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  • Trading Knowledge  >  Trading Blog

4 January 2022,07:49

Trading Blog

How Can You Deal with a Bear Market?

4 January 2022, 07:49

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Like the tides, the financial markets wax and wane. It’s all part of the natural cycles of the financial system since no bull market can last forever. A bear market is usually defined as a 20% or more drop of a major stock index. While the index most commonly used as the benchmark is the S&P 500, other indexes including the Nasdaq Composite might be used. A bear market might refer to instruments beyond equities as well, like commodities like gold or oil, might enter a bear market as well.

While few would celebrate a downtrend – most investors are bullish – bear markets are never permanent either.  While dealing with a bear market requires investors to manage their portfolios differently, the basic principles remain the same: diversify, mitigate risk, and look for opportunities.

Hedging and diversification

If your portfolio isn’t already diversified, it’s probably time to do so anyway. Having a diversified portfolio protects your investment both on the way down and on the way up. Look into owning index funds or other diversified investments.

Other assets you can diversify into include cash, real estate, and gold. All of which, of course, has their own up and downsides. Your choice of diversification should also take into consideration your investment goals and risk tolerance. For example, cash might depreciate alongside rising inflation, but it is also the most liquid asset. Meanwhile, gold is a relatively stable hedge against inflation, but has historically underperformed stocks and bonds.

Some assets are also known to have correlations. Precious metals, for example, has a historically inverse correlation with the stock market while the Canadian dollar is correlated commodity prices. Owning both sides of negatively correlated assets limits your losses.

However, investors should note that negative correlated assets usually only have mild to moderate relationships. This means that while two assets might have a negative correlation, it cannot be fully reliable as a hedge.  

That said, there are instruments and strategies that can that provide strong or perfect hedges. Things like purchasing options or taking a short position, for example, provide a perfect hedge against a long position in a stock. However, strategies like these come with additional costs (like premiums or interest) that rise the longer you maintain the hedge and are usually only used in extremely volatile periods. In general, the better a hedge, the higher the cost will be.

Have Cash on Hand

It’s nearly impossible to accurately predict how long a bear market will go on for. Be sure to set aside enough cash for necessities and emergencies, especially since prolonged, poorly performing markets signal an economic downturn.

If you have spare cash, it might be tempting to “buy the dip”. Again, it’s hard to predict where the bottom is. Instead, employ strategies like averaging down.

Look for Opportunities

Start compiling a list of assets that you have always wanted to own and wait for the right signals to buy on a bargain according to your trading strategies. While there will always be the fear of an impending crash, bear markets will always come to an end, and assets like stocks with strong fundamentals will come out on top.

A down trending market is also the time to be shorting. However, short selling is riskier than taking on a long position, and should also be done by experienced traders. Practice on a demo account, start small, and apply risk management.

Minimise Your Risk

Whether it’s the equity markets or forex, any major downtrend will tend to ripple outwards and cause volatility. A bear market is the time to tread carefully and minimise your risk. Reduce your leveraged positions, apply risk management [link], and never trade on emotion.

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