When you read about financial markets, you encounter different technical terms and technical jargon. One of the most common concepts which you meet in almost every post written about financial markets is bear market. This term is often juxtaposed with bull market, its polar opposite. In what follows, we are explaining in detail what the bear market is and how traders can benefit from prolonged price declines.
What Is a Bear Market?
A bear market is a market’s condition when prices move down for a long period of time. For the market to become bearish, prices of securities should slip by at least 20% from recent tops. During such time, general pessimism overtakes the market, and investors express negative opinions about its future.
When a market turns into a bear market, it does not need to fall in its entirety. It is sometimes enough for one large index to drop to suggest that a market’s condition is bearish. If, say, the S&P 500 slides by more than 20% and extends its losses for some time, investors will say that they are experiencing a bear market. Individual securities can be in a bear market, too, if they continue sinking for two months or longer.
It is worth remembering that a 20% decline is only an arbitrary number. There are cases when markets become bearish even before they shed 20%. Another indicator of a bear market is investors’ sentiments. Not only do investors express pessimism but they also avoid taking risks. In bear markets, investors are more risk-averse than risk-seeking, refraining from speculation and placing only sure bets.
How Do Traders Make Money During Bear Markets?
This is not to say that investors do nothing but lose during a bear market. Although bear markets are characterized by declining prices, it is possible to make money even in such unfavorable conditions. When prices dip, investors earn on short selling, put options, and inverse ETFs.
When investors earn gains by short selling, they sell borrowed shares and then buy them again at lower prices. Note that this is a risky enterprise that can lead to large losses. If you practice short selling, you need to borrow the shares from a broker before placing a short sell order. Your profit and loss amount will be the difference between the price where the shares were sold and the price where they were bought back.
In bear markets, traders also make money with the help of a put option. This option allows you to sell at a specific price on a specified date or before it. You can use put options to speculate on stocks’ falling prices. You can also hedge against falling prices to protect your long-only portfolios. But note that you need to have certain options privileges in your account to make such trades.
Another option to make money in a bear market is inverse ETFs. Inverse ETFs change values of the index they track in the opposite direction. Thus, the inverse ETF for the Nasdaq would climb by 2% if the Nasdaq index slid by 2%. Remember that there are numerous leveraged inverse ETFs that increase the returns of the tracked index by several times. You use inverse ETFs to speculate or protect your portfolio.
What Triggers Bear Markets?
Bear markets can happen during financially stable times but usually they are concomitant with economically difficult periods and recessions. A bear market can be cyclical and last for a couple of weeks or months. Longer-term bear markets, called secular, carry on for years or even decades.
The signs of a week or slowing economy are low employment, low disposable income, low productivity, and a decline in business profits. The government’s intervention in the economy can also lead to a bear market. The US bear market of 2007-2009, for instance, was alternatively blamed on the economic policies of the Bush and Obama administrations.
The US bear market of 2007-2009 was the most prolonged bear market in the country’s financial history. It occurred during the Financial Crisis and lasted for about seventeen months. The S&P 500 gave up half of its value during that time.
The latest bear market happened in 2020. When the coronavirus pandemic reared its ugly head in February 2020, global stocks suddenly entered a bear market. The Dow Jones then sank 38% from an all-time high (29,568.77) reached on February 12 to the low of 18,213.65 hit on March 23. This was one of the deepest dives in the history of the index. The Dow Jones was able to break past the 3,000 mark only in May 2020, which means that it was experiencing a bear market for approximately three months. During the 2020 bear market, even financial stocks slid, though they usually trade well in hard times. Between mid-February and the end of March 2020, financial stocks dwindled 8%.
Phases of Bear Markets
Bear markets have four different stages.
- The first stage is characterized by high prices and investors’ desire to take risks. Closer to the end of this phase, investors leave markets and take profits.
- The second phase of a bear market is marked by a sudden decline in prices. As prices begin to fall, trading activity and corporate profits also drop. Economic indicators start sinking below average, too. All this is usually accompanied by investors’ pessimism and anxiety. This stage of a bear market is called capitulation.
- During the third phase, speculators enter the market, after which they increase prices and trading volume.
- In the fourth phase, prices continue falling but slowly so. When low prices accompanied by good economic data begin to lure investors back into trading, bear markets might start transforming into bull markets.
The Origin of the Name Bear Market
The difference between the two types of markets – bear and bull – can be grasped by observing how these two animals fight in the wild. A bear attacks by swiping its paws downwards. Markets set on a downward trajectory resemble the bear’s attack. In contrast, bulls attack by lifting their horns to the air. Hence is the name for a market that moves upward.