Modern investors can trade a bear market by using popular derivative tools. As CFDs can come with many risks, traders are advised to create an efficient bear market trading strategy.
Fear of a bear market is never far away. When the market starts to fall, some investors start to panic. But there are so many ways to take advantage of falling prices that there’s no need to make a move out of fear. Keep calm and learn how to trade in a bear market.
How to use this guide
- Understand the anatomy of a bear market: We cover the three stages of primary bear markets and signs to look out for that indicate the beginning of a downturn.
- Learn how to invest in a bear market: There are a variety of ways that both investors and traders can speculate on market downturns, or at the very least, protect their existing holdings.
- Create an account and log in: Fill in our simple application form and find the market you want to trade on our trading platform. With us, you can trade in a bear market, speculating on price movements using derivatives.
What is a Bear Market?
A bear market is generally used to describe a downward market. But specifically, it is a market that has fallen by 20% or more from a previous high, lasting for a long period of time (usually two or more months). This occurs when the number of sellers outweighs the number of buyers, resulting in pessimistic market sentiment.
For example, the USA500 entered a bear market in June 2022, when it fell more than 20% from its all-time high made in January 2022.
A bear market can also be used to describe securities or commodities whose prices have dropped more than 20% from their recent high. For example, Bitcoin entered a bear market in November 2021 after dropping more than 20% from its recent all-time high.
Some investors who want to mitigate the impact of these market declines may opt to hedge their share portfolio. But this strategy is dependent on risk-appetite and available capital, as it involves opening multiple positions.
For traders, bear markets can offer great opportunities for profit because derivative products will enable you to speculate on rising and falling markets. By using derivative products, you can open a position on securities without ever needing to own the underlying asset.
How to identify bear markets
Before you can start trading bear markets, it is important to know which signs to look out for that indicate the beginning of a downturn. These include:
Failed market rallies
The most common sign that a bear market is impending is an uptrend that doesn’t gain any traction. This means that the bulls are losing control of the market.
Rising interest rates
When interest rates rise, consumers and businesses will cut spending, causing earnings to decline and share prices to drop.
When the economy as a whole start to contract – indicated by rising unemployment, high levels of inflation, and bank failures – it is usually a sign that the stock market will take a downturn too.
Defensive stocks starting to outperform
When companies involved in the supply of consumer staples start to outperform other sectors, it’s often seen as a sign that a period of economic growth is over because consumers are cutting back on unnecessary items.
The Three Stages of Primary Bear Markets
A primary bear market is defined as a long sustained decline marked by deteriorating business conditions and a subsequent decrease in demand for stocks. Just like with primary bull markets. a primary bear market will have secondary movements that run counter to the major trend.
Stage 1 - Distribution
Just as accumulation is the hallmark of the first stage of a primary bull market, distribution marks the beginning of a bear market. As the “smart money” begins to realize that business conditions are not quite as good as once thought, they start to sell stocks. The public is still involved in the market at this stage and becomes willing buyers. There is little in the headlines to indicate a bear market is at hand and general business conditions remain good. However, stocks begin to lose a bit of their luster and the decline begins to take hold.
While the market declines, there is little belief that a bear market has started and most forecasters remain bullish. After a moderate decline, there is a reaction rally that retraces a portion of the decline. According to Dow's theory, reaction rallies during bear markets are quite swift and sharp - a large percentage of the losses would be recouped in a matter of days or perhaps weeks. This quick and sudden movement would invigorate the bulls to proclaim the bull market alive and well. However, the reaction high of the secondary move would form and be lower than the previous high. After making a lower high, a break below the previous low would confirm that this was the first stage of a bear market.
The first thing that comes to investors' minds in such a situation is that we're looking at the previous 2008-2009 bear market—where the S&P 500 index shed 58% and the 2000-2002 bear market – where S&P 500 lost 53%. Both are more than twice the current drop.
In the 3 charts above, we see how the 3 periods (including our current bear market) have several similarities but never identical paths.
However, from a macroeconomic perspective, it was a completely different situation, as the whole financial system was at serious risk of collapse. Now, despite the many headwinds, risks lean more towards a global recession.
Stage 2 – Panic
As with the primary bull market, stage two of a primary bear market provides the largest move. This is when the trend has been identified as down and business conditions begin to deteriorate. Earnings estimates are reduced, shortfalls occur, profit margins shrink and revenues fall. As business conditions worsen, the sell-off continues.
Again we look at the previous bear markets and highlight the panic stage.
The 2022 bear market entered the panic stage that should be confirmed by a space between the next lower high and the previous low.
Stage 3 - Despair
At the top of a primary bull market, hope springs eternal and excess is the order of the day. By the final stage of a bear market, all hope is lost and stocks are frowned upon. Valuations are low, but the selling continues as participants seek to sell no matter what. The news from corporate America is bad, the economic outlook is bleak, and not a buyer is to be found. The market will continue to decline until all the bad news is fully priced into stocks. Once stocks fully reflect the worst possible outcome, the cycle begins again.
Bear market trading strategies
There are a variety of ways that both investors and traders can speculate about market downturns, or at the very least, protect their existing holdings from unnecessary losses.
When deciding on a trading strategy for a bear market, a major decision is which type of trading vehicle should be used: leveraged products, futures, or options. Derivatives are a popular form of derivative trading that allows a trader to speculate on an asset by going short during a bear market. It is an agreement between the trader and the Forex broker to pay each other the difference between the opening and closing prices of a financial instrument. Derivatives allow traders to gain exposure to an asset without having to own the underlying asset. Derivatives are often leveraged, which allows traders to hold larger positions than the actual value of the amount they invest to open the trade. Remember that leveraged products, such as derivatives, magnify your potential profit – but also your potential loss.
Open a demo account to start practicing trading with derivatives in a bear market.
“Short” Trading Strategies
As the saying goes, ‘the trend is your friend’. Short-selling is a way in which you can follow the directional momentum in a bear market – you’d take a sell position (go short), by speculating on falling market prices. If your prediction pans out, you’ll make a profit. But even in bear markets, prices can move either way. So, you’ll incur a loss if the price action moves against your position.
When shorting a stock via a traditional method, traders borrow shares they do not own. These shares are usually lent from their financial broker and sell the borrowed shares at market value. The trader aims to repurchase the same shares at a lower price and return the shares to the lender. This is typically a practice of large institutions rather than individual investors, but some brokers will facilitate short selling.
With derivatives, you can go long and short on a variety of different markets. In this situation, the key is to identify the cause of a bear market and find stocks that are heavily exposed to it. For example, in the coronavirus-led bear market of 2020, travel stocks were hit the hardest due to countries locking down their borders. Airlines were hit the hardest.
With us, you can also trade a basket of shares with a single click. Share baskets are mini portfolios of stocks built around a specific theme such as meme stocks, social media stocks, EV stocks, and many other ThematiX.
Exchange-traded funds (ETFs) are marketable securities that track a basket of securities, a stock market index, bond, or commodity. ETF trading usually has more liquidity and lower fees than mutual funds, making them a popular choice for traders wanting to short a bear market.
Shorting a market index such as the S&P 500 is a popular choice with traders as this index represents a basket of underlying stocks. Their popularity is founded in their accessibility for most traders as well as their technical and highly tradeable trends. Some traders prefer to target the underlying stocks themselves. Investors use indices to hedge their portfolios during a bear market.
“Long” Trading Strategies
A safe-haven asset is a financial instrument that typically retains its value – or even increases in value – while the broader market declines. These assets are negatively correlated with the economy, which means that they are often used by investors and traders for refuge during a bear market.
In theory, you would take a long position on a safe haven, in order to prepare for market downturns. This is seen as an alternative to closing positions or going short, as it enables you to hedge any existing holdings.
Popular safe havens can change over time, so it is important to keep up with investment trends. However, there are a few safe havens that have remained favorites over the years, including:
Many consider the decision to buy gold a behavioral bias, based on gold’s history of backing currencies and as a store of value. The theory goes that because gold has historically been considered a safe haven when there are signs of a significant market collapse, investors swarm to the precious metal. Gold as a safe haven has become a self-fulfilling prophecy.
The most popular ways to invest in gold and gold-related assets are through:
- Gold Mining Stocks like Barrick Gold Corp (#ABX), Newmont Mining (#NEM), Franco-Nevada (#FNV), and other
- Gold Mining Funds like Direxion Daily Junior Gold Miners Index (#JNUG), and other
- Gold ETFs like SPDR Gold Shares ETF (#GLD) and other
- Gold Spot and Futures
Safe haven or safety currencies depreciate in times of optimism and appreciate in times of pessimism like other safety assets that are in demand when markets are fearful, such as investment-grade bonds.
- US Dollar: For over 50 years, the US dollar has been one of the most popular safe havens during economic downturns. It exhibits several safe-haven characteristics – most crucially, it is the most liquid currency on the forex market.
- Japanese Yen: The yen earned its reputation as a safe haven due to Japan’s high trade surplus versus its debt. The value of foreign assets held by Japanese investors is far higher than Japanese assets owned by foreign investors – this means that when markets become ‘risk off’, money moves out of other currencies and back into domestic markets, which strengthens the yen.
- Swiss Franc: A study by the central bank of Germany, Deutsche Bundesbank, found that the Swiss franc often appreciated when the global stock market showed signs of financial stress. Common reasons that investors favor the Swiss franc as a safe-haven currency include the political neutrality of the Swiss government, the strong Swiss economy, and its developed banking sector.
Government bonds are a fixed-term ‘I owe you’ from a government, which have periodic interest payments – treasury bills and notes are a type of bond. The only difference between them is the amount of time before you will be reimbursed in full. Treasury bills have maturities of a year or less, while treasury bonds can have maturities of ten years or more.
Investors tend to have more confidence in bonds issued by governments of developed economies – the most popular are:
Investors will often seek to diversify their portfolios by including defensive stocks. These are the shares of companies that are perceived as consumer staples, so their products are needed regardless of the state of the economy. These can include food and beverage producers and utility companies.
When an economy is doing well, investment tends to flow into ‘cyclical stocks’, which are the companies that produce non-essential items. Whereas when an economy is experiencing a period of decline, the focus moves to companies that meet consumer needs.
Like safe havens, investors tend to start piling into defensive stocks when bearish sentiment emerges. Traders can also monitor defensive stocks as a way of identifying when the market experiences a change in mood, using the companies as an indicator of the health of the broader stock market. These includes:
- Quality defensive stocks, such as conservative Telcos/utilities with yield and some growth potential, such as Verizon (VZ), Deutsche Telekom (DTE), Orange (ORAN), Enel (ENEL), and others.
- Extremely defensive high-end stocks such as LVMH (LVMH), Prada (PRD), Hermes (HRMS), and others.
- Consumer defensive such as Walmart (WMT), Carrefour (CA), and others.
*Please note that no investment is 100% "safe” as every type of asset comes with its own risk. Popular safe havens can change over time, so it is important to keep up with investment trends.
How to weather a bear market
All traders need to set up an effective risk-management strategy in order to minimize risk if the markets go against them. This is less of a problem in a bull market when there are likely to be opportunities to recoup former losses by buying security as it is revalued higher. However, trading in a bear market can be more difficult. To keep your head when everyone in the financial market is stampeding towards the exits requires the ability to be decisive and act quickly. This must be backed up by a solid understanding of the technical resources that are available to help manage your trading account.
The standard trade management tools apply in a bear market. That means ensuring appropriate trade execution orders have been used. A stop-entry order is simply an order to buy or sell a security when its price moves past a particular point. A limit entry order can help to diversify a trader's game plan by making it possible to short into rallies in a bear market. These orders bring some predictability to a trading strategy by making sure trades are executed at a predefined price. Some traders prefer to take more active control of their accounts and not to be automatically taken out of their position.
Stop-loss orders are a useful tool to close an open trade that is going against you at a predefined price level to limit the loss of capital. However, markets can move fast, and this is often the case when they turn bearish. Bear markets don't head down continuously – prices may pull back from time to time. This means traders may risk being stopped out when the market is simply consolidating, rather than making a fundamental shift.
Traders aren’t always guaranteed to get closed out at the price they set their stop-loss orders at, which is known as slippage. The faster the market moves, the greater this slippage can be. To circumvent this, you might choose to trade an option with a strike price where a stop-loss would have been located. This could allow you more time to evaluate whether you are truly in a losing position.
Final words on the bear market
Traders increase their probabilities of trading market trends by having a stringent trading strategy and capital management plan. This applies equally when trading both bull and bear markets. There are some important aspects worth considering when attempting to trade a bear market.
A bear market can move rapidly so it is wise to choose trades cautiously and manage risk appropriately. During bear markets, it is possible for investors to be successful by seeking out and buying good value stock portfolio propositions during a falling market. Dividend stocks in a bear market may still pay healthy dividends or can be sold later if they recover their value. Traders need a range of investment strategies to manage their risk/reward ratios. This includes various forms of trading (derivatives, futures, options) for speculation or hedging purposes. Derivatoves allow a trader to speculate on an asset (stock, ETF, or index) by going short during a bear market.
Free trading tools and resources
Remember, you should have some trading experience and knowledge before you decide to trade a bear market. You should consider using the educational resources we offer like CAPEX Academy or a demo trading account. CAPEX Academy has lots of free trading courses for you to choose from, and they all tackle a different financial concept or process – like the basics of analyses – to help you to become a better trader.
Our demo account is a great place for you to learn more about leveraged trading, and you’ll be able to get an intimate understanding of how CFDs work – as well as what it’s like to trade with leverage – before risking real capital. For this reason, a demo account with us is a great tool for investors who are looking to make a transition to leveraged trading.