Time to Be Friends with Bears as Well as Bulls? Trading Both Sides

It’s been a long, mostly steady trend higher in the stock market since the lows of the financial crisis all the way back in 2009. But the market stopped trending higher last year. And earlier this year, traders were reminded that stocks can, in fact, go down.

We’ve been covering the reasons for the rough start to this year. Kira Brecht has been following the drop in earnings estimates and the stock market’s obsession with crude oil. Meanwhile, Fred Ruffy has been tracking the nuances and shifts in volatility during these choppy first few months of the year.

These fundamental and structural signs seem to point to a change in the stock market’s character when compared to the last six years. The days of buying every dip and subsequently expecting the broader market to reach new all-time highs might be gone for a while.

The change is a bit clearer when studying the long-term technical position of the S&P 500 Index (SPX). You can see the consistent pattern of higher highs and higher lows in the SPX dating back to 2012 in figure 1. The pattern of higher highs and lows broke down last summer, and since then the SPX has been violently chopping sideways between about 1870 and 2100.

Adapting to a Trader’s Market

In response to the change in the broader market’s trend, some traders are reducing risk by trading smaller position sizes. This is something JJ Kinahan, chief market strategist at TD Ameritrade, has been talking about recently. The change in trend last year and subsequent uptick in volatility has created a “trader’s market,” Kinahan notes. He goes on to add that some traders are “trading perhaps smaller position sizes than they normally would.”

A “trader’s market” means there are opportunities for both bulls and bears. It means traders might consider making friends with the bears after all these years.

So, what are some bear-friendly trading approaches?

Short Stock: Unlimited Risk/Limited Reward

One of the basic ways to make friends with the bears is by shorting stock. To short a stock, a trader borrows shares from her broker and sells the stock in the market. To close a short position, the trader must eventually buy back the stock in the market and return the borrowed shares to the broker.

If the trader buys the stock back at a lower price, she earns a profit. Conversely, if she buys the stock back at a higher price, she records a loss.

Although shorting stock is a basic way to trade the bearish side of the market, it can be extremely risky. In fact, the risk of shorting a stock is theoretically unlimited because there’s no limit to how high stocks can trend. There is, however, a limit to how low stocks can trend: A stock can go as low as zero. This means the potential reward from shorting a stock is limited to the stock falling to zero minus transaction costs.

Long Put: Limited Risk/Limited Reward

Another way to make friends with the bears is to buy a put option. Options give traders the right, but not the obligation, to buy or sell shares of the underlying stock at a specified price. A trader can buy and sell options from his broker provided he has the appropriate options trading approval.

If a trader buys a put option on a stock, he might earn a profit if the option rises in price and he sells for a profit or he buys shares of the stock at a low price in the open market and exercises the put to sell them at the strike price. Conversely, if a trader buys a put option he might experience a loss if the option falls in price and he sells or it expires worthless.

An important difference between shorting stock and buying puts is that the risk associated with a long put is limited to the premium paid for the option. 

Need a Bear Hug?

The risks, potential rewards, and general mindset of trading from the bearish side are quite different from trading on the bullish side of the market. Traders who are new to bearish trading strategies might practice shorting stock and buying puts in a thinkorswim^® paperMoney^® account. This paper-trading practice can help traders get a better understanding of some of the dynamics at work on the bearish side.

In addition to practicing these strategies in a paperMoney account, be sure to take full advantage of the resources available to you. In particular, you can learn more about options at the link below.