How to Trade in a Bear Market

During my non-professional trading career, I studied and experimented with various strategies. For a period (which might include present days), I had my go at picking value stocks.

In pursuit of value, I use to buy stocks that were down even if the market was up. I was trying to position myself for a sort of mean-reversion trade, like buying FB now. But I managed only to buy names that were down for a real reason, so when the overall market turned, they got punished even more, instead of rotating into favor.

The prime characteristic of a bear market is a sequence of lower highs and lower lows. No one wants to buy at the beginning of a bear market, obviously; the fact is, no one receives an alert when a bear market starts. You buy because you think you are still in the previous regime, and in that context buying at that level would make sense. Going back to the FB example, look at the circle in the graph:

Looks like a normal retracement in a strong trend, so you buy there. A couple of months later, your investment is worth 40% less (if, like me, you do not use any stops).

I am going to talk to you about a strategy that will help you find a good entry point, if you think the market is bear, or to adjust your entry point / manage your position because you bought before a regime change.

This is not a cooking recipe, where amounts and actions are well defined, and if it was, it would be a recipe to avoid you to die from food poisoning, not a recipe to earn you a Michelin star. It will not make you rich by itself but it might help you to go in the right direction.

If you bought thinking you were in a bull market and realize the regime has changed, the best thing to do is to cut your losses and regroup. Your initial thesis is not valid anymore. If you have no position and would like to buy something that is trading below its 200 days moving average, there are plenty of documented reasons you should avoid that idea. If you follow these two simple rules, you can stop reading here, anything below would be useless to you. And congratulations, you are a better trader than me (for what it is worth :)).

This is a strategy for people like me, someone that is not able to put a stop loss because they know the stock will fly straight after they sold, people that are not able not to ‘put their hand in the jar’, even if they know it is a no-no, when they see a stock down 50%. I probably read this strategy in one of the Market Wizards books but it does not matter who invented it:

• it is not my idea
• it makes sense to me

A Bear Market

Markets go down (and up, if you reverse the picture) following this pattern: the black line is the price while the green line is the 200 day moving average.

Ideally, you want to buy there…but it is really hard:

Price accelerates downward and then retrace back towards the 200MA. In short (pun intended), this happens when short sellers with a short time horizon start to take their profits becoming buyers; bulls see the price finally going up, think the worst is over and jump in looking for a bargain. Price rebounds but then sellers come back, relieved to see levels at a lower ‘pain’ for them, and a new downward cycle begins.

Usually (ahahahah, like if there is anything ‘usual’ around here) these turning points happen when the price to 200MA ratio is around 0.8; I will repeat it again, this is more art than science. The idea is to see the market capitulating, those red bars way longer than anything in the recent past.

Technical Analysis offers the tools to help you buy close to the red lines, conscious that when you buy the first red line you do not know and do not expect a second will happen. Well, most of the time you know there will be another leg down but you buy nonetheless, innit? 😉 The allure to be the ‘smart’ one who got the bargain is too big, even if in reality is just a lack of patience.

Divide your trade size by 4 – Step 1

By now we understood that, despite all our efforts, our trade entry price will be terrible. Dividing our position by 4 is foremost an acknowledgment of this fact, it is a basic risk management technique. If the maximum amount that you want to risk on this trade is €1000, the first trade should be worth €250.

So we buy. If we did our homework, the price will rebound later because we were looking for a sort of capitulation point. If the price does not rebound, this is your first lesson: you have to revisit your idea of capitulation. But you have also to remember that the feedback loop is really bad, so you might have done the right thing and still have a bad outcome.

To be more precise, the stock price can ‘go back’ to the 200MA also sideways, as recently in Tencent:

You see price forming a nice base above 55. This can be a confirmation as well that selling pressure runs out of steam.

If at this point you gave up reading, great! That’s the point, you should not do this, go back to Dollar Cost Averaging your broad index ETF or 60/40 portfolio.

But you are a stubborn dawg.

Step 2

So, price rebounds and then go below our entry point. And then starts to go way lower. We want to use another quarter of our trading size to adjust our entry price because we clearly missed the first time. We wait to be in what feels like real pain (at least we think it is at this point), -20% or more. Then we look again for signs of capitulation, the second red line in the previous graph. Here is an update on the Tencent story:

Aside from the 9th of March, it was straight down after breaking the support.

If we buy at -20%, our overall position is now -10%. In the ideal scenario, the market rebounds at least 11% from here: we then sell half of our position and we are back at Step 1, with our entry price 10% lower than before. We are market wizards indeed!

Unfortunately, the ideal scenario is possible but not common. Bear markets are nasty and we have probably seen only the beginning.

Step 3

The bad news is that we have half of our trading size deployed and in double-digit percentage losses. The good news is that we still have half left to be deployed.

The idea is to use the other half of our trading size to scalp our entry price level down: look for other extreme selling points, get in and get out generating ideally a +10% gain each round trip. Each 10% gain will reduce your initial loss by 10%, so if we were 40% in the red now we are ‘just’ 30%.

To give you an idea, here is the graph of the Sugar ETN I traded a while ago:

Three times the price jumped more than 20% while in a bear market; you are great if you manage to cash-in half of those movements, that’s why a 10% gain is nothing to be frown upon.

You can use this dry powder in two tranches, like Step 2 if you want, instead of deploying it all in one go. It depends on the opportunity and your feeling about the market.

The obvious risk is that you get in and do not find a profitable point to get out. Now you will really feel any additional losses. Red figures will be punchy.

The End Game

The whole point of the strategy is to wear out the bear market and have to deal with ‘manageable’ losses, figures that won’t make us puke, sell everything at the worst possible moment and never invest again.

After all, we choose our stock very carefully and we are finding ourselves in this position because…Putin invaded Ukraine, not because our stock is a dead cat, innit? Fundamentals at a certain point will matter again and the price will go up.

Or not. Let’s take Citigroup as an example:

Citigroup, like many other banks, was considered a good investment before 2008. Then the world, and especially the banking sector, changed forever. If you invested in 2006 and 2007, chances that you will see back those prices are quite slim and no strategy will save you from the losses you see now.

Trading costs

If you are still paying trading fees to your broker, consider them before giving yourself a ‘profit’. You have to trade less frequently, accept higher swings otherwise you will only generate profits for your broker and not your account.

This aspect is very important when your portfolio is not huge and your broker has a minimum trading fee irrespective of the size of your order. Let’s say you have a €10k portfolio and you want to trade 10 stocks: this means €1000 per stock and €250 per trade. If your broker has a €2 minimum fee per trade, you almost pay 2% of your profits to your broker per round-trip: that’s a huge part of your profits!

Conclusion

The other day I was listening to someone talking about DeMar DeRozan and I reflected on the fact that, as a basketball player, I never really learned when to take my shots. Here is a similar situation, you put yourself in a bad spot and you try to find a way out; you should not have been there in the first place but…

A lot of intelligent people will tell you to never average down and they are right. In this particular case, you acknowledge that fact by initially committing only 1/4 of your trading size. It is not averaging down, it is you realizing that you will be wrong more often than not, so an incremental approach is more appropriate.

Does it mean that during a bull market you will only invest 25% of your capital?

No.

This wants to be just a raw tool to have in your risk management framework. A plan to hopefully get you out of a nasty situation. Single name positions should be an exception, not the rule; if your total portfolio is just a few names then you need a completely different toolbox.

Pros usually sell/buy towards the end of the day and if you follow @rampcapitalllc you probably understand what I mean. If at 4 pm GMT the S&P500 is green and then it closes red, we are in a bear market (or soon to be). Again, not a set-in-stone rule but something to pay attention to if you want to understand where the wind is blowing.

Hope this piece made you think and, as usual, please leave your comments/feedback below.

What I am reading now:

Follow me on Twitter @nprotasoni