Recent market volatility has some investors wondering, “What is a bear market?”
Now, during bear markets. even the most seasoned trading veterans can get hurt.
You see, in volatile market conditions, market pundits come out of the woodworks and comment on the environment… It’s bad enough some traders and investors are trying to catch falling knives by purchasing stocks in a weak market, thinking it’ll reverse. But now they have to deal with having to dissect more information. If you’ve run into these problems…then listen up.
Some traders actually thrive in bear markets…while some thrive in all market conditions. You see, there are ways to make money when stocks are crashing and hedge your portfolio during bear markets. That said, let’s explain bear markets and some ways to potentially profit or hedge your portfolio.
Bear Market Explained
A bear market is a downward trend in major stock market indices. More specifically, stocks are considered to be in bear market territory if they decline by at least 20% over at least a two-month period.
Now, there are two types of bear markets: cyclical and secular.
A cyclical bear market is one that lasts a few months to a few years. On the other hand, a secular bear market is one that lasts anywhere between 5 and 25 years.
However, over the past few decades, we’ve only seen cyclical bear markets. Think of the bear market between 2000 and 2002 – infamously known as the dotcom bubble.
Additionally, between 2007 and 2009, we saw a cyclical bear market…when the S&P 500 Index, Nasdaq Composite, and Dow Jones Industrial Average fell over 20% from their apexes in late 2007. Thereafter, the markets were hit with derivatives that only a handful of traders and investment managers understood. Ultimately, this caused the global financial crisis.
Here’s a look at the weekly chart of the SPDR S&P 500 Index during the bear market between late 2007 to 2009.
Looks pretty ugly right?
If you were a buy-and-hold investor during this time…you probably would’ve panicked in the moment and sold your entire portfolio. However, not long after that, the market quickly rebounded and went on one of the most historic bull runs.
Moving on, let’s look at some ways to prepare yourself for a bear market, and potentially make money with new strategies.
Stock Market Basics – What to do in Bear Markets
Now, if you’re a buy-and-hold investor, take notes… Bear markets could be detrimental to longs, as some of us have already witnessed during the dotcom bubble and the global financial crisis.
There are a few ways to hedge your portfolio and potentially make money during weak markets. You could:
- Use exchange-traded funds (ETFs) to hedge your portfolio.
- Options to hedge your portfolio or speculate on a continued downtrend.
- Use technical indicators to signal when the market could reverse from an uptrend to a downtrend.
Use exchange-traded funds (ETFs) to hedge your portfolio
Exchange-traded funds (ETFs) could be useful to protect your portfolio. If you’re long multiple stocks that are influenced by market moves, ETFs are a cost-friendly way to hedge against a falling market. For example, let’s assume you are primarily long S&P 500 stocks, and want to hedge your position over the short term. Well, you could use ETFs to do so. You see, there are exchange-traded products (ETPs) that provide inverse exposure to major market indices.
Here are some ETPs offering short exposure to the market:
- ProShares Short S&P 500 (SH)
- ProShares UltraShort S&P 500 (SDS)
- ProShares UltraPro Short QQQ (TQQQ)
- ProShares Short QQQ (PSQ)
Now, there is a plethora of inverse ETPs out there. There are a few things to keep in mind if you want to use this as a way to hedge your portfolio.
First, these ETPs typically only offer inverse exposure for 1 day. For example, the ProShares UltraShort S&P 500 aims to provide investment results corresponding to two times the inverse of the daily performance of the S&P 500. That in mind, if the S&P 500 is down 2% one day, SDS would be up 4%.
Inverse ETFs could be dangerous, especially if you hold onto these positions for periods longer than a day…thinking you would be hedged. Due to the compounding of daily returns, inverse and inverse leveraged ETFs’ performance will differ from your expected target return.
Don’t worry…if this doesn’t sound like something you’re interested in taking part of to hedge your portfolio, you could also buy put options.
Options to Hedge Your Portfolio
Let’s say you are only long a few stocks, and the market just entered bear market territory… you want to hedge, but you’re not comfortable buying inverse or inverse leveraged ETPs.
Well, you can buy put options to hedge your position. If you don’t know how to trade options or how they work, check out this guide here – you’ll want to turn to page 13 to learn how to hedge with options.
Moving on, let’s take a look at what to do if you’re long stock and want to hedge.
Let’s assume you’re long 100 shares of Canopy Growth Corp. (CGC) from $27, and the company just released positive news. However, you believe current market volatility could cause CGC to pull back within the next month.
Well, you could buy a put option to offset your position. You see, put options provide you with short exposure. So if the stock does indeed pull back, you would be able to minimize your losses.
Here’s a look at the risk profile of the long stock position.
Now, let’s say you think CGC could fall below your entry price, and potentially break below $25 within the next month. Well, you could purchase 1 put option expiring in a month to hedge your position. Here’s how the hedged position would look.
If you don’t already know how to trade options, this is the same risk profile as a call option. Notice how your downside is minimized to just over $115. However, if the stock fell to $24, you would’ve been down $300…think of what could happen if you start trading bigger…
Finally, there is one last way to protect yourself against bear markets…
Using Technicals and Stop Losses to Protect Your Portfolio
Generally, I find technicals to be helpful with timing entries and exits. Ideally, I like to be flat and take a speculative play.
However, if you’re already long stock, you can use the “money pattern” to stop out of your position, or purchase puts against your position.
Well, when the blue line crosses below the red line, that signals to me it’s time to get out. Now, these are moving averages on the hourly chart. With moving averages, if the shorter-term simple moving average (SMA) crosses below the longer-term, it indicates there could be a shift in trend…especially if the stock or ETF has been in an uptrend, as shown in the chart above.
Pretty simple right?
You could place a stop loss anywhere you’re comfortable to sell your long position. For example, let’s say you’re long from $9.50, and notice this pattern. You could place a stop loss below $10.50 (a support level) once you see this bearish pattern.
Keep in mind, I primarily trade options, and if I see this pattern, I would purchase puts as a speculative play.
To sum it up – A bear market occurs when an index or index ETF falls by over 20% within a two month period.
Now, bear markets are typically quick and do not last as long as bull markets.
If you want to hedge against a market downturn, you could potentially look to buy inverse ETFs, put options against your long stock position, or use technicals and stop losses.