Trading in a bear market

A bear market occurs when prices have fallen in value by more than 20% from recent highs, during a period of negative market sentiment.

The financial markets naturally grow and contract due to changes in supply and demand. This constant change is caused by fundamental economic factors influencing the natural buy and sell cycle of an economy. This gives rise to bull and bear markets. A full-on bear market shouldn't be confused with shorter-term corrections of a bull market. It's almost impossible to predict when a bear market will occur, or how long it will last for. It is equally as difficult predicting the end of a bear market and this makes trading these markets especially tricky.

The most recent bear market was during the global financial crisis, when the Dow Jones Industrial Average fell 54% from October 2007 to March 2009. This bear market crash offered astute traders numerous opportunities to short sell the global index markets and individual securities.

When prices start to rise in a bear market, usually after a downtrend, this can lead to bull traps​​.

The typical bear market short trade would be based on an underlying trade idea. This incorporates the target asset and the price that a short trade should be initiated at.

Shorting a market index​​ such as the S&P 500 is a popular choice with traders as this index represents a basket of underlying stocks. Their popularity is founded in their accessibility for most traders as well as their technical and highly tradeable trends. Some traders prefer to target the underlying stocks themselves.

Exchange-traded funds​​ (ETFs) are marketable securities that track a basket of securities, a stock market index, bond or commodity. ETF trading usually has more liquidity and lower fees than mutual funds, making them a popular choice for traders wanting to short a bear market. Inverse ETFs provide a useful tool to either speculate for profit or to protect a stock portfolio.

Traders increase their probabilities of trading market trends by having a stringent trading strategy and capital management plan. This applies equally when trading both bull and bear markets. There are some important aspects worth considering when attempting to trade a bear market.

Essentially, bull and bear markets are either going significantly up or down in value and market capitalisation. A popular bull and bear market definition traces the terms back to how each animal attacks. Bulls drive up with their horns. Bears rake down with their claws.

In a bull market, share prices rise steadily off the back of investor confidence. This confidence increases demand and keeps supply low. A characteristic of a bull market is that price action​​ is usually steady without major whips and stalls. It can continue in this fashion for many years; however, markets cannot remain bullish forever. The balance between demand and supply will naturally change leading to price corrections​​. They are not always severe enough to be classified a bear market. A great example if this would be the 12 months that the S&P 500 index stalled during 2015/16. Price action dropped 14.5%, which is not enough to fulfill the definition of a bear market. As such, this period was just a price correction in a bull market.

Read more about the history of bull markets​​.

One of the major characteristics of a bear market is that it is usually influenced by widespread investor fear over the future outlook for an economy. This fear leads to panic selling, which causes large drops and spikes in price movements. These periods are often fraught with scare mongering in the press as market proponents predict financial conflict. As such, bear markets tend to feed themselves and become, to an extent, self-perpetuating.

Since 1990, there have been two bear markets that were both two years in duration. Although price movements were more volatile and severe than the preceding bull markets, they did come to an end. This in turn gave rise to the next bull market that would then run on further and longer than the last.

All traders need to set up an effective risk-management strategy in order to minimise risk if the markets go against them. This is less of a problem in a bull market when there are likely to be opportunities to recoup former losses by buying a security as it is revalued higher. But trading in a bear market can be more difficult. To keep your head when everyone in the financial market​ is stampeding towards the exits requires the ability to be decisive and act quickly. And this has to be backed up by a solid understanding of the technical resources that are available to help manage your trading account.

The standard trade management tools apply in a bear market. In particular, that means ensuring appropriate trade execution orders​ have been used. A stop-entry order is simply an order to buy or sell a security when its price moves past a particular point. A limit entry order​ can help to diversify a trader's game plan by making it possible to short into rallies in a bear market. These orders bring some predictability to a trading strategy by making sure trades are executed at a predefined price. Some traders prefer to take more active control of their account and not to be automatically taken out of their position.

Stop-loss orders​​ are a useful tool to close an open trade that is going against you at a predefined price level to limit the loss of capital. However, markets can move fast and this is often the case when they turn bearish. Bear markets don't head down continuously – prices may pull back from time to time. This means traders may risk being stopped out when the market was simply consolidating, rather than making a fundamental shift.

Traders aren’t always guaranteed to get closed out at the price they set their stop-loss orders at, which is known as slippage. The faster the market moves, the greater this slippage can be. To circumvent this, you might choose to trade an option with a strike price where a stop-loss would have been located. This could allow you more time to evaluate whether or not you are truly in a losing position.

Our award-winning online trading platform, Next Generation, allows traders to speculate on the price movements of an endless number of assets. Bear and bull markets are clearly displayed through charts and graphs, which you are able to customise to suit your own trading strategy. Take advantage of our price projection tools, drawing tools and technical indicators, which are all included within our charting features. Watch more platform tutorials​ here.

A bear market describes a period of trending downward stock prices, often as a result of negative investor sentiment. However, a recession can be defined as poor economic health that is monitored over at least two consecutive quarters of the financial year, often measured through gross domestic product (GDP).

Bear markets can often lead to or go alongside with an economic recession, although they can also provide effective trading opportunities for investors.