7 Important Tips To Follow While Trading In A Bear Market

What is a Bear Market?

A stock market is said to be “bearish” when it experiences prolonged price declines. Prices of securities fall 20% or more from recent highs for a couple of months, and pessimism and negative investor sentiment are prevalent everywhere. Bear markets also may trigger general economic downturns such as a recession as companies start laying off people. 

Bear markets are formed due to a sluggish economy, indicated by weak productivity and a drop in business profits, and sometimes due to government interventions (like changes in tax rates). The 2008 financial crisis caused a bear market that lasted for 17 months. 

A bear market is a bad sign for all investors, some of whom are likely to lose thousands of dollars. This is why investors have come up with strategies to survive in a bear market. This article outlines seven important tips that you should follow to stay afloat and make money even as prices fall. 

How to Survive in a Bear Market?

1. Diversification of Stocks 

Using exchange-traded funds (ETFs) with your stocks can add diversification to your portfolio through a sector rotation approach. There are some stocks like those of automobile companies, home improvement, etc. that do well when the market is booming, but if you are in a bear market or sense one approaching, it is better to switch your stocks to more conservative ones like utilities. Depending on your familiarity with the market, you can pick those stocks which move in the opposite direction of the major indices and add those to your portfolio. 

2. Shorting Stocks 

Good stocks might make it through a bear market, but bad stocks will certainly not. So how to short stocks? You simply borrow a security and sell it on the open market, planning to buy it back later for less money. 

The prices of bad stocks are likely to keep declining further, so if you sell a stock for $100 today, the chances are that its value will decline to $80 in a week, and you buy it back and return to the original owner. In the process, you pocket $20 per stock.  

This seems to be a simple tactic but is often carried out only be experienced traders because if you are wrong and the stock price goes up rapidly, your losses can be huge. 

3. Buying Short and Long-Term Puts 

A put option gives you the right, but not the obligation, to sell a stock at a certain price (called the strike price). For example, if you buy a put option that allows you to sell a stock at $50, and due to the falling market, the current price of the stock drops to $40, you can sell it at $50 and make a $10 profit. 

So, if you have a hunch that certain stocks will certainly drop in value, buy put options for those stocks. When their price does fall in a bear market, use your right to sell the stocks and make profits. 

4. Selling Naked Puts 

A naked put is a strategy where the investor writes, or sells, put options without holding a short position in the underlying security. When you sell a put option, you hope that the stock expires above its strike price so that you earn the premium as profit. The catch here is that since the entire market is falling, people will readily accept the puts that you sell. 

But, if you bet on the right companies whose stock prices are likely to go up, then, in all those puts, you make profits. In the meantime, if those companies keep paying dividends, you can earn those until the expiry date too. 

5. Find the Assets Whose Price Increases   

Even though the overall market experiences a decline, some assets’ (not necessarily stocks) value go up. Precious metals like gold and silver outperform during this period. Food and personal care stocks often called ‘defensive stocks’ usually do well. 

This is why it is important to follow financial websites and news to check which sectors are likely to make money during a bear market and reallocate funds accordingly. The trend is that once a sector or asset starts performing well in this period, it continues to do so for quite a while. So, acting fast will give you a first-mover advantage. 

6. Hunt for Dividends 

Dividends are payments made by publicly-listed companies as a reward to investors for buying their stock. This money comes from the company’s net income. Most companies pay dividends for their stocks even during a bear market to honor customer loyalty. If a company is anyway doing well while the market is falling, or if you know any other company that continues to give dividends on to its investors, purchase those stocks to get a steady income. 

7. Go 100% Cash

This is often the last resort for investors during a bear market – it’s like playing dead when a bear is about to attack you, hoping it will leave soon. Unlike short-selling, the plan here is to sell off everything, or at least all the most overvalued securities, and convert them to cash or money. Now, until the market returns to normal, you don’t have a care in the world because you own very little (presumably safe) stocks or nothing. 

There danger here is that you must control yourself not to invest again in an impulse before normalcy because bear markets tend to last a long time. A bad investment in such a time could make you worse off. When the market crosses the phase, analyze your choices, and come up with a strategy as to whether you want to invest in the same stocks as before or you want to try out other securities. 

Are You Ready to Face a Bear Market? 

If you are new to investing, you certainly don’t want to experience a bear market right away. However, it is important to be prepared for the same. There are several free stock trading platforms online that let you trade stocks with virtual cash so that you can test out strategies and get the feel of a real stock market without losing any money.