Preparing For The Bear With Low-Priced Trades
One day, there will be a bear market. That is truly the only part of the bear market that we know with certainty. Since traders began making markets, there have price swings in both directions and trends in both directions. It seems unlikely that has changed and that means another bear market is inevitable.
We can’t know when the next bear market will start but we can prepare for it. One reason to prepare for it is simply because the current bull market is old. This is true no matter how we measure a decline.
Declines come in several sizes. A pullback in the stock market is generally defined as a decline of at least 5% and less than 10%. A decline of more than 10% becomes a correction and a decline of more than 20% is defined as a bear market.
The Bull Market Is Extended
On average, according to research analysts at CFRA, the research firm that recently bought the analysis division of S&P, pullbacks are quite common, occurring once a year on average. Corrections generally occur at least once every three years and we experience a bear market, on average, every five years.
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Source: CFRA Research
In the current market, it has been about 13 months since the last 5% pullback. The last 5% pullback ended in June 2016.
The most recent correction ended in January 2016. That was less than two years ago.
But, the most recent bear market ended in March 2009. This is based on the Dow Jones Industrial Average which has not fallen by more than 20% since that time. That means the current bull market is nearly 8.5 years old, 77% longer than the average bull market lasts.
Fundamentals Point to a Pullback
Compounding the concerns related to the age of the current bull market are concerns related to the valuation of the current stock market. The Shiller CAPE ratio is a widely accepted valuation tool when studying the long term. Data is available back to the late 1800s for this metric.
CAPE is the cyclically adjusted price to earnings (P/E) ratio. It measures earnings over the past ten years, the cyclical part of the calculation.
The ratio is adjusted for inflation which satisfies the objection of many bulls that with low interest rates, the market should be at high valuation levels. Interest rates reflect inflation and the CAPE factors that into its calculation.
The history of CAPE is shown below. It is now at the level it reached prior to the stock market crash of 1929. Higher values of the ratio were recorded only during the internet bubble which ended with a devastating market crash beginning in 2000.
Other fundamental indicators show a similar pattern. The broad stock market, by traditional measures, appears to be extremely overvalued.
In general, we expect fundamental ratios to be mean reverting. This means they will fluctuate around an average value (the mean). In bull markets, fundamental ratios fluctuate above the mean and reach an extreme before turning down. In a bear market, the fundamental metric will usually fall significantly below the mean.
In cases like the current one where the measure reaches an extreme far from the mean, the reversal is likely to be severe. In the current environment, that means we should expect a steep decline in the CAPE ratio and, consequently, a steep decline in the major stock market indexes.
Actions to Prepare for a Bear Market
The question for investors seems only to be when the bear market will occur. The age of the current bull market indicates it could begin at any time. The degree of overvaluation present in the current market indicates the bear market could be deep.
Investors could wait for the bear market to begin before they take any action. They could, for example, choose to ignore the risk of a decline until the price of the S&P 500 falls below its 200-day moving average (MA). This MA is a widely followed trend indicator.
Or, investors could begin taking action now. If acting now, the risk of loss needs to be carefully considered.
There are several types of losses to consider when making trades that are expected to benefit from a market reversal. One of the risks is that the trader will be wrong. Right now, that would mean opening a trade to benefit from a market decline and seeing the market move higher.
That could lead to a loss of capital and a loss associated with a missed opportunity. Both losses have a real impact on the amount of wealth an investor ultimately accumulates.
These risks cannot be eliminated. But, there steps a prudent investor can take to minimize the risks.
Since it is possible the stock market can decline, an investor would want to consider bearish strategies. A bearish strategy is one that could profit from a decline. On the hand, a strategy that could profit from an increase in prices is a bullish strategy.
An Imprudent Strategy for a Bear Market
One bearish strategy is to short overvalued stocks. This strategy could succeed even if the market rises since the overvalued stock could decline even in a bull market.
Shorting a stock involves selling it even though you don’t own it. To complete the sale, you borrow the shares from your broker. You will eventually repay that loan by buying the shares at a later date.
If a stock declines in value and can be bought later at a lower price, the short trade delivers a profit. If the stock increases in value, the short trade shows a loss. The risk of a stock going up is a large risk for a trader with a short position.
Other risks include the fact that the broker can demand repayment of the loan at any time. This could force the trade to be closed at a loss or before a significant profit is realized.
There is also a cost to borrow shares, an interest charge paid to the broker, and that charge can vary day to day. Again, it is possible the cost to maintain the loan forces the trader to close the position at a loss or before a significant profit is realized.
A Better Way to Trade the Bear
Instead of shorting a stock, a trader can use several options trading basics strategies to benefit from a decline in prices. The most obvious strategy is to buy a put option. Another strategy is to sell a call. Selling a call is also a risky strategy but risks can be managed by creating a spread.
For example, EQT Corporation (NYSE: EQT) is an oil and gas company that is expected to report earnings per share of $1.01 this year and $1.59 next year. At the current price EQT is trading with a price to earnings ratio of almost 40. It’s an expensive stock.
EQT could decline if the stock market sells off or if oil declines. The company also faces other risks and is an excellent short trade candidate, or in this case we could manage risk with a bear call spread. The risks and rewards of this strategy are summarized below.
Source: The Options Industry Council
To implement this strategy, one call is sold and another call with a higher exercise price and the same expiration date is bought. The loss is limited to the difference between the exercise prices less the premium received to open the position.
For EQT, a call expiring on December 15 with an exercise price of $65 could be sold for about $2.75. A $70 call could be bought for about $1.45. The total income is about $135 since each contract covers 100 shares and the risk is equal to $365.
This trade offers a potential gain of 40% if the market sells off before the end of the year. Given the age of the bull and the overvaluation of fundamentals, this is a high probability trade with relatively small risk.