5 Tips for Trading During a Bear Market
Market volatility is inevitable but impossible to predict. That’s why it can make sense to protect your downside even in the best of times so you aren’t caught flat-footed when markets move against you.
Here are five ways you can help manage risk in your trading portfolio—in good times and bad.
Do: Right-size your trading portfolio
Unlike your long-term investment portfolio, your trading portfolio likely consists of a relatively small number of stocks—which can expose you to greater volatility when the broader market turns south. That’s why I suggest limiting the size of your trading portfolio to no more than 20% of your total investable assets. If it’s more than that, you may want to take steps now to shrink it.
Do: Keep trades small
Just as limiting the size of your trading portfolio can help manage risk, so can limiting the size of individual trades. The concept of “value at risk”—the amount of your total investable assets you’re willing to risk on a single trade—is important here, and I generally try to limit mine to 2%. For example, if your total portfolio is worth $500,000, it may be unwise to risk more than $10,000 on a single trade. During a bear market, that number should probably be lower, since it’s even likelier that a trade may move against you.
Do: Consider ETFs
Exchange-traded funds (ETFs) can be bought and sold throughout the trading day, and some are traded just as heavily as individual stocks. But because ETFs track a basket of securities, they tend to be less volatile than individual equities. ETFs are still subject to losses, of course, but it’s almost inconceivable that all the stocks an ETF tracks would fall to zero. Individual stocks, on the other hand, can and do, albeit relatively rarely.
That said, beware inverse and leveraged ETFs. Inverse ETFs are designed to return the exact opposite performance of whatever index or benchmark they are meant to track, while leveraged ETFs use debt and/or derivatives to generate double or triple the daily performance of a certain index or asset class. Such funds are incredibly speculative and can quickly incur significant losses should the market move against them. Schwab clients can log in to screen for trade candidates.
Do: Actively manage risk
With any trade, it’s wise to employ some downside protection tools—such as stop orders—to help reduce the likelihood that your positions will fall below your intended exit points. Of course, stop orders get you only so far, and the three main types each have their benefits and limitations:
- Standard stop orders: When one of your positions reaches the sell-stop price you’ve set, it triggers a market order to sell your position at the next available price. During a typical trading day, your stock would be sold at a price close to the market price at the time the stop order was triggered. But when a stock is falling rapidly, your execution price could be significantly lower than your stop price—and if you leave a stop order open beyond the trading day, it won’t provide any protection at all. Stop orders execute only during regular trading hours, so if a stock gaps down at the next day’s open, you could face a much larger loss than expected. Therefore, you may want to close out or reduce the size of positions you feel are at greater risk of gapping down.
- Stop-limit orders: Unlike standard stop orders, stop-limit orders allow you to set both a stop price and a limit price—or the price below which you don’t want the trade to execute. So, if a declining stock reaches your stop price, it will be sold, as long as it can fetch your limit price. However, if the next available price after the stop is below your limit, your order won’t be executed unless it bounces back to your limit within the trading day.
- Trailing-stop orders: With a trailing-stop order, the stop price trails the bid price of the stock as it moves higher. The stop price essentially self-adjusts and remains below the market price by the number of points or the percentage that you specify, as long as the stock is moving higher. Once the stock begins to move lower, the stop price freezes at its highest level less the amount specified. But just like standard stop orders, you aren’t protected from an overnight gap down.
Don’t: Jump the gun
When the market drops, it can be tempting to immediately start bargain shopping. But bargains can become the opposite if the downtrend continues. When there’s a big dip in the market, I generally recommend waiting for two consecutive positive days before opening a new position—and even then I suggest starting small.
When in doubt, wait it out
Bear markets don’t last forever. Indeed, since 1946 the S&P 500® Index has experienced 11 bear markets lasting an average of just 16 months1—while the 12 bull markets during the same period lasted an average of more than five years.
So, if your emotions get the better of you, simply waiting out the dip may be the best option of all. In such instances, consider closing out or reducing the size of some of your positions and maintaining a higher level of cash than normal within your trading portfolio, until volatility levels off.
In the end, trading is supposed to be enjoyable. If you can stomach the ride, these tactics can help you hone your approach in any down market—and perhaps even limit your losses.
1Schwab Center for Financial Research and FactSet. Historical data as of 04/24/2017, with updates through 01/17/2020.