What's an investor supposed to do when a bear market wipes away years worth of gains? Considering it happened between 2000 and 2002 and then again in 2008, it's a question with asking. Here are a few ideas investors can keep in mind to not only avoid losing money in a bear market, but actually make money from it.
As you read through these rules, you may notice the strategies become more advanced. That's ok. Use the ones you're comfortable with at first, and then you can add more to your repertoire over time.
Above all other rules, this one is the most important of all ... don't lose big. Small losses are part of the game, as you have to give stocks a little wiggle room. Letting a small loss turn into a large loss is just sloppy.
Of course, there's no set amount of how much of a loss is "too much". For long-term stock investors, a retreat of 8% from any peak may be a good exit point. For short-term scalp traders who aren't even looking for an 8% gain on a trade, stop-losses of 1/3 of the targeted gain are reasonable. For option traders, a 30% berth may be required. It's all relative.
The second prudent bear-market strategy is the use of so-called 'inverse' ETFs (exchange-traded funds). What's that? Just like the name implies, and inverse ETF moves in the opposite direction of its underlying index. In other words, they go up when the market goes down.
Not only are inverse ETFs available, leveraged inverse ETFs offer a potential gain that is greater than the potential demise of its index or sector. A double-leveraged ETF will rise by twice as much as that index falls, but there are even a few triple-leveraged ETFs now available.
The only caveat regarding the use of leveraged inverts exchange-traded funds is simply that they're not the kind of investment you'd ever want to simply buy and forget about. Why? The inverse leverage works both ways, and the market - or its sectors - will almost certainly move higher eventually.
A third bear-market strategy is simply shorting stocks... taking advantage of their declines by selling them at a high price, then buying them back at a lower price (yes, it's allowed). Note that being able to sell a stock short requires a margin account.
But what about the horror stories we've all heard about margins accounts and short sales that went awry? While those stories may be true, they are few and far between... and almost always the result of poor discipline on the part of the investor rather than the account or trade itself.
The fourth effective money-making tool you can use in a bear market is put options. Like leveraged ETFs, changes in option values can also be greater - in percentage terms - than the changes in the underlying stock or index. However, unlike ETFs, a wide variety of strikes and expiration lets you custom-build your trades' risk/reward ratio.
On the flipside, options eventually expire, while stocks and ETFs don't. The trade-off is simply that options can cost a fraction of what it would cost to take on an equivalent position in a stock or ETF, essentially making option trades a 'disposable' hedge.
Oh, and before you start applying these for techniques indiscriminately during a bear trend, there's one more fact to accept. Even though things may now seem this way at the time, not every stock sinks in a bar market. Most do indeed fall, but enough stocks rise in a bearish environment that they're worth seeking out and owning, at least for a while.
The ultimate message should be simple... it doesn't take a genius to survive a bear market - it just takes a little action, and some willingness to learn how to do a few new things. Don't let another downturn push your portfolio in the wrong direction.
As you read through these rules, you may notice the strategies become more advanced. That's ok. Use the ones you're comfortable with at first, and then you can add more to your repertoire over time.
Above all other rules, this one is the most important of all ... don't lose big. Small losses are part of the game, as you have to give stocks a little wiggle room. Letting a small loss turn into a large loss is just sloppy.
Of course, there's no set amount of how much of a loss is "too much". For long-term stock investors, a retreat of 8% from any peak may be a good exit point. For short-term scalp traders who aren't even looking for an 8% gain on a trade, stop-losses of 1/3 of the targeted gain are reasonable. For option traders, a 30% berth may be required. It's all relative.
The second prudent bear-market strategy is the use of so-called 'inverse' ETFs (exchange-traded funds). What's that? Just like the name implies, and inverse ETF moves in the opposite direction of its underlying index. In other words, they go up when the market goes down.
Not only are inverse ETFs available, leveraged inverse ETFs offer a potential gain that is greater than the potential demise of its index or sector. A double-leveraged ETF will rise by twice as much as that index falls, but there are even a few triple-leveraged ETFs now available.
The only caveat regarding the use of leveraged inverts exchange-traded funds is simply that they're not the kind of investment you'd ever want to simply buy and forget about. Why? The inverse leverage works both ways, and the market - or its sectors - will almost certainly move higher eventually.
A third bear-market strategy is simply shorting stocks... taking advantage of their declines by selling them at a high price, then buying them back at a lower price (yes, it's allowed). Note that being able to sell a stock short requires a margin account.
But what about the horror stories we've all heard about margins accounts and short sales that went awry? While those stories may be true, they are few and far between... and almost always the result of poor discipline on the part of the investor rather than the account or trade itself.
The fourth effective money-making tool you can use in a bear market is put options. Like leveraged ETFs, changes in option values can also be greater - in percentage terms - than the changes in the underlying stock or index. However, unlike ETFs, a wide variety of strikes and expiration lets you custom-build your trades' risk/reward ratio.
On the flipside, options eventually expire, while stocks and ETFs don't. The trade-off is simply that options can cost a fraction of what it would cost to take on an equivalent position in a stock or ETF, essentially making option trades a 'disposable' hedge.
Oh, and before you start applying these for techniques indiscriminately during a bear trend, there's one more fact to accept. Even though things may now seem this way at the time, not every stock sinks in a bar market. Most do indeed fall, but enough stocks rise in a bearish environment that they're worth seeking out and owning, at least for a while.
The ultimate message should be simple... it doesn't take a genius to survive a bear market - it just takes a little action, and some willingness to learn how to do a few new things. Don't let another downturn push your portfolio in the wrong direction.
About the Author:
Editor of the Small Cap Network, James Brumley holds a degree in finance and has dedicated the last 10 years toward helping investors identify market tops and bottoms. If you have an interest in finding out when the next bear market rally will take place, you can join the Small Cap Network Newsletter free of charge.
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