The Best Part of a Bear Market Is How to Profit from It

Dec 17, 2021

In today’s Money Talks, we’re wrapping up our bear-market “survival” series.

Over the past several weeks, I’ve shared my best advice to help you prepare for (and even profit from) the next bear market in stocks, whenever it occurs.

In Part 1, I told you why the next bear market could be more severe than most folks believe possible.

In Part 2, I shared the simple steps every investor should take before any selling begins.

In Part 3, I explained why cash is critical in a bear market and showed you some of the best ways to raise it.

And in Part 4, I gave you my top three “rules” for safe bear-market investing.

This week, we’ll end with a look at a few of my favorite ways to profit from the unique opportunities bear markets can offer.

The first is what most folks would call trading.

Now, I understand that “trading” can be a dirty word to serious investors. It’s often associated with pseudoscientific “chart reading” or gamblers hoping to strike it rich overnight.

But in this case, I use it simply to mean taking a shorter-term approach to your investing.

Many investors dream of getting the chance to buy high-quality stocks at dirt-cheap prices in a bear market.

As I mentioned last week, there’s nothing wrong with that. It’s the single greatest opportunity most bear markets offer. (More on that in a second.)

But shorter-term investing or trading can work very well too.

The greater volatility of bear markets means many stocks can move much further, much faster — both up and down — than they typically do in bull markets.

This means it’s often possible to capture nice profits in stocks — on both the long and short side of the market — in a relatively short time.

Now, there are a few things you need to understand if you decide to try your hand at this approach.

First, the greater volatility means your risk is generally greater too. The stakes can be much higher than in a bull market, and there’s less room for error.

So, if you hope to trade a bear market successfully, you must be disciplined about managing your risk.

If you’re a novice, extremely conservative, or still find yourself struggling to follow your stop losses from time to time, this approach may not be suitable for you.

Second, most folks will likely do best sticking to long-only trades.

As I mentioned earlier in this series, making money shorting stocks in a bear market can be tricky. It’s counterintuitive, but it’s true.

You see, while most stocks do move significantly lower over the course of a bear market, they often experience violent rallies along the way.

These bear-market rallies tend to last just long enough — and push stocks just high enough — to cause all but the most disciplined short sellers to panic and “cover” their positions just before the bear market resumes.

So, for most folks, the simplest way to trade in a bear market is to buy stocks before these rallies.

This brings me to my third point: To do this consistently, you’ll likely need the help of some tools.

As CEO of TradeSmith, I believe several of our tools would be ideal for this approach.

These include our cycles-based Timing by TradeSmith Peaks and Valleys indicator, as well as some of our Ideas by TradeSmith strategies like Low-Risk Runners and Kinetic VQ.

Our usual bear market advice is to wait for the overall market to trigger a Bullseye Signal before getting back into most stocks. But traders could simply choose to follow the aforementioned indicators in individual stocks or exchange-traded funds (ETFs) before this signal occurs.

Folks who aren’t TradeSmith subscribers could use one or more of several common technical or sentiment indicators to help time their potential entries instead.

And again, in any case, you’ll want to be sure to use trailing stops or other exit strategies to take profits and protect your downside when you’re wrong.

My next strategy isn’t really a strategy at all. But it can be incredibly powerful.

It is simply to create what I call a bear market wish list.

This is simply a watchlist of “dream stocks” that you’d love to own for the long run.

Now, the specific stocks you add to this list are ultimately up to you. And there aren’t necessarily right or wrong answers. But I do have a couple of general suggestions.

First and foremost, I would stick primarily to great businesses.

If you’re not sure what this means, you can check out some basic characteristics I shared with Money Talks readers in October. I would also encourage you to check out some of the excellent fundamental research from our newsletter partners for additional ideas.

I also think it makes a lot of sense to take the advice of legendary investor Peter Lynch and focus on companies you know and whose products you use and believe in.

You’ll also need to identify when you would like to buy these stocks.

We’ve already established that the goal is to buy these kinds of stocks at low prices. But how do you know what qualifies as “cheap”?

This is where a basic understanding of stock valuation is helpful.

Earlier this year, I covered some general guidelines in my essay on investment factors. But there is a ton of free information available online for folks interested in learning more.

And as I mentioned earlier, the fundamental research from our newsletter partners can be a great resource here as well.

However, waiting for a great stock to get cheap enough to buy is only part of the equation.

The reality is, in a severe bear market, cheap stocks can always become cheaper. Even the best stocks can fall further than you might believe possible.

So, as I explained last week, you also want to avoid trying to “catch a falling knife.”

Our TradeSmith Health Indicator system is the best and easiest way for most folks to do this. But again, even simple trend-line analysis can work if you’re not a TradeSmith subscriber.

Finally, the last bear market strategy I’ll share with you today is my favorite.

In fact, it’s my favorite strategy to use in bull and bear markets alike.

I’m referring to selling put options on individual stocks, or “sell put” trades, as we call them here at TradeSmith.

I covered the ins and outs of sell put trades in my seven-part series on options trading this summer. So, I won’t rehash it all today.

(If you missed it, you can catch up here.)

All you really need to know is that this strategy works the same in a bear market as it does any other time.

The idea is to sell puts on stocks you’d love to own at that specific strike price.

If the stock moves higher or stays about the same, you’ll generally get to keep the premium you received up front, free and clear.

If the stock moves lower, you may get the opportunity to buy shares at a lower price than you would have been able to when you made the trade.

The one big difference is that you can often make much more money using this strategy in a bear market.

That’s because options prices are based on volatility, which tends to rise when investors are fearful. All other things being equal, the higher volatility goes, the more money you can make selling a given option.

So, if you sell puts during periods when fear and volatility jump higher, you can make multiples more than you can during any other time.

The easiest way to track volatility is through the CBOE Volatility Index (VIX), which you can view in TradeSmith Finance or through free sites like Yahoo Finance.

VIX levels of 20 or higher are generally considered high. But in bear markets, spikes above 30, 40, and even 50 or more are common. These are often great times to take advantage of this strategy.

Again, risk management is critical with this strategy. Be sure to keep your position sizes small, and stick to selling puts on stocks you’d love to own. You might even consider using this strategy on some of your “wish list” stocks you identified earlier.

That’s it for this week. As always, I’d love to hear what you think. You can reach me directly at [email protected]. I can’t respond to every email, but I personally read them all.