Bear markets can be very appealing to traders. Volatility is very high during bear markets, with the market often moving up and down a few percent in any given day. Short term and swing traders dream of vast profits when they try to catch these fast uptrends and downtrends.
Although it is possible to make vast profits from trading bear markets, the risk is also much higher. Trading on the side of the long term trend is much easier than trading against the long term trend. That’s why it’s easier to profit from shorting the market’s downtrends than going long the market’s rallies in a bear market.
The safest thing to do is not trade the bear market’s rallies. Profit from the short side and don’t go long until you think the bear market is over. Going long in anticipation of a bear market rally can be very dangerous if your timing is too early.
(Here’s the optimal way to trade a bear market).
Nevertheless, many traders still want to make money from “catching the falling knife” and trading the bear market’s rallies. That’s because the market can have fierce 20%+ rallies within a bear market. Here’s an example.
Notice how the S&P 500 made 2 very quick 20%+ bear market rallies in 2008. These rallies lasted just a few days. The thought of 20%+ profits in just a few days makes some traders’ mouths water.
So if you’re one of those traders who just has to trade bear market rallies, here’s how you should do it to protect your risk.
Trade rallies differently depending on what stage of the bear market you’re in
Bear markets tend to have 3 stages: a beginning, middle, and end. The way you go long in anticipation of bear market rallies depends on what market stage you’re in.
The beginning of the bear market.
The first decline in a bear market can happen in 2 ways, depending on what the last leg of the previous bull market was like.
- The market will crash if the last leg of the previous bull market saw parabolic price action.
- The market will slowly swing downwards if the last leg of the previous bull market saw high volatility.
Here’s an example of the first case. This is the NASDAQ in March 2000. Notice how the NASDAQ crashed in the first leg of its bear market because it went parabolic before topping in March 2000.
Here’s another example of the first case. This is silver in May 2011. Notice how silver crashed in the first leg of its bear market because it went parabolic before topping in April 2011.
Here’s an example of the second case. This is the S&P 500 in October 2007. Notice how the S&P 500 slowly went down after October 2007 (first leg of the bear market) because it rallied in a very choppy manner before October 2007 (last leg of the previous bull market).
Here’s how you should trade rallies in the first leg of a bear market:
- Scale-in as the market is going down if the market is crashing right now (e.g. silver in 2011 or the NASDAQ in 2000). The further down the market goes, the more you should scale in. Also remember to set your scale-in price targets far apart. The market is crashing, so you don’t want to scale-in too quickly.
- If the market is crashing right now, you should trade for a big bear market rally. The market will make a big and fierce rally once the initial crash wave is over.
- Use a more short term contrarian trading strategy if the market is swinging downwards in a choppy manner (e.g. the S&P in 2007). Go long when the market falls a little and take your profits when the market rises a little. This is because the market is swinging downwards in a choppy manner, which is most suitable for short term trading.
The first rally in a bear market frequently retraces 50% – 61.8% of the decline wave. So if you’re going long in a bear market, get out when the market approaches its 50% retracement. Here are some examples.
Here’s silver’s first big rally in its post-2011 bear market. Notice how the bear market rally retraced 61.8% of its previous decline.
Here’s the S&P 500’s first big rally in its post-2007 bear market. Notice how the S&P retraced more than 50% of its previous decline wave.
The market tends to make a big retracement in its first bear market rally. This is because not everyone recognizes that a bear market has begun. There’s enough of a “buy the dip” mentality to generate a large bear market rally. That’s why the rally frequently retraces 50% – 61.8%
Going long during the first bear market rally is not a bad idea. The market rarely crashes in a straight line to the bottom of the bear market, which means that there are less-risky profits to be made from trading on the long side.
On the otherhand, you can use the first bear market rally to get out of your long position if you missed the top. For example, let’s assume that you realized the bull market was over AFTER the bull market had already topped. Cut your long position on the 50-61.8% retracement. This will minimize your losses. Do not cut your long position as the market is going down.
The middle of the bear market.
The middle of a bear market is when the market really crashes nonstop without any meaningful bear market rallies. Here’s an example of silver in 2013.
Here’s an example of the S&P 500 in October 2008. Notice how the S&P crashed nonstop from May-October 2008.
The best thing to do during this market stage is NOTHING. Sometimes the middle stage of a bear market will have big rallies, like the S&P 500 did in 2001.
But often the market won’t have big rallies in the middle stage of a bear market, like October 2008 for the S&P 500. It’s impossible to know beforehand which case will play out this time (there will be big rallies vs. there won’t be big rallies). Hence, you have to assume the worst case scenario and completely avoid the possibility of a crash.
You don’t want to go long in anticipation of small bounces. The risk:reward is heavily skewed towards the downside during the middle part of a bear market, so your long position will be annihilated by the downtrend if your timing is wrong.
The end of the bear market.
The final leg of a bear market is when you should go heavily long. The first rally of a new bull market is extremely fierce, so the long term risk:reward is skewed towards the upside. Yes, the market might face some more short term downside risk. But as long as you hold your position long enough, the first bull market rally will earn you massive profits.
See how strong the first post-bear market rally was in 2009. This is the S&P 500.
See how strong the first post-bear market rally was in 2003. This is the S&P 500.
One of the best ways to take advantage of this rally is to use leveraged ETFs. Leveraged ETFs compound like crazy when the underlying market rallies incessantly. Buying and holding leveraged ETFs during the first leg of a new bull market is extremely profitable.
But be careful not to use too much leverage. For example, use a 2x leveraged ETF instead of a 3x leveraged ETF. In the event that your timing is too early, a less leveraged ETF will yield smaller short term losses than a leveraged ETF with higher leverage.
How to determine position sizes when trading bear market rallies
You must scale-in when going long in a bear market in anticipation of bear market rallies. You are trading against the long term trend, which means that your risk is greater than if you were to trade on the side of the long term trend.
A common scale-in strategy is 20-20-20-20-20. This means that you scale in 20% long every time the market falls a significant amount. This means:
- You will earn a small profit if the market makes a medium term bottom after hitting your first BUY price.
- You will lower your average BUY price if the market continues to fall after hitting your first BUY price. This decreases your risk.
You should focus on managing your risk in a bear market. The real money is made by trading on the long side in a bull market.
Also, don’t be too greedy when trading bear market rallies. Close your position when you have a decent profit. Don’t be too stubborn and try to catch the exact top of the bear market rally. Don’t hold a profitable long position for too long because the rally might just end a little sooner than you expected. The longer you wait, the more likely it is for your profits to vanish as the bear market’s downtrend resumes.
Remember, the safest thing to do during a bear market is NOTHING. The high volatility in bear markets can kill both long positions and short positions. So if you do decide to take medium term long trades in anticipation of a bear market rally, do so with extreme caution. Use smaller position sizes, scale in, and don’t be too greedy when your position is profitable.