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Bear Market Explained

We studied the difference between a trader and an investor and understand that both move with market trends. Investors buy and hold assets to achieve larger profits over an extended period, while traders make smaller profits by entering and exiting markets frequently to take advantage of market movements. The downward and upward trend of market movements is termed “bear” and “bull” market respectively. We have a general understanding that a bull market refers to when prices rise in the financial market.

The question is, can we still profit in a bearish market?

What is a Bear Market?

A bear market is when the economy experiences a prolonged fall in prices. Bear markets often are correlated with drops in the stock market or indexes such as the S&P 500. However, individual stocks, assets can also be deemed to be in the bear market if they experience a fall of 20% or more or in cryptocurrencies’ case like Bitcoin, down to 85% in a downward trend over a prolonged period of widespread investors’ pessimism and negative sentiments for over two months. Bear markets can also follow general economic downturns, such as a recession.

Understanding the Bearish Trend

Stock values typically reflect potential expectations of cash flows and corporate income. As growth prospects decline and expectations are lowered, stock prices can decline. Mass fear and a rush in people to protect their assets’ downside losses can lead to long periods of depressed asset prices. As such, traders and investors are more risk-averse than risk-seeking in a bearish market.

An example of a bearish market:

Photo by OneStopBrokers

Causes of a Bearish Market

Typically, a weak and slow market caused by low employment from weak productivity will result in low disposable income brings about a bearish market. Such occurrences inherently cause a drop in business profits – Such cases lowers investors’ confidence in their investments, causing them to sell off shares to avoid losses, and traders will rush to exit markets. In some cases, governments may intervene in the economy that will cause a bear market. e.g. changes in tax rates.

Photo by Olga DeLawrence on Unsplash

Bear Market Phases

Phase 1 – Characterized by high prices and high investor sentiment, investors begin to drop out of the markets and take in profits.

Phase 2 – Capitulation occurs, where stock prices start to fall sharply, with a decline in market activity and corporate profits. Economic indicators, which may have been optimistic once, also start to fall below normal. Investors begin to panic at this stage as their confidence in the market starts to fall. 

Phase 3 – Speculators start to enter the market, thereby increasing some rates and trading volumes

Phase 4 – Stock prices continue to fall. However, this is also when investors begin to speculate and start entering the market again, leading to a bullish market. 

Profiting in a Bear Market

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Short-Selling

Investors and traders can profit in a bearish market by selling borrowed shares and repurchasing them at lowered prices, otherwise known as short-selling. Short-selling is also a method used by traders or investors to hedge their funds, minimizing their portfolio risks. Short-selling is often viewed as a risky step as markets tend to move upwards in the long-term. However, there are situations like during a bear market that traders can take advantage of to use short-selling to hedge their risks. 

Example: Kimberly, an investor, sells (shorts) 100 shares of a stock at $100. The price falls, and the shares are covered at $90. Kimberly makes a profit of $1000 ($10 x 100). In this case, should the stock trade higher unexpectedly, Kimberly will need to buy back the shares at a premium, resulting in heavy losses.

This technique, however, carries high risks and may cause heavy losses. It can also be a costly process due to margin requirements, like margin trading

Put Options

Some traders also engage in derivatives like Put Options, to tackle a bearish market. Put options is a contract that gives the owner the right, but not the obligation, to sell–or sell short–a specified amount of an underlying security at a pre-determined price within a specified time frame. This makes engaging in Put Options a straightforward strategy with low risk and high reward potential during a bearish market. However, the options contract must be utilized within the specified timeframe as when the stock declines below the put strike price (price of the derivative’s underlying security), the put value will increase. In vice versa, should the stock price stay above the strike rice, the put will expire with no value to it, and the trader will not be required to buy the asset.

Example: A stock is trading at $45 per share. Harry, a trader buys a Put Option contract when its underlying security price is below the strike price, at $40 for 5 stock shares at a cost of $200 (Otherwise $225 at underlying security price). Harry will profit when the stock trades below $40 before contract expiration. 

Prospective traders and investors may join DigiFinex Derivatives’ telegram group to get daily long and short signals by top industry analysts.

Short-Selling vs Put Options

Short-SellingPut Options
An investor borrows a security and sells it on the open market plans to buy it back later at a lower price.Put options give holders of the option the right, but not the obligation, to sell a specified amount of an underlying security at a specified price within a specified time frame.
Short sellers bet on and profit from a drop in a security’s price.Put options are available on a wide range of securities, including stocks, indexes, commodities, and currencies.
Has a high risk & reward ratio. It can offer big profits, but losses can mount heavily at the same time.Prices are affected by changes in the price of the underlying asset and decline in value over time
Increase in value as the underlying asset falls in price, and lose value when nearing contract expiration

In Summary

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Whether in a bullish or bearish market, traders and investors can profit when they engage the right strategies to hedge their risks and maximise profits. While we learned that it is possible to profit even in a bearish market, you need to understand market trends and take advantage of them to earn your Bitcoin.

For related articles, read DigiFinex Academy.

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