10 Ways to Profit in a Bear Market
Bear markets are brutal when they hit. Ask any stock investor who was fully invested in stocks during 1973–1975, 2000–2002, or 2008. You relieve the pain from the carnage by vigorously pulling your lower lip up and over your forehead to shield your eyes from the ugliness. Fortunately, bear markets tend to be much shorter than bull markets, and if you’re properly diversified, you can get through without much damage.
For nimble investors, bear markets can provide opportunities to boost your portfolio and lay the groundwork for more long-term wealth-building. Here are ten ways to make bear markets very bear-able (and profitable).
Find good stocks to buy
In a bear market, the stocks of both good and bad companies tend to go down. But bad stocks tend to stay down, while good stocks recover and get back on the growth track.
For the investor, the strategy is clear. If the stock of a good, profitable company goes down, that presents a buying opportunity. Translation: Good stuff is on sale! Here’s where some basic research yields some diamonds in the rough. When you find companies with good sales and profits and a good outlook and then you use some key ratios, you can uncover a great stock at a bargain price (thanks to that bear market).
Hunt for dividends
A dividend comes from a company’s net income, while the stock’s price is dictated by buying and selling in the stock market. If the stock’s price goes down because of selling yet the company is strong, still earning a profit, and still paying a dividend, it becomes a good buying opportunity for those seeking dividend income.
Unearth gems with bond ratings
A bear market usually occurs in tough economic times, and it reveals who has too much debt to deal with and who is doing a good job of managing their debt.
This is where the bond rating becomes valuable. The bond rating is a widely viewed snapshot of a company’s creditworthiness. The rating is assigned by an independent bond rating agency (such as Moody’s or Standard & Poor’s). A rating of AAA is the highest rating available and signifies that the agency believes that the company has achieved the highest level of creditworthiness and is therefore the least risky to invest in (in terms of buying its bonds). The ratings of AAA, AA, and A are considered “investment-grade,” whereas ratings that are lower (such as in the Bs and Cs or worse) indicate poor creditworthiness.
If the economy is in bad shape and stocks have been battered, and if you see a stock whose company has a bond rating of AAA, that may be a good buy!
Rotate your sectors
Using exchange-traded funds (ETFs) with your stocks can be a good way to add diversification and use a sector rotation approach. Different sectors perform well during different times of the ebb and flow of the economic or business cycle.
When the economy is roaring along and growing, companies that offer big-ticket items such as autos, machinery, high technology, home improvement, and similar large purchases tend to do very well, and so do their stocks (these are referred to as cyclical stocks). Sectors that represent cyclical stocks include manufacturing and consumer discretionary. Basically, stocks of companies that sell big-ticket items or “wants” do well when the economy is growing and doing well.
However, when the economy looks like it’s sputtering and entering a recession, then it pays to switch to defensive stocks tied to human need, such as food and beverage (in the consumer staples sector), utilities, and the like.
Go short on bad stocks
Bear markets may be tough for good stocks, but they’re brutal to bad stocks. When bad stocks go down, they can keep falling and give you an opportunity to profit when they decline further.
When a bad stock goes down, the stock often goes into a more severe decline as more and more investors look into it and discover the company’s shaky finances. Many folks would short the stock and profit when it continues plunging.
Going short is a risky way to bet on a stock going down. If you’re wrong and the stock goes up, you have the potential for unlimited losses. A better way to speculate on a stock falling is to buy long-dated put options, which gives you the potential to profit if you’re right (that the stock will fall) but limits your losses if you’re wrong.
Carefully use margin
Many investors don’t use margin, but if you use it wisely, it’s a powerful tool. Using it to acquire dividend-paying stocks after they’ve corrected can be a great tactic. Margin is using borrowed funds from your broker to buy securities (also referred to as a margin loan). Keep in mind that when you employ margin, you do add an element of speculation to the mix. Buying 100 shares of a dividend-paying stock with 100 percent of your own money is a great way to invest, but buying the same stock with margin adds risk to the situation.
Notice the phrases “after they’ve corrected” and “dividend-paying stock.” Both phrases are intended to give you a better approach to your margin strategy. You would hate to use margin before the stock corrected or declined because the brokerage firm wants you to have enough “stock collateral,” so to speak. Using margin at the wrong time (when the stock is high and it subsequently falls) can be hazardous, but using margin to buy the stock after a significant fall is much less risky.
Buy a call option
A call option is a bet that a particular asset (such as a stock or an ETF) will rise in value in the short term. Buying call options is about speculating, not investing. Remember, a call option is a derivative, and it has a finite shelf life; it can expire worthless if you’re not careful.
The good part of a call option is that it can be inexpensive to buy and tends to be a very cheap vehicle at the bottom (bear market) of the stock market. This is where your contrarian side can kick in. If the stock price has been hammered but the company is in good shape (solid sales, profits, and so on), betting on a rebound for the company’s stock can be profitable.
Options are a form of speculating, not investing. With investing, time is on your side. But with options, time is against you because options have a finite life and can expire worthless. For more on wealth-building strategies with options, consider the book High-Level Investing For Dummies (Wiley).
Write a covered call option
Writing a covered call means that you’re selling a call option against a stock you own; in other words, you accept an obligation to sell your stock to the buyer (or holder) of the call that you wrote at a specified price if the stock rises and meets or exceeds the strike price. In exchange, you receive income (referred to as the option premium). If the stock doesn’t rise to the option’s specified price during the life of the option (an option has a diminishing shelf life and an expiration date), then you’re able to keep both your stock and the income from doing (writing) the call option.
Writing covered call options is a relatively safe way to boost the yield on your stock position by up to 5 percent, 7 percent, and even more than 10 percent depending on market conditions. Keep in mind, though, that the downside of writing a covered call is that you may be obligated to sell your stock at the option’s specified price (referred to as the strike price), and you forgo the opportunity to make gains above that specified price. But done right, a covered call option can be a virtually risk-free strategy.
Write a put option to generate income
Writing a put option obligates you (the put writer) to buy 100 shares of a stock (or ETF) at a specific price during the period of time the option is active. If a stock you’d like to buy just fell and you’re interested in buying it, consider instead writing a put option on that same stock.
The put option provides you income (called the premium) while it obligates you to buy the underlying stock at the option’s agreed-upon price (called the strike price). But because you want to buy the stock anyway at the option’s strike price, it’s fine, and you get paid to do it too (the premium).
Writing put options is a great way to generate income at the bottom of a bear market. The only “risk” is that you may have to buy a stock you like. Cool!
If you’re going to retire ten years from now (or more), a bear market shouldn’t make you sweat. Good stocks come out of bear markets, and they’re usually ready for the subsequent bull market. So don’t be so quick to get out of a stock. Just keep monitoring the company for its vital statistics (growing sales and profits and so on), and if the company looks fine, then hang on. Keep collecting your dividend and hold the stock as it zigzags into the long-term horizon.