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How To Make Money In A Bear
Market -- Part 2
Last week, we looked at some statistical ways to
trade a bear market. This week, let's build upon this and add some additional
knowledge and strategies.
Defining And Trading A Bear Market
As I stated in my last column, we've run over a thousand tests and the behavior
of a bear market is different from the behavior of a bull market. Bull markets
tend (as a whole) to rise quietly. Volatility tends to dry up as the market
slowly moves higher. This is the type of behavior one sees looking at the S&P
500 and the Nasdaq indices when they are trading above 200-day moving average.
Positions can usually be held longer and stops can be tighter as the lower
volatility persists.
Bear markets are very different. All you have to do is look at the behavior of
the markets as they crossed under their 200-day moving average in 2000 and
stayed there for the majority of the time until last Spring (2003).
Big, sharp moves down with oversold conditions
becoming more oversold. Time after time it looked like the end of the world
(look at the charts in October 2000 and in July 2002). And each time, the
snapbacks were violent. In some cases, massive short gains were wiped out in a
few days as the market reverted higher. And then after the snapback, more
downside was seen. How do you trade this type of behavior? Here are a few ideas:
1. Picking bottoms in a bear market is a losing proposition. We've looked
at this literally hundreds of different ways in our new book "How
MarketsReally Work" and the tests all came to the same conclusion:
shorting specific level pullbacks (short-term up-moves in a long term downtrend)
far outperform buying these same up-moves in a down market.
2. Watch how the market responds to good
news. When the market is below its 200-day MA, and it shrugs off good news, it foretold the
sell-off, especially in the weaker Nasdaq market. This is subjective but a good
rule of thumb is "if it doesn't go up on good news, it's going down...especially
when trading under the 200 day". I didn't come up with this myself...it's been
around for decades.
3. Stops need to be widened and position size needs to be lessened. Why?
Because higher volatility is the norm. Again, look at the volatility in 2002.
The $VIX reached the 50% level (it's well less than half that today). Your gains
will likely come quicker than they did in a bull market, but the risks (caused
by the greater volatility) are also greater.
4. Watch the Semis (SMH) and watch the Brokers (XBD). As they go, the
market will go. The Semis broke first here as we transitioned from a bull market
to a market that now looks like it may be the beginning of a bear. And the
brokers were not far behind. And look at the Semis last year. They bottomed a
month before the rest of the market. The behavior of these two indices do a
very, very good job of telling when a major reversal is likely near.
5. I'm not going to bash the brokerage firms, but my guess is there will
be too many "Buy" recommendations on stocks. And making stock recommendations
remains a dismal science. Look at how many companies either beat or miss the
forecasts each quarter. It's astounding. In most cases, the companies did
nothing right or wrong...it was simply the "analysis" that was wrong. Be extra
careful with "buy recommendations" here, especially as prices are dropping.
Markets almost always move stocks, not vice-versa.
6. Downside gaps are traps, especially below the 200-day moving average.
Bad news is pounced on. Just look at the stocks that disappointed this week. The
urge is to buy these stocks because they are "cheaper" and will potentially
bounce. But these bounces (on average) don't occur, especially compared to when
stocks are above their 200-day MA.
A friend of mine once told me that when a growth stock gets hit hard because
they missed the numbers and the analysts start referring to it as "cheap" and a
"value," that stock is usually dead money for at least a year (think CSCO after
it hit 70 and then missed their numbers for the first time. Four years later and
it still hasn't recovered). He gave me this advice in 1990. Over the next 14
years it's been one of the better truisms out there. In fact, from 2000-2002,
you could have made some great money "shorting stocks" that missed the numbers
after they gapped lower. Bad went to worse. I'm not saying it's going to happen
again but I am saying that you should think twice before buying these
stocks...at least until the market moves solidly again above its 200-day MA
again. And if you do short these stocks, and past history repeats itself,
there's likely a better than usual chance for outsized gains. Just stay vigilant
with your stops.
7. More on number 6. In a bear market, professional traders like to sell
calls against the stocks mentioned above. They understand that these stocks are
many times dead money and call premium can be captured. Only do this if you
fully understand the risks involved in trading options.
Putting It All Together
OK, let's now put some structure into what we've discussed.
1. In a bear market, short selling will likely outperform long buying.
2. This short selling is best done after the market has rallied to a
pre-defined point. We identified three of these points last week.
3. Opportunities also potentially exist in shorting companies the first
time they disappoint (and are trading under their 200 day MA) and in selling
calls on these stocks.
4. Most important: Stops, proper position size (meaning smaller position
size) and risk control must take precedent as volatility will likely be higher.
5. The Semis and the Brokers will likely tell us when a reversal is near.
As they go, the market goes.
If we actually are in a bear market, there will be ample opportunity to make
money. But, that money will be made by those who best understand that declining
markets trade very, very different than rising markets. And if you have any
questions on the above, please feel free to e-mail them to me at
lconnors@tradingmarkets.com
Three Things Of Note
1. Professional trader John Carter will be conducting a 3-day
seminar on trading the e-minis (the seminar includes live trading) in
mid-August. You can find more details on John's seminar
here.
2. Kevin Haggerty, former head of trading for Fidelity Capital
Markets, did a 3-day seminar last month at the Waldorf Astoria. The CD-ROM from
this seminar will be shipping next week. If you'd like details on Kevin's event
you can find them
here.
3. Gary Kaltbaum is releasing an interactive
CD-ROM course which covers advanced CANSLIM methods. More information is at
www.garyk.com
Summary
For some people, the market's decline feels like it's the end of the world. And
it's certainly more fun to see the market rise than it is to see it fall. But,
as we saw in 2000-2002, there is ample opportunity to make money in a declining
market. Many novices quit trading when prices drop. Many professionals make
most of their money during these times. The only difference is that the
professionals possess the knowledge that the novices never had. Hopefully my
columns from the past two weeks helps you on the path to this knowledge.
Have a great week trading (and thanks for all the e-mails from the Little League
parents. Your stories are priceless)!
Larry Connors
