As we all know, the global market is extremely volatile. Even experienced investors may panic during times of uncertainty: nobody knows when it’s coming, how long it will last and how heavily it will impact stock prices.
Most of us know that we’ll survive a falling market, but few know that you can also prosper from it. In today’s trading, all you really need is movement. It doesn’t really matter if prices fall or rise – there is ample opportunity to make money. Here, we tell you how to stay on top of the next bear market.
What is the bear market?
Just when you think that the economy is smooth sailing and your portfolio performance is steadily going upward, market volatility pops up out of nowhere. As share prices fall, it’s often the case that the market will fall with them.
Speaking the language of finance, falling markets are also called “bear” markets. If you are new to trading, you might wonder what ‘bears’ have to do with it. In point of fact, there are even more mammals involved: a “bull” market, as opposed to a bear one, refers to a stock market that has been rising or is expected to rise.
So, how did all these animals get into finance? Well, there are actually a few theories about it. The most popular one is derived from the way in which these animals attack their prey: a bear swipes downward with its paws while a bull thrusts upwards with its horns. In both situations, the zoological terms are applied to the market when prices move by 20% or more over a period of time of two months or more.
Why markets fall
The stock market is known for having its constant ups and downs. Over the past decade, it has gone from the bottom of the Great Recession to new record highs.
There are many reasons that can cause a market to fall. Economic crises, political developments, changes in national economic policy or even a bad PR campaign performed by a large company can bring with it a bear market. The main indicators of the falling markets, among others, are weak productivity, low employment, a drop in business profits and low disposable income. Traders and investors always anticipate something new to occur that might push stocks into decline.
Continuously plummeting share prices result in a downward trend that investors expect to continue, which, in turn, reinforces the downward spiral. Eventually, sellers, frightened by an unexpected economic event, cause a market crash.
The dilemma of the falling markets is that you never really know whether it will be a simple 5% to 10% correction or a much deeper price decline. It can be quite tricky to determine the best timing and to manage active trading at the dawn of a bear market.
How to trade in a bear market
Now that we defined a bear market and identified its causes, we can move on to the trading techniques that can be successfully utilised during this downturn.
A great way to protect your portfolio from losses is to use options contracts:
- Buy puts. Buying put options is a typical bear market trading strategy with high reward potential and relatively low risk. To be profitable, the stock price should drop below the put option strike price, so the option is in the money before expiration. In this case, the loss is limited to the option price paid
- Bear call spreads. This strategy offers low risk but limited returns. The profit is the premium paid by selling out-of-the-money calls while simultaneously buying in-the-money calls. Once employing this technique, investors expect the stock to fall below the strike price of the calls sold before expiration in order to keep the premium. If the market moves against you, the out-of-the-money calls serve as insurance, limiting your loss to the difference between the strike prices
- Bear put spreads. A bear put spread trading strategy revolves around buying an in-the-money put and simultaneously selling an out-of-the-money put. This technique limits your loss to the amount you pay to enter the trade and provides a fair return once the stock closes below the out-of-the-money put prior to expiration
However, one of the most popular strategies of investing in a bear market is selling short. This practice includes borrowing stock that you don't own, selling it while the price is high, and then buying it back after the price declines. You can also short "against the box", following the same algorithm but with the stocks you already own.
Short selling can be easily done using today’s most favoured financial tool – contracts for difference (CFDs). These are ideal when you want to profit from a fall in price or a specific company decline. Without the need to own the actual asset, CFD trading provides you with an opportunity to use leverage, which can be as high as 1:30 – meaning you can control much larger volumes of shares by depositing a smaller initial amount of capital. It also significantly magnifies your potential gains, as well as your potential losses.
Margins and leveraged trading can become your best friends during the bear market. If you utilise them wisely, they will serve you well.
It is very important to stay patient. Don’t be in a rush to sell your stocks and get out of the game. Keep collecting your dividends and hold the stock, as a bear market doesn’t last forever. Revise your portfolio, keep an eye on the companies’ statistics, and act accordingly. By employing some strategies mentioned above, you can do quite well during those times when many others suffer large losses to their portfolios. At the end of the day, to be a successful trader, market movement is all you need.