Short Selling and Other Bear Market Strategies
If you were to take a step back and look at the stock market over the long term – say 10 years or more – you’ll notice that despite the roller coaster chart, it always trends higher eventually. This important detail is the primary reason many financial advisers recommend holding on for the long term and adopting a buy-and-hold investment strategy. Despite having to weather some economic downturns, it’s not necessarily a bad philosophy.
But there’s a major flaw to this plan. While the market does trend higher over long periods of time, unless all you’re doing is investing in broad indexes like the S&P 500, your portfolio won’t look the same. That’s because most investors pick individual companies to invest in. Even if you diversify, you’ll probably hold around 10 companies in total. But if you’re wrong about just one of those 10, your portfolio will suffer over the long term instead of succeed.
In order to stay competitive, you’ll need to play both side of the market – for better or worse.
Joining the down side of the market
You don’t have to identify yourself as strictly a bull or a bear when it comes to investing. The best investors know how to switch between when the tide turns. But bear markets are usually volatile places filled with fear and uncertainty, making it difficult to maintain investment discipline. Nevertheless, understanding how to ride the rapids is the key to beating the bear market and making profits.
The simplest thing you can do when you see a stock that’s going to fall is to short sell it. This is where you sell a stock upfront instead of purchasing it with the understanding that you’ll buy it back later – ideally at a lower price. The difference is where profits are made.
A margin account is required in order to make this kind of trade and it comes with significant risk. Unlike a long trade where the worst case scenario is bankruptcy in the stock and a 100 percent loss, a short trade gone wrong can result in losses greater than 100 percent. Additionally, stocks that pay dividends actually work against the short seller in that the payments are actually taken away from you, instead of being paid to you.
A safer bet in bear markets is to purchase put options. This gives you the right (but not the obligation,) to sell a stock at a predetermined price. If the stock drops as predicted, you can exercise the option and profit. But if it doesn’t work out, the only loss you assume is the purchase price of the option contract.
You might be thinking that a simpler way to beat the odds is to avoid stock picking, invest in an index fund and wait. But there are two reasons why this isn’t the best plan. For one, you’ll never beat the average using this method. But more importantly, it doesn’t account for lifestyle needs or risk tolerance. If you’re less than 10 years away from retirement and the market experiences a major correction or black swan event, you might need to delay retirement or settle for less than you expected.
Navigating bear markets isn’t just for risk tolerant investors, all investors should know when and how to leverage a portfolio to take advantage of downside movements.