How to Turn a Bear Market in Your Favor
Since the Global Financial Crisis 15 years ago, stock markets have been on a seemingly unstoppable tear. Despite geopolitical turmoil, uncertain economic recoveries, and even a worldwide pandemic, many equity investors have only known good times.
Now, the party seems to be over. In June 2022, the S&P500 tipped into bear-market territory (defined by a 20% drop from a recent high) for only the 15th time in almost a century. About $10 trillion has been wiped off equity values as certainty hardens that the US Federal Reserve’s efforts to curb inflation are pushing the economy into a recession.
For stock-market investors, it’s time to run and hide, right?
Not necessarily. The natural reaction of inexperienced investors to steep losses is to panic and sell. This is often the worst response. You might have spared your portfolio temporary pain but once you’re out of the market, those losses become permanent.
In fact, bear markets present ample opportunity for investors to design strategies that will not only protect their existing portfolios from short and medium-term losses but to profit from the downturn as well. Realising those opportunities, however, often requires investors to pivot away from an ingrained “buy low, sell high” mindset that leads into the dangerous territory of trying to “time the market”.
Any investor who held onto their stock portfolios through the 2008-2009 Global Financial Crisis, for example, would have ultimately been rewarded with spectacular returns a few years down the road.
“If the market is going down, trying to buy at the bottom is difficult to execute successfully,” said Dan McCarthy, a Strategist at DailyFX. “A lot of equity traders have a natural bias to trading from the long side (buying assets they hope will rise), rather than playing from the short side.”
A possible solution for those that want to maintain long-term holdings is to use a percentage of portfolio capital to hedge the exposure using short-selling. In physical stock markets, that means an investor will “borrow” shares from a broker and sell them at a certain price, then hope to buy them back later for a lower price and return the shares to the broker, keeping the price difference as profit. Trading Contracts-for-Difference (CFDs) is simpler: the investor simply clicks the Sell button on the contract of their choice.
There are two principal motivations for short-selling: protection and profit.
Shorting for Protection
A long-term investor will generally have a portfolio of stocks that they intend to hold for at least five years. That portfolio will rise and fall over time, but history shows that a well-constructed portfolio will have a diversified mix of companies that will deliver positive returns in the long run.
Investors can still sandbag that portfolio with some short-term trades, however.
“Say you have a US share portfolio and you think that market might experience a rocky road for the next few months, you can short an Index CFD for the US stock index as a whole,” said Dan Herriotts, Head of Dealing at IG. “To varying degrees, that can hedge you against a market move to the downside, depending on the weighting of the equities within your portfolio. Your portfolio stays where it is – with a long-term horizon – but for the next two or three months you can benefit from any market correction.”
To do this on IG’s platform, an investor would place a Sell Order on the US500 — possibly setting the price level to trigger a trade at a certain percentage below the current level — adding Stop and/or Limit orders to restrict losses or close out the trade at a certain profit level.
Investors can do the same with individual stocks. Before a major corporate announcement – most commonly before quarterly earnings – you could sell a CFD on that company’s stock. If the results please the market and the stock goes up, the shares you own gain value. If the opposite happens, you make a profit from your short trade on the decline.
Shorting for Profit
Short-selling doesn’t need to hedge your existing portfolio. It’s also common to use CFDs to make speculative trades that capitalize on short-term market dips, as long as they fit with your overall investment strategy.
“You should be thinking about risk management, looking at your stop-losses and really thinking about your investment strategy and investment horizon,” said Herriotts. “Then make sure that the trades you put in place fit that investment strategy and your level of risk management.”
Just as investors use the options market to hedge their equity and other holdings, smaller investors can use CFDs as outlined to protect their own portfolios – but it isn’t necessary to have a complementing investment.
Speculating on drops in the S&P500, ASX, or any other equity gauge without a corresponding stock investment – or Selling CFDs on any company you think is set to fall without holding the shares – is a common strategy, albeit one that carries an inherently higher risk.
Nevertheless, the impact of a bad earnings announcement often has spillover effects that investors can use to their advantage. If a major tech company’s results disappoint the market, other tech stocks often drop as well, so you might Sell a US Tech 100 CFD.
Closer analysis of current economic conditions can help investors home in on specific opportunities, too. In the current climate of rising interest rates, high inflation, and slowing growth, certain sectors are expected to fare better than others. Investors will usually pivot away from “growth” sectors that are sensitive to higher borrowing costs and toward “value” sectors.
Therefore, short-selling technology, real estate, or construction sectors through CFDs on sector ETFs might yield positive results in this environment. This can be done simply and effectively through the thematic and basket investing options on the IG platform, where investors can access ETFs in sectors from Artificial Intelligence to Hotels & Cruise Lines to Lithium & Battery Tech.
Employing broader strategies across different asset classes can yield a much wider range of opportunities, such as:
– Bond yields usually move inversely to stocks, so an investor might Sell a CFD on a US Treasury ETF when the S&P500 rallies, or vice versa.
– Gold and the US dollar have a very reliable negative correlation over time, so when the US dollar is strong as it was in early 2022, Selling gold-based CFDs makes sense.
– Bitcoin has established a strong negative correlation to gold.
Certain currency pairs also exhibit very strong negative correlations, and there are many data sources available that track these correlations over specific time periods. It’s important, therefore, to examine your portfolio and your investment outlook, and develop a strategy that exploits the inherent opportunities in current market conditions. It’s also crucial to be aware that asset classes and instruments that have previously shown strong correlations may not necessarily continue to show those links in the future.
It’s equally important to choose a service provider that offers access to the largest possible universe of assets.
“When looking at choosing a broker, check if they offer the range of markets that could come into play,” said Herriotts. “If you are looking at strategies that use some markets that are less heavily traded, it's good to look at the broker and see the range of markets they offer. Because of its comprehensive array of assets across all sectors and classes, the IG platform is the ideal place to evolve your investing and keep pace with changing markets.”
CFDs come with a high risk of losing money rapidly due to leverage. You do not have any interest in the underlying asset. Refer to our PDS and TMD at www.ig.com/au. The information on this page does not contain personal financial or investment advice or other recommendation, or an offer of, or solicitation for, a transaction in any financial instrument. No representation or warranty is given as to the accuracy or completeness of the above information. Consequently, any person acting on it does so entirely at his or her own risk. The information does not have regard to the specific investment objectives, financial situation and needs of any specific person who may receive it. IG accepts no responsibility for any use that may be made of these comments and for any consequences that result. IG Australia Pty Ltd ABN 93 096 585 410, AFSL 515106.
