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Trading in a Bear Market

written by: Tim Plaehn•edited by: Jason C. Chavis•updated: 7/27/2010

There are a number of trading options in a bear market that will generate continued profits as the market falls. Examples include short selling and working with inverse ETFs. Using these tools will help an investor leverage the market even in tough times.

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    What is a Bear Market?

    Those who like to put a number on the things that usually define trading options in a bear market can usually target the situation as a 20% or greater drop in the value of the major stock market indexes. For investors it is a time of fear and worry as investors sell their stocks, causing further deterioration in stock values. There are, however, trading options that work in a bear market. Traders need to remember that true bear markets will last from 6 to 18 months and the intervening bull market will run for 5 to 7 years. The 2008-2009 bear market is a good example. The stock market as indicated by the S&P 500 peaked at around 1,425 in May of 2008 and by early March of 2009 the index bottomed out at under 680, losing over half its value in 9 months. Traders who had bear market strategies during this period made excellent profits while long-term investors saw their investments lose half their value or more. Just remember, bear markets are short and abrupt and bull markets last for years. The previous bear market was back in 2000 to 2002.

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    Learn to Trade Stocks Short

    The strategy used to profit from falling share prices is called short selling. A short seller sells stock he does not own and buys it back at a lower price, making a profit on the difference between the price when sold short (higher) and the price when the stock is purchased back (lower). To sell stock he does not own, the trader must first borrow the shares from his broker. The borrowing process is automated and when the trader places a short sell order, the brokers system will locate the stock and allocate it to the trader's account before completing the short trade. Short selling can only be done from a margin brokerage account and the margin requirement for a short sale is the proceeds from the sale plus 50% of the amount of the sale. After the stock has (hopefully) declined in value, the trader closes the short sale trade by entering a buy-to-close trade for the stock. If the stock went down, the cost to buy-to-close will be less than the proceeds of the short sale and the difference is the profit.

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    Inverse Exchange Traded Funds

    There is a relatively new type of exchange traded fund, or ETF, that is designed to move in the opposite direction of the designated index or commodity price. These ETFs will have the words inverse, bear or short in their name along with the tracked index. For example the ProShares Short S&P 500 ETF, symbol SH, is the inverse fund for the S&P 500. If the S&P 500 index loses 2% of its value during the trading day, SH is designed to go up in value 2%. Also in the mix are leveraged, inverse ETFs. These funds will have twice or three times the daily percentage change of the tracked stock index in the opposite direction. The ProShares UltraShort S&P 500 ETF, symbol SDS, will have a value increase of 4% when the S&P 500 drops 2%. Traders can use these inverse and leveraged, inverse ETFs to generate profits in a bear market. They will increase in value proportionate to the losses of the tracked indexes. An important item to remember is that the inverse ETF price changes reflect the daily changes in the index. Over a period of days and weeks the inverse relationship can break down. Bear market traders should use these funds for one to two day trades and not for extended investing, especially the leveraged ETFs. A list of inverse ETFs can be found at the ETFdb website.

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    Watch your Back and the Bottom Line

    Short selling and inverse ETFs are excellent trading options in a bear market. Traders need to remember that bear markets are limited in duration and can only fall so far. The returning bull market can rebound rapidly, turning bear market profits into giant losses. After the bear market bottom on March 9, 2009 the S&P 500 gained over 23% in just two weeks. Not a good time to own a 3X inverse ETF and hoping the market will turn down again. It never did, at least through May of 2010. Short sellers need to be aware of the short squeeze when the many traders short a particular stock drive up the share price by trying to close out their short positions.