How To Trade In A Bearish Market

Grab new financial opportunities with our complete guide on a bear market and how to trade in such an environment,

A brown bear waking in front of a candle chart on a white background -How To Trade In A Bearish Market

Introduction

We’ve all watched those exciting blockbuster movies about trading. The compulsory scene in every one of these movies is the one that involves investors shouting ‘Buy, buy, buy!’ while the market prices are rising higher and higher.

What happens when the market declines and everyone is selling their investments, though? Do you buy or sell? Is there opportunity in what is called a bearish (declining) market?

In this article we will answer all these questions as well as equip you with some practical and useful strategies you can use to capitalize on such a market scenario.

What Is A Bearish Market?

In simple terms, a bear market happens when it falls by more than 20% over two months. This is usually the case due to a period of market pessimism that may be caused by a number of economic reasons.

The very basic lesson in economy and market trends is that the markets are governed by the supply and demand and that they are constantly changing. This natural buy and sell cycle within an economy leads to bull and bear markets. On the contrary of a bear market, a bull market is when the market is on the rise and prices are rising higher.

Prices are constantly rising and falling. However, what distinguishes a bear market from a mere temporary slump is when this period is prolonged for over two months. For example, when the global financial crisis in 2007 hit, the market’s prices slumped by 54% from October 2007 to March 2009. The good news is that traders were presented by a number of financial opportunities during this period.

Different Types of Bear Market

A bear market can attack in different ways for different reasons, leaving different repercussions. There are three types of bear markets.

Event-Driven Bear Market

As you might have already imagined, this kind of market comes about when an important event happens globally. A war, terrorist attack, oil shock and as happened recently, a pandemic, can all trigger a bear market. These types of bear are usually short-lived, recovering quickly after a small decline.

Structural Bear Market

On the other hand, this type of bear market tends to last the longest. A structural bear market occurs when imbalances within the economy and stock market bubbles are present. For example, when the global financial crisis hit in 2007 this was a structural bear market given it was linked to a bank crisis. Moreover, this type of bear market takes the longest to recover with an average time of almost 10 years until the market is restored.

Cyclical Bear Market

This type of bear market usually happens after a period of high interest and inflation rates in an economy and  tends to last for around two years.

The Characteristics Of A Bear Market

So how do you know it is actually a bear market and not just a temporary downturn of prices? Apart from the fact that it lasts more than two months these are the signs you should look for:

  1. Stock values start declining due to lower stock prices.
  2. Consumers buy less so company profits start dropping.
  3. Investors stop risking their capital and move their investments to safer options such as investment-grade bonds and Treasury bills. This is known as negative investor sentiment.
  4. There is a risk for deflation of money due to less money around.
  5. At some point what goes down must come up, so a turnaround happens. Due to lower interest rates, spending and borrowing happens again.

How Can You Profit During A Bear Market?

We have arrived to our million-dollar question. Mostly, we have been speaking in the negative, mentioning prices dropping and values declining. But there are most definitely opportunities in all this pessimistic talk. Traders have been using a downward market to their advantage for a very long time in financial history. So how can you profit from a bear market?

It might be intimidating and quite scary watching the money you have invested dwindling over time however with some resilience, you can most definitely reap the rewards of such uncertainty. Take a look at the below strategies:

Strategy #1: Buy Stocks But Make Sure They Are Great Stocks

During a bear market, all stocks tend to go down. However, bad stocks stay down while good stocks will increase in value eventually. You will be able to make money if you buy a great stock at a cheaper price than usual and then just weather the storm until its value rises again. What is crucial here is the research you put in, in finding your diamond in the rough.

So how can you find a good stock? The most obvious one to look out for is a company is a solid history of good sales and profits. A quick assessment of the company’s executive leadership as well as an analysis of how it stands when compared to its competitors is a good indicator of the outlook of the company. Making sure the debt-to-equity ratio is in line with industry norms as well as looking at the price-earnings ratio can give you a good idea of the stock’s market value.

Strategy #2: Diversify Your Portfolio

Variety is the spice of life and diversification is a great tip for any businessman, including investors. Different industries within the market perform differently during different times of the economic cycle. Take the bear market that happened during COVID-19 as an example. While certain businesses like gyms and physical cafeterias struggled, the stocks of online entertainment services such as Netflix soared. It is important to keep in mind that switching to stocks that are tied to basic human needs such as food and beverage is always the safest option to choose whilst going through a bear market.

Exchange-traded funds (ETFs) can be a great way to diversify your investments. ETFs are, in essence, a collection of assets purchased on the stock exchange via a stockbroker. Due to the diversity found within the stock it is a safer way to approach investing during a bear market. Moreover, it is an easier and simpler option for beginner traders given most ETFs requires require less active management. This will also result in fewer fees making them more cost-effective than mutual funds.

Strategy #3: Use Margin Carefully

Margin is a feature that allows traders to use borrowed funds from your broker to buy securities. So how does it come in when you use it during a bearish market situation? You can use margin to buy dividend-paying stocks after they have corrected. However, make sure you keep in mind the risk involved when using margin. Whilst you can profit from margin, you can equally lose money given you are technically using borrowed funds to trade. Having said that, using it wisely (and carefully) can really leverage your trading and gain advantage over other traders.

Strategy #4: Take a short-selling position

If you cannot beat them, join them! When the market is losing momentum, the obvious choice is to short-sell (go short). If the market will keep declining then you will profit from your prediction.

Make sure you do this in the beginning as the likelihood of the stock declining is higher. Keep in mind that you can never be 100% sure the direction the market will take (this is what makes trading so exciting of course) so there is still a risk you will lose money if the prices decide to rise.

Strategy #5: Assess The Situation Regularly

Monitoring the situation regularly and deciding to take profit regularly can be a safer way to check in and profit from a bearish market. Even in a bearish market, prices tend to go up and down regularly so safeguarding your profits by locking them in on a regular basis can help put your mind at ease.

Strategy #6: Locate A Good Entry Position

As every investor knows, timing is everything when trading. Opening a position once the market drops by 20% (and it is officially a bear market) will give you an advantage over other traders. Make sure you follow international and financial news closely and be ready to open a position once market situation is favourable.

Strategy #7: Use A Stop-Loss Order

A very useful trading tip to be implemented regularly in your trading activities should be setting a stop-loss order. A stop-loss order is when you set a limit on your position, allowing you to exit a position once a less favourable price is reached. For example, if you are short-selling, make sure your stop-loss order is higher than the price you bought at. Setting a stop-loss order will help you minimize unnecessary losses, especially during a bearish market!

Strategy #8: Employ Patience In Every Trading Action

A tip that should be followed in every market situation is being patient! This is especially the case in a bear market. While everyone is scrambling to get out of a declining market, a little bit of patience may go a long way.

Good opportunities for your earnings to flourish are present so hold your reins and be patient. Sometimes the hardest thing is doing nothing. All you can do is regularly monitor the stock for important data (such as sales, profits and percentage of growth reported) and if all seems to be going well from the company’s point of view, then hold on. You will thank your patience for reaping the rewards later!

Conclusion

If you jump to conclusions (excuse the pun) and dismiss a bearish market as the perfect time to sell your stock. However, you might be losing out on a number of financial opportunities if you do so! During a bear market, you have the opportunity to increase your trading portfolio and this can help you gain capital for long-term profit opportunities.

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