How to profit from downward markets and falling prices
When the market starts to fall, some investors start to panic. But there are so many ways to take advantage of downward markets that there’s no need to make a move out of fear. Keep calm and learn how to trade falling prices.
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 a pessimistic market sentiment.
It usually refers to the overall market or an index, but individual stocks or commodities could also be said to experience a bear market.
What are the other types of downward markets?
To avoid confusion between a bear market and other downward price movements, we’ve looked at four types of downward market, and how they differ from a bear market. These are:
- Market pullbacks or retracements. This is a temporary reversal in the movement of a share price. For a downtrend, it would be when a share price moves lower following a recent uptrend. A retracement doesn’t usually mean much on its own, as prices fluctuate all the time, so it is important to use technical indicators to determine whether it is a reversal or the start of something more
- Reversals. A reversal is a turnaround in the price movement of an asset, in this case, when an uptrend becomes a downtrend. Unlike a retracement, it is a more sustained period of decline. It is important to watch out for reversal candlestick patterns, such as double or triple bottoms
- Market corrections. This is a 10% decline in the price of a stock or index from a 52-week high. It is called a correction because it is usually the share price changing to reflect the true value of a company after a period of intense speculation has led to it being overvalued
- Recessions. A recession is a complete economic decline that takes place over a six-month period or longer. If the economy is in decline, securities will suffer too as businesses earnings are impacted
Another term traders interested in a downturn need to know is a ‘bottom’. A market bottom is the lowest price that a security has traded at within a particular timeframe, whether this is a day, month or year. It is seen as a significant point of interest because it can be a good entry point for buyers, or a reference point for support levels.
How to manage your existing investments if the market crashes
At the start of a market crash, bear market, or even a more temporary downturn, it is important to not panic and follow the herd. While these downward price movements do have adverse impacts on portfolios, the extent to which you are at risk will completely depend on your goals as a trader or investor.
For buy-and-hold investors there isn’t necessarily a need to fear a market downturn because you’re interested in the long-term trajectory of the stock market. Bear markets do tend to be significantly shorter than bull markets, which is why the stock market has – overall – increased in price. For example, the FTSE 100 could fall in price by almost 4000 points and still be at a higher level than it was 20 years ago, despite two bear markets in-between. However, as we will go through in a moment, the risks involved in downturns will completely depend on the method you use to invest in them.
Some investors who want to mitigate the impact of these shorter-term 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.
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For traders, downturns and bear markets 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.
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Bear market investing: how to make money when prices fall
There are a variety of ways that both investors and traders can profit from market downturns, or at the very least, protect their existing holdings from unnecessary losses. These include:
- Dealing short ETFs
- Trading safe-haven assets
- Trading currencies
- Going long on defensive stocks
- Choosing high-yielding dividend shares
- Trading options
- Buying at the bottom
Perhaps the most common way of profiting when a market declines, is short-selling. There are a variety of ways that an individual can short-sell, depending on which market you want to trade and the product you want to use.
The traditional method involves borrowing the share (or another asset) from your broker and selling it at the current market price. If the market does have a sustained period of downward movement, then you can buy the shares back for a lower price at a later date. You would then return the shares to the lender and take home the difference in price as profit.
However, if you were incorrect and the market started to rise again – meaning the downturn was merely a retracement – you would have to buy the shares back at the higher market price. It is worth noting that when you short-sell, there is the potential for unlimited losses because in theory there is no cap on how much a market can rise.
Short-selling with derivatives
Short-selling is a key function of derivatives trading itself – these products are purely speculative and take their price from the underlying market price. Derivatives do not require the trader to own the shares or assets in question.
When you spread bet, you are placing a bet on the direction in which a particular asset’s price is headed. If you open a short spread bet position, your profit is dependent on the prices going down, giving you the same outcome as a traditional short-selling position. When you trade CFDs, you are purchasing a contract to exchange the difference between the opening and closing price of an asset, in this case a stock. You would open a position to ‘sell’ a CFD.
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While we’ve mainly been focusing on downturns in securities markets, short-selling applies to plenty of other markets too, including currencies.
Dealing short ETFs
A short exchange traded fund (ETF), or inverse ETF, is designed to profit when the underlying benchmark declines. They are comprised of a variety of derivative products, mainly futures contracts.
It is similar to shorting a security, except instead of borrowing an asset to sell, you are buying the market. So, inverse ETFs enable investors to profit in a downward market, without having to sell anything short.
For example, if you expected the FTSE 100 to decline in value, you might invest in a short FTSE 100 ETF. If the UK benchmark did decline in value, the short ETF would increase.
Inverse ETFs are often not thought of as long-term investment vehicles, as the derivatives they are based on will be bought and sold daily by the fund’s manager, which means that there is no guarantee of its performance. Instead, they are commonly used by investors to hedge their share portfolio against more short-term declines.
Short ETFs are considered a less risky alternative to traditional short-selling, because the maximum loss is the amount you have invested in the ETF.
For traders, speculating on short ETFs is still a viable method of profiting from market downturns, as in much the same way as investors, they just opt to ‘buy’ the market. However, traders can just take a short position on a regular ETF. There is not the same necessity to rely on inverse ETFs alone.
Trading safe-haven assets
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 market declines.
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.
Common examples of safe-haven assets include gold, government bonds, the US dollar, the Japanese yen and Swiss Franc. However, it is important for investors and traders alike to remember that just because an asset is traditionally considered a safe haven, doesn’t guarantee it will perform as such in every market downturn.
If we take the example of gold, to invest in the safe-haven asset, you’d be looking to buy the physical precious metal as a store of value. However, if you were just looking to speculate on the value of safe havens, you could use derivative products so that you didn’t need to take delivery of the asset itself.
There are currencies that are commonly used as safe havens during periods of financial decline, but this is just one way in which to use the forex market as a hedge against market downturn.
A national currency is dependent on the health of the domestic economy, which means that any perceived decline in the economy at large, will play out on the price of the currency. If an economy is seen as weaker than other global economies, its currency will depreciate compared to other global currencies. For example, during Brexit negotiations, the political turmoil and instability impacted the appeal of investing in the UK. This saw volatility play out across the FTSE 100 and British pound sterling.
Traders can take a position on the price of a declining economy by opting to short a currency. When you trade forex, you’re inherently buying one currency and selling another. For example, when you sell GBP/USD, you would do so if you believe the value of the pound will fall in comparison to the US dollar.
During market downturns, many market participants will seek to understand the relationship between exchange rates and stock prices in order to prepare their positions for the volatility and take advantage of any declining prices. However, there is not necessarily a clear-cut relationship, which makes it vital for traders to perform thorough analysis before opening a position.
Going long on defensive stocks
Investors will often seek to diversify their portfolio 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 produce 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 for the health of the broader stock market.
Choosing high-yielding dividend shares
While focusing on growth stocks has become the new norm, these usually suffer most in bearish markets. This is because if their valuation isn’t backed up by strong fundamentals – meaning they’re overvalued – the stocks could have further to fall.
Hunting for dividend stocks can be a great way to find value amongst a declining market. While a company’s share price might take a hit, it doesn’t necessarily mean that the fundamentals of the company are meaningless. If a company is still producing a strong balance sheet, they could still pay dividends.
You can use online tools such as IG’s stock screener to find companies with a high dividend yield. Once you have identified a dividend stock, you can either invest via our share dealing service or speculate on the company’s share price by opening a trading account.
Trading options contracts gives you the right, but not the obligation, to buy or sell an underlying asset at a specific price by a set point of expiry. Options are commonly used for pure speculation, but they are also a popular way for investors to hedge against falling share prices.
There are a range of options strategies that can be used, two common ones are:
- Buying put options
- Writing covered calls
Buying put options
When you buy a put option on a stock, you would do so in the belief that the company is going to decline in value. Buying a put gives you the right to sell shares at the strike price – so if the underlying market price falls below the strike price, you could exercise your option and sell the shares at a higher price.
For example, let’s say shares of company XYZ are currently trading at £35, but you believed they were due to decline in value. You buy a put option with a strike price of £30 for one months’ time. If at the time of expiry, the market price was £25, you could exercise your put option and sell the shares at the higher price of £30.
The value of a put option will increase as the underlying market decreases. Conversely, its value would decrease if the underlying market price gets closer to the strike price.
Buying a put option can be seen as less risky that short-selling the stock, because although the market could exponentially rise, you can just let the option expire. The most you will lose is the premium you paid to open the position.
Writing covered calls
Writing a covered call means that you’re selling a call option against a stock that you currently own – essentially, you are accepting the obligation to sell that stock to the holder of a call option. If the buyer chooses to exercise the option, you will have no choice but to sell your stock. This means that there is a limit on the amount of profit you will make.
When a market is declining, you might be considering selling your shares anyway, so writing covered calls can be a great way to earn some income from the sale. The buyer would be hoping that the market is going to bounce back, so if the stock doesn’t rise, it is likely that you’d be able to keep your shares and the premium.
Regardless of whether or not the holder exercises their call option, you would be paid a premium for taking on the risk of writing a covered call.
Buying at the bottom
When the stock market falls, the value of good and bad stocks alike will decline. However, the good ones will likely recover. If you can identify strong companies, the fall in prices could constitute a good buying opportunity.
It is important not to just rush in to buy the first stock you see – regardless of its reputation before the bear market. Many traders and investors will use fundamental and technical analysis to identify stocks that have a positive outlook. You should always look at the company’s balance sheet, valuation, management strategy and debt levels.
Lenders will be looking at which companies are best positioned to pay off their debts, and recover from the bear market – so, by assessing how creditworthy a lender believes a company to be, traders can identify good opportunities to buy at the bottom. Bond ratings of AAA, AA and A indicate that a company is believed to be creditworthy, while anything below is considered a risk.
Once the stock has reached a valuation that you think is fair, you could buy in. It is important to remember that the share price likely will not bounce back immediately but if you are confident in your analysis, you should be fairly well assured it will eventually.
To start trading stocks, follow these simple steps:
- Find an opportunity: we offer various tools including the IG market screener, to help you find what you’re looking for
- Open an IG trading account: it only takes a few minutes to open a trading account or to start using our share dealing service
- Place your trade: when you’re ready to trade, open your first position by selecting the market you want to short and choosing ‘buy’ on the deal ticket
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
- Economic decline. When the economy as a whole starts 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
- Rising interest rates. When interest rates rise, consumers and businesses will cut spending, causing earnings to decline and share prices to drop
- 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
How often do downward markets occur?
There is no sure-fire answer to this, because it completely depends what type of market downturn you’re talking about.
Retracements and pullbacks could happen multiple times a day in periods of volatility, while larger market downturns, such as corrections, bear markets and recessions happen less frequently. For example, analysts tend to expect one market correction every two years.
Bear markets and recessions garner a lot of attention and have wide reaching effects. The last significant bear market was during the 2008 financial crisis, when the S&P 500 dropped by more than 56%. It lasted for 517 days.
It is important to remember, economic downturns last (on average) for less time than periods of growth. Since 1945, US economic expansions have lasted an average of 57 months, compared to just ten months for economic downturns.
Downward market summed up
- Downward markets is the term often used to describe bear markets – which is when a market declines by 20% or more for a sustained period of time
- There are other types of downward movement: pullbacks or retracements, reversals, market corrections and recessions
- At the start of a bear market, or even a more temporary downturn, it is important to not panic and follow the herd
- For buy-and-hold investors, market downturns aren’t necessarily a concern, as they’re focused on the long-term trajectory of the stock market
- For traders, a downturns and bear markets offer great opportunities for profit because most trading products will enable you to speculate on rising and falling markets
- There are multiple ways to make profit in falling markets: short-selling, dealing short ETFs, trading safe-haven assets, currencies and options, focusing on defensive stocks and dividend stocks, or buying at the bottom
- There are some signs that a bear market is starting, such as failed market rallies, economic decline, rising interest rates and defensive stocks gaining in value
- Downward markets can occur at different frequencies depending on the type of movement in question. For example, a pullback will be more frequent than a recession
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