Profiting in bear and bull markets

Both bear markets and bull markets represent tremendous opportunities to make money, and the key to success is to use strategies and ideas that can generate profits under a variety of conditions. This requires consistency, discipline, focus and the ability to take advantage of fear and greed. This article will help familiarize you with investments that can prosper in up or down markets.

A bear market is defined as a drop of 20% or more in a market average. Generally, bear markets occur during economic recessions or depressions, when pessimism prevails. But amid the rubble lie opportunities to make money for those who know how to use the right tools. Here are some ways to profit in bear markets:

1. Short Positions. Taking a short position, also called short selling, occurs when you borrow shares and sell them in anticipation the stock will fall in the future. If it works as planned and the share price drops, you buy those shares at the lower price to cover the short position and make a profit on the difference. For example, if you short ABC stock at $35 per share and the stock falls to $20, you can buy the shares back at $20 to close out the short position. Your overall profit, therefore, would be $15 per share. (For more, see our Short Selling Tutorial.)

2. Put Options. A put option is the right to sell a stock at a particular strike price until a certain date in the future, called the expiration date. The money you pay for the option is called a premium. A put option increases in value as the underlying stock falls. If the stock moves below the put's strike price, you can either exercise the right to sell the stock at the higher strike price or sell the put option for a profit.

3. Short ETFs. A short exchange traded fund (ETF), also called an inverse ETF, produces returns that are the inverse of a particular index. For example, an ETF that performs inversely to the Nasdaq 100 will drop about 25% if that index rises by 25%. But if the index falls 25%, the ETF will rise proportionally. This inverse relationship makes short/inverse ETFs appropriate for investors who want to profit from a downturn in the markets, or who wish to hedge long positions against such a downturn.

A bull market occurs when security prices rise faster than the overall average rate. Bull markets are accompanied by periods of economic growth and optimism among investors. Here are some appropriate tools for rising stock markets:

1. Long Positions. A long position is simply the purchase of a stock or any other security in anticipation that its price will rise. The overall objective is to buy the stock at a low price and sell it for more than you paid. The difference represents your profit.

2. Calls Options. A call option is the right to buy a stock at a particular price (the strike price) until a specified date (the expiration date). Calls go up in value as the underlying stock's price rises. If the stock price rises past the option's strike price, the option buyer can exercise the right to buy the stock at the lower strike price and then sell it for a higher price on the open market, thus generating a profit. The option buyer can also sell the call option in the open market for a profit, assuming the stock is above the strike price. 

3. Long ETFs. Most ETFs follow a particular market average, such as the Dow Jones Industrial Average (DJIA) or the Standard & Poor's 500 Index (S&P 500) and trade like stocks. Generally, the transaction costs and operating expenses are low, and they require no investment minimum. ETFs seek to replicate the movement of the indexes they follow, less expenses. For example, if the S&P 500 rises 10%, an ETF based on the index will rise by approximately the same amount.

Markets trade in cycles, which means most investors will experience both bull and bear markets. The key to profiting in both market types is to spot when the markets are starting to top out or when they are bottoming. 

One way to do this is by looking at the advance/decline line, which represents the number of advancing issues divided by the number of declining issues over a given period. A number greater than 1 is considered bullish, while a number less than 1 is considered bearish.

A rising line confirms the markets are moving higher. However, a declining line during a period when markets continue to rise could signal a correction. When the line has been declining for several months while the averages continue to move higher, this could be considered a negative correlation, and a major correction or a bear market is likely. An advance/decline line that continues to move down signals the averages will remain weak. However, if the line rises for several months and the averages have moved down, this positive divergence could mean the start of a bull market.

The advance/decline line is just one indicator that can help you determine the trend. For more, see the Basics of Technical Analysis. 

There are many ways to profit in both bear and bull markets. The key to success is using the tools for each market to their full advantage. Short selling, put options, and short or inverse ETFs are a few bear market tools that allow investors to take advantage of market weakness, while long positions in stocks, ETFs and call options are suitable for bull markets. In addition, it is important to use indicators to spot when bull and bear markets are beginning or ending.