Thanks to this 4 year bull market that we’ve been experiencing, a lot of investors have forgotten what a bear market feels like. If (and when) the next bear market comes around, here’s a list of tips on how survive and invest profitably in a bear market. This post includes both strategies for more sophisticated traders and less inexperienced investors.
A more complex, but often more profitable way of making money in bear markets is to buy call options. Call options are options that allow the buyer to sell a certain financial security at a future date based upon the current market price. A call option is basically a bearish call. In effect, this is very much like shorting a stock. Now let’s get into some of the more nitty gritty stuff regarding options.
Options, as I have mentioned, are a rather complex way of investing (or trading, if you’re an options trader). The thing about options is that you’re not inherently buying a security – you’re simply making a bet on the probability of two outcomes (whether the security will go up or down in price). Hence, when you’re buying an option what you want to look for are option mispricings.
Options mispricings means that the market has not calculated the probability of the underlying security going up or down correctly. Options are priced based on the Black-Scholes model. Now inherent in every model are assumptions – sometimes, these assumptions are invalid and just straight up wrong. That is when an option will be mispriced, making it cheap to buy and therefore potentially extremely profitable to investors.
Now there are many options mispricings, but one of the biggest is based upon recent volatility. A big component that determines the price of options is the volatility factor. (Volatility is how choppy the market price has been). Options are cheapest (meaning that they’re mispriced) when recent volatility has been low. Volatility tends to get low at the peak of bull markets. For example, volatility was near record lows in the beginning of 2007, coinciding with the multi-year bull market.
Thus, options are priced the cheapest when volatility is low because the options pricing model assumes that the same low volatility will be projected into the future. This is where the mispricing occures. Recent low volatility in reality is more likely to be followed by greater than average volatility in the near future. Why? Because when prices are most steady, meaning that they’re moving steadily in one direction, is usually in the end of a bull market. What follows a bull market? An insanely choppy bear market, like the one we experienced in 2008.
Hence, recent low volatility is actually a sign of great upcoming volatility.
To conclude, a really good way is to buy call options on stocks, because in the beginning of all bear markets
- Options are dirt cheap.
- Stocks have only one way to go – down.
Hence, a natural corollary of this is…..
Volatility is measured by VIX, also known as the Volatility Index, courtesy of the Chicago Board Options Exchange (or short-form CBOE). This index is just a measure of volatility. But did you know that you can actually buy and sell volatility? Thanks to Wall Street wizardry, one can now invest and trade in the most arcane of financial products.
Volatility is purchased as an option. As I’ve already mentioned, volatility is dirt cheap when recent volatility has been low. Ironically, low recent volatility usually portends greater than normal chances of high volatility in the near future. Hence, maybe you should consider buying some volatility in a bear market.
Buy Recession Proof Stocks
Certain types of stocks and companies in certain industries thrive when the economy is doing poorly. In terms of consumer companies, low end retailers such as dollar store chains tend to do very well in recessions. This makes logical sense, as more and more consumers are feeling the pinch and therefore need to shop on less at cheaper stores. That is why in this dour economy Dollar Tree’s stock has more than quadrupled in 3 years.
In addition, some bankruptcy companies and legal services companies also do rather well – think of it this way. When business goes south, activities in court and the U.S. Bankruptcy Department (if that even exists) go up. As more and more businesses go bankrupt, that (ironically) means more business for legal services companies.
The last and most common way for investors to make money in bear markets is by shorting stocks. Shorting a stock is inherently the opposite of buying a stock – you’re borrowing someone else’s shares, selling those shares at today’s market price, and hoping to buy back those shares (which you are required to) at a lower price in the future. Thus, shorts are bearish bets.
However, there is one key danger that all short investors must face, which is that you can be forced out of a position in the worst possible time. Here’s what I mean.
When you short a stock, you’re losses are theoretically infinite, because theoretically a stock price can shoot to a bajillion dollars, resulting in infinite % losses for your short. Oppositely, you’re gains are finite – the max you can make is 100%, meaning that the stock goes to zero. Now inherent in this is a problem. Let’s assume that you have $100,000 in your investment account, and short $75,000 shares worth of Google. Then, in the ensuing 2 months Google increases 33%. By law, your broker must buy back all your Google shorts, at a 33% loss. Then, in 3 months Google’s price falls 50%.
Hence, you’re bearish call on Google had been dead right, but you still lost money because your timing was too early. Shorting stocks requires your timing to be dead on, and that is the problem. Who can be dead on more than 80% of the time? Few and far between. Oppositely, when you buy a stock you’re timing isn’t as important. You can simply sit through a rough time until your investment turns profitable.
This post was written by Troy, who blogs about investing and finance. Click here to check out his blog.