long-term growth expectations
 
I like to always keep a close eye on tightening credit conditions, which occurs when it becomes harder to borrow money from the bank. In times of uncertainty or an economic slowdown, banks will tighten their lending taps to hedge for risk. Each of the last three bear markets started when a positive percentage of banks tightened lending standards. A recent Fed survey showed banks expected credit standards to tighten this year.
 

What can I trade in declining markets?

Price declines are not the end of the world. Therefore it’s highly recommend to increase your knowledge about what asset classes to trade if markets turn bearish. Below a few of our picks:

Put options

A put option is an option contract that gives the buyer the right, but not the obligation, to sell the underlying security at a specified price (also known as strike price) before or at a predetermined expiration date. It is one of the two main types of options, the other type being a call option. Put options are traded on various underlying assets such as stocks, currencies, and commodities. They protect against the decline in the price of such assets below a specific price. Although it can be used to protect (hedge) your portfolio, options are considered to be a complex product. So make sure you understand how they work before start trading them. 

Buy ETF’s

An exchange-traded fund, or ETF, is a fund that can be traded on an exchange like a stock, meaning it can be bought and sold throughout the day. ETFs often have lower fees than other types of funds. Depending on the type, ETFs have varying levels of risk. Some ETF’s aim to gain value in declining markets. A few examples are 

ProShares UltraPro Short QQQ
ProShares UltraPro Short S&P500
ProShares UltraShort S&P500

Short index futures

Futures contracts, or futures, are legal agreements to either buy or sell a given security, commodity, index or asset at a specific time in the future, for a previously agreed-upon price. For investors, they offer access to commodities and other markets they might not be able to access otherwise.

Futures are a popular way to hedge bearish markets. By selling an S&P500 index future (ticker:ES) you will earn if the index declines. Downside of a future is that the contract sizes are rather large and you need to have a pretty large account in order to use this asset class for hedging. 

Algo trading

We wouldn’t be taken seriously if we would mention this interesting play during market declines. Reason be, robots trade long and short not to mention in very liquid asset classes. Although we mainly focus on forex robots, we also offer algorithmic strategies for other cfd’s, such as indices, stocks and commodities. Biggest advantage of using a trading bot is that it goes short without being affected by any kind of emotion. Since shorting is a complex game plan, you might as well give it a go with a trading bot. 

Find good stocks to buy

In a bear market, the stocks of both good and bad companies tend to go down. But bad stocks tend to stay down, while good stocks recover and get back on the growth track.

Conclusion

It’s hard to prevent your portfolio from being affected due to a market crash, correction or pull back. A bear market is a bit easier to detect, since many indicators as well as the media will start to send warning signals. Selling all your stocks is not a good idea,  since you will lose dividend payments and your money will be exposed to inflation. If we had to pick we would opt for any of the given options in this article whereas ETF’s are probably the lesser risky choice. As algorithmic trading crusaders we invite you to test one or strategies to see how they behave during any market condition.  

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Risk Warning: CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage. Between 74-89% of retail investor accounts lose money when trading CFDs. You should consider whether you understand how CFDs work and whether you can afford to take the high risk of losing your money.