How to Make Money in a Bear Market

08/25/2010 12:01 am EST

Focus: STRATEGIES

Recent market action and economic news points strongly toward the possibility of a double-dip recession and the resumption or continuation of a bear market in equities and exchange traded funds.

If the bear is back, the average retail investor and mutual fund manager now face the possibility that they’re—once again—standing in front of a freight train. 

But there is a special group of knowledgeable individual and professional investors who have been making gains since the market has turned south. Here’s how they’re doing it: 

  1. By moving a portion of their portfolios to cash. Professional investors and managers routinely move assets to cash when the market heads south. The old adage “Cash is King” is particularly valid during bear market meltdowns

  2. By using stop loss points to exit profitable positions and take profits home or minimize losses on losers

  3. By buying protective put options to hedge long positions and limit losses without selling positions

The point is that investors who are winning during this difficult time understand that if they’re not losing money, they’re effectively making money because when things turn back up, they’ll be moving ahead with wealth accumulation instead of spending what could be years just getting back to break even. 

Investors Can Actually Make Money During Bear Markets 

Most investors will continue doing what they always do: Sitting around wringing their hands and worrying and searching the financial press and television looking for a nugget of hope from people who know less than they do. 

But there is another group of individual investors, financial advisors, and newsletter writers who have been able to capitalize on this recent decline in the market. It’s not rocket science, and here are just three methods they’re using. 

  1. Buying stocks, ETFs or mutual funds that do well in bear markets. This is an obvious possibility, and, in fact, many investors have already figured this out.  Possibilities include the traditional defensive sectors like consumer staples and utilities.

  2. Buying bonds, mutual funds, or ETFs that track widely followed bond indexes because bear markets are typically accompanied by a flight to quality that causes the face value of bonds to rise.

  3. Buying inverse ETFs that move opposite the underlying index so the value of the investment rises as the underlying index declines. This has been made possible through the relatively recent development of these inverse funds, and one of the best providers of this product that I’ve found in my work at Wall Street Sector Selector is the ProShares family of exchange traded funds. They offer a wide variety of inverse ETFs that allow “shorting” of the market, that can be used in both qualified and non-qualified investments, and that track the major indexes, sectors, and international markets. Inverse ETFs are tricky and you need to understand how they work and have a proven tactical trading plan, but if you do, there is plenty of opportunity on the “short” side of the markets.

  4. Trading the VIX, or CBOE Volatility Index, also known as the “fear” indicator. The VIX tends to move opposite to stock prices—rising when prices fall and falling when prices rise—as fear and complacency enter and exit the market. Today, two popular ETFs, VXX and XXV, allow traders and investors the opportunity to go “long” or “short” the VIX, depending upon their outlook for upcoming market moves.  A position in VXX is designed to rise in value as stock prices fall, so it offers another avenue for “shorting” the market.

(In my work at Wall Street Sector Selector, we use inverse exchange traded funds to take advantage of downtrends in the market and also use VXX and XXV to trade the volatility inherent in today’s environment.  Currently, our standard portfolio is fully invested in inverse, or “short” ETFs, and we also hold a position in VXX, expecting that volatility will rise. Positions can change at any time.)

In summary, no one can say for sure if recent market action is the start of a new bear or if this is just a sharp correction. No one can tell you that it will or won’t continue. Sadly, there are no crystal balls, as much as we’d all like to have one. But even these days, some investors are making money, and all investors have alternatives to watching the bear maul their portfolios. 

By John Nyaradi of WallStreetSectorSelector.com

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