Profiting in Bear and Bull Markets

Both bear markets and bull markets represent tremendous money-making opportunities. The key to generating profits is to use strategies and ideas that fit the conditions of these markets. That requires consistency, discipline, focus, and the ability to take advantage of fear and greed.

This article will help familiarize you with investments that can increase in value in up or down markets.

Key Takeaways

  • A bear market is indicated by stock prices that drop consistently over a period of time.
  • A bull market is indicated by stock prices that rise consistently over a period of time.
  • There are various opportunities to make money in either market, if you can spot the market's direction early enough.
  • Bear market investment strategies include short positions, put options, and short ETFs.
  • Bull market investment strategies include long positions, call options, and ETFs.

Ways to Profit in Bear Markets

A bear market exists when a broad group of security prices falls persistently for a period of time. A drop of 20% or more in an overall market average over two months is a hallmark of a bear market.

Generally, bear markets occur during economic recessions or depressions, when pessimism prevails. However, amid the rubble lie opportunities to make money for those who use the right investment tools. Here are some ways to seek profit in bear markets:

1. Short Positions

You take a short position, also called short selling or shorting, when you borrow shares and sell them in anticipation of the stock price falling more in the future. If the share price drops, you buy those shares at the lower price to cover the short position and make a profit on the difference.

For example, if you short ABC stock at $35 per share and the stock price falls to $20, you can try to buy the shares back at $20 to close out the short position. Your overall profit would be $15 per share (before accounting for transaction fees).

2. Put Options

A put option gives its holder the right to sell a stock at a particular price (the strike price) until a specified future date (the expiration date). The money you pay for the option is called a premium.

A put option increases in value as the price of the underlying stock falls. If the stock price moves below the put's strike price, you can either exercise the right to sell the stock at the higher strike price or sell the put option itself for a profit.

3. Short ETFs

A short exchange-traded fund (ETF), also called an inverse ETF, produces returns that are the inverse of a particular index. Short ETFs are constructed to take advantage of market declines.

This inverse relationship makes short/inverse ETFs appropriate for investors who want to profit from a downturn in the markets. For example, an inverse ETF—say, one that performs inversely to the Nasdaq 100—will rise about 25% in value if that index falls by 25%, thus making you money.

However, if the index falls 25%, the ETF will rise proportionally. A short ETF also may be an appropriate investment for those who wish to hedge long positions against such a downturn.

Bear markets typically last a much shorter time than bull markets.

Ways to Profit in Bull Markets

A bull market occurs when security prices rise persistently over a period of time. If a market index rises an average of 20% or more over two months, the pros consider the trend to indicate a bull market. Bull markets are accompanied by periods of economic growth and optimism among investors. Here are some ways to invest in rising stock markets:

1. Long Positions

A long position is simply the purchase of a stock or any other security in anticipation of a rise in price. So, you'd go long a security and let it ride the upward trend of the bull market. The overall objective is to buy the stock at a low price and sell it for more than you paid. The difference represents your profit (before accounting for transaction fees).

2. Call Options

A call option gives its holder the right to buy a stock at a particular price (the strike price) until a specified future date (the expiration date). Calls go up in value as the underlying stock's price rises.

If the stock price rises past the option's strike price, the option buyer can exercise the right to buy the stock at the lower strike price and then sell it for a higher price on the open market, thus generating a profit. Option buyers may also choose to sell the call option itself in the open market to close out positions that are profitable.

3. Long ETFs

Most ETFs follow a particular market average, such as the Dow Jones Industrial Average (DJIA) or the Standard & Poor's 500 Index (S&P 500), and trade like stocks. Investors might buy an ETF if they expect the market it follows to rise. For example, if the S&P 500 rises 10%, an ETF based on the index will rise by approximately the same amount.

Generally, ETF transaction costs and operating expenses are low, and they require no investment minimum. ETFs seek to replicate the movement of the indexes they follow, less expenses.

One of the most famous U.S. bull markets began in 1982 and lasted until 2000. The Dow stood at 776.82 on Aug. 12, 1982. In January 2000, it peaked at 11,722.98.

How to Spot Bear and Bull Markets

Markets trade in cycles, which means most investors will experience both bull and bear markets. The key to profiting in both market types is to try to spot reversals (when the markets are topping out or bottoming). Those are ideal places for investors to enter (or exit) positions.

The Advance/Decline Line

One way to figure out tops and bottoms is by studying the advance/decline line. The advance/decline line charts the number of advancing issues divided by the number of declining issues over a given period. A number greater than 1 is considered bullish, while a number less than 1 is considered bearish.

A rising line confirms the markets are moving higher. However, a declining line during a period when markets continue to rise could signal a correction.

A line that's been declining for several months while the averages continue to move higher could be considered a negative correlation. A major correction or a bear market may be likely. An advance/decline line that continues to move down signals that the averages remain weak.

However, if the line rises for several months as the averages have moved down, this positive divergence could mean the start of a bull market.

The advance/decline line is just one of the many indicators that can help you determine the trend.

What's a Bear Market?

A bear market is one in which the prices of the securities in that market decline over a period of time (considered by many to be two months). The Securities and Exchange Commission asserts that market prices should decline by 20% during this period in order to earn the label of bear market.

What Does Go Long Mean?

The term go long simply means to buy a security. If you go long 100 shares of ABC stock, that means you've bought those 100 shares. You've entered a long position. The opposite of a long position is a short position. That means that you've shorted, or sold, a security.

Do I Lose Money in a Bear Market?

Only if you sell. It's true that your account can lose value. However, if you are able to hold on to your investments during a bear market, they can regain their previous value (and potentially gain more) as the bear market reverses and prices climb back up. This can be a challenge for many investors. Some people need their funds. Or, fear overcomes the fortitude required to hold positions that are losing value.

The Bottom Line

There are many ways to profit in both bear and bull markets. The key to success is matching the right investment tools to each market and using them to their full advantage. Short selling, put options, and short or inverse ETFs are a few bear market investments that allow investors to profit from market weakness. Long positions in stocks, ETFs, and call options are suitable for bull markets. 

In addition, it is important to use indicators to spot when bull and bear markets may be beginning or ending.

Article Sources
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