In general, the overall equity market has been in a strong uptrend for the last several years. Some of this is due to the recovering economy and some can be attributed to the Federal Reserve intervention/stimulus called Quantitative Easing. This last phase of Quantitative Easing or QE3, as it has been commonly referred to, has mainly consisted of purchasing $85 billion worth of government bonds per month. For the last several months, the Fed has been “tapering” this QE3 back by $10 billion per month. As the Fed continues to reduce the stimulus, and with other market uncertainties abound, including potential inflation and potential higher interest rates, the market, at some point, may slide into more of a bearish market from the current bull market. We all know that the market just doesn’t go up forever; we will see some kind of correction eventually. When this correction happens, you can still trade the market on the downside, if you are prepared. Here are several strategies that are good to understand.
1. Short the Security
If you have a margin account, you can short the stock or EFT. Not everybody is comfortable shorting the market; however, many traders are becoming more familiar with this strategy as the market uncertainty becomes greater. Basically, you are borrowing the security from the broker and selling it at a higher price and then buy it back at a lower price as the security drops in value. This allows you to pay the broker back the security and you can profit from the difference between the top and bottom, less any transaction fees. The risk here is if the security goes up in value when you are short, which can be a significant loss until you “cover your short”. You want to be sure that you have a confirmed downtrend and that you use good risk management by using appropriate stop loss orders.
2. Buy Put Options
If you have a confirmed downtrend and want to short the market, an alternative to shorting the security might be to buy “puts” or put options. What is a put option? Put options are options that are inversely correlated to the underlying security, meaning as the underlying security goes down, the put option will go up by the ratio known as the ‘Delta Coefficient’. The higher the delta, the higher correlation there will be. For example, if the delta coefficient is -.8, then as the underlying security goes down a dollar per share, the put option will go up approximately 80 cents per share. This can be a very good strategy in a bearish move, as long as you use good risk management, using a stop loss and proper position sizing.
3. Inverse Exchange Traded Funds (ETFs)
Inverse EFTs are ETFs that you can buy long, but, like put options, will go up as the underlying securities go down. This is an easy way to short the security as the ETF managers are buying puts against the securities inside the fund so you don’t have to trade the put options directly. These are great for the larger index equity funds. Also, these are limited to the larger EFTs, like the S&P 500 and the Dow 30, for example.
In conclusion, these are the main bear market strategies just to get you started. While inverse EFTs may be more limited to just trading the market indexes, this may be the simplest and most effective way to start trading the downside of the market.