How to Trade in a Bear Market

The technical definition of a bear market is a market whose asset value has contracted by at least 20%. This should not be confused with a 10% fall, which is described as a “correction.” Generally, there is a direct correlation between bear markets and economic recessions or depressions, but they don’t mean the same thing.

Some people often confuse bear markets with recession. A recession refers to the contraction of an economy in two consecutive quarters as measured through the gross domestic product (GDP). If bear markets prevail for a long time, they can result in a recession. Bear markets may therefore indicate a looming recession, but not all the time.

How to detect a bear market

Bear markets have characteristic indicators that aren’t hard to miss. In bear market periods, stock prices start to fall. Also, there is usually a notable decline in spending in the economy, leading to deflation. Corporate earnings also decrease, setting the stage for higher unemployment levels and cuts to non-essential expenditure. Generally, bear market conditions create an environment with negative investor sentiment.

Types of bear markets

Structural bear markets

These are triggered by structural weaknesses or failure of structural safeguards in financial markets, regulatory environments, and drastic changes to established  “business as usual” models. Such factors often result in widespread adverse effects on markets, such as the piling up of bad loans and the creation of bubbles that may suck in many corporations and individual investors.

Structural bear markets have been known to last beyond three years, and their effects may take nearly a decade to recover from.  Also, structural bear markets have far-reaching effects which often go beyond the borders of a country. The great depression is an example of what a structural bear market looks like.

Event-triggered bear markets

As the name suggests, an event-driven bear market is caused by impactful occurrences that have large-scale effects on the fundamental pillars of the economy. Examples include terrorist attacks, global pandemics, wars, and economic wars. These types of events usually create jitters among investors, corporations, and governments and may hold on for as long as the event takes to dissipate.

Cyclic bear markets

This type of bear market is a periodic bear market, hinged on the changing trends during a business cycle. On average, they last around two years and are usually characterized by reduced profits, increased losses by corporations, and high interest rates. Ultimately, these types of bear markets result in effects that can take a relatively long time to reverse.

How to get money out of bear markets

1. Following the trend

This is simply conforming to the established market trend when you believe that the market will keep moving downwards. In a bear market, this strategy is suitable for day traders because it requires a hawk-eyed tracking of a trend. In such instances, you should look for buying opportunities in breakouts. However, this type of trading requires one to be on high alert and be on the lookout for changes in technical indicators and market fundamentals. Doing otherwise can result in costly losses.

2. Shorting

The strategy involves borrowing stock to investors when the stock is trading at a higher price with the hope of making a profit when you buy them back at a lower price. This strategy can return a profit if the stock loses its value but can also lead to losses if the stock gains value.  Simply put, it is a good strategy if you hold a bearish view of stock, thereby making it an effective way to leverage a bearish market. The longer the bearish trend continues, the more profitable it gets. However, the annual interest paid on short positions is an unavoidable expense which some traders may find unattractive.

3. Going for put options

This is a low-risk, high-return venture that fits well within the context of a bear market. Once you are convinced that a stock is on a bearish reversal, you can purchase the put option strike price and count on the stock price to go below it. In such a scenario, the investor will make a profit because the put option will already be “in the money” before expiration.

4. Inverse ETFs

This strategy involves going for exchange-traded funds (ETF) whose relationship with a market index is inversely proportional. That way, if you buy an inverse ETF linked to a particular index, you ought to be either bearish or bullish about the index during the contract period. If that index gains, then the ETF will lose value with the same percentage margin and vice versa. This is, therefore, a straightforward way to bet against indices and profit from them during a market bear rally.

5. Spreading the risk with bear options calls

This strategy involves buying “in-the-money” call options and selling “out-the-money” call options, with the aim of spreading your risks and profiting from selling premiums. It is basically using two options calls to cover each other in case the market goes against you. In a bearish market, this means that you are hoping that the stock price will keep spiraling down and go below the strike price before the expiration.

Bottom line

Bear market trading requires a high level of alertness and great awareness of what is happening in the market. Things can change pretty fast in this type of market, and therefore decision-making must be incisive and prompt but backed by a strong basis. Nonetheless, bear markets are high-risk ventures holding potential for high rewards.