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The Overall Market Trend Is Important in Bearish Trading

The Overall Market Trend Is Important in Bearish Trading

“A sinking tide lowers all boats.”

“The trend is your friend.”

“It is easier to swim with the tide than against it.”

All of the above adages are rooted in fact, to some extent. Historically, these sayings have been applied to the financial markets to encourage investors to reduce risk by trading in the direction of the market. By definition, a bear market can be considered a 20% or greater move by the major indices from peak levels. A less aggressive selloff, but often just as painful, a bull market correction can be viewed as a 10% move from major index high levels.

A sinking tide lowers all boats

When it comes to the stock market, the saying “a sinking tide lowers all boats,” is not 100% accurate. Even in the face of a powerful bear market, there will be some stocks that advance in price anyway.

While in the midst of a bear market, traders will seek out stocks that are performing well despite the overall market action. This can create something of a self-fulfilling prophecy as more and more traders focus their buying on a relative handful of stocks that are performing well. As a result, even the most unfavorable action within the overall stock market may not be enough to push the price for these stocks lower.

The trend is your friend

This expression is possibly the oldest, and one of the most useful phrases regarding investing in stocks. A bearish trader often fears selling short at the bottom and then having to endure a price advance resulting in a loss of investment capital.

In reality, it is easier to identify the trend that a particular stock or asset is moving in right now than it is to determine where the price will be heading next. As a result, it can be plausibly argued that in the case of a bearish trader the idea of “selling short low and buying back lower” is more likely to be a successful strategy than one that attempts to “sell short high and buy back low.”   

This line of thinking forms the crux of an investment approach most commonly referred to as “trend following.”  As the name implies, this approach to trading and investing makes no attempt to pick tops or bottoms but instead focuses on simply identifying whether the current trend for a given stock or asset is presently bullish, bearish or neutral. The primary goal of trend following for a bearish trader is simply to ride a bearish trend as long as possible and to miss a significant portion of any bull market advance.

It is easier to swim with the tide than against it

This adage is similar in concept to “The Trend is Your Friend”. This phrase simply acknowledges that it is generally easier to go with the flow than to predict when a turning point is about to take place. While making money by selling short in the face of a rising stock market or by buying during a bear market can be successful, it is a much more difficult task than going with the flow and trading in the direction of the major trend. Fighting against the prevailing current is a more advanced strategy that only a certain small percentage of traders find profitable.

The potential benefits of identifying a bearish trend

While there are unique risks involved in bearish trading, there are also some important potential benefits. A perusal of a long-term bar chart for the vast majority of stocks reveals that even the best performers experience meaningful price declines from time to time. As a result, learning to identify a bearish trend and selling short affords a trader an opportunity that does not exist for a trader who will only buy stocks in an effort to profit from an advance in price. It offers them the potential to take advantage of both bullish and bearish market trends.

Overall bear markets in the major stock market averages are inevitable. During these periods of time the majority of stocks will decline in price. For the average trader who only considers buying stocks and not selling them short, it can be a difficult environment in which to make money to say the least. Being able to take advantage of bear market conditions can be a huge advantage for the trader willing to assume the substantial risk.

Likewise, in any market environment there are always some companies that are struggling and whose stock suffers as a result. A trader who develops the ability to identify a bearish trend could uncover potentially profitable opportunities that the majority of traders cannot.

Identifying a bearish trend

So how does a trader identify a bearish trend?  As with many aspects of trading, there is no one best method to definitively designate a trend as bullish or bearish. There are, however, several useful and simple tools that traders can use in an effort to designate the current trend as bullish, bearish or neutral.

One of the most common trend-following tools used by traders is the moving average. A moving average is a technical analysis tool that simply calculates the average price for a stock or index over a given period of time. A trader can then compare the current price for the stock or index to the moving average. If the price of the stock or index is above the moving average a trader can reasonably designate the trend as bullish. If the price of the stock or index is below the moving average a trader can reasonably designate the trend as bearish.

Many traders will compare a major stock market index such as the Dow Jones Industrials Average, the S&P 500 Index, the Nasdaq 100 index or the Russell 2000 small-cap index to its own 200-day moving average in order to assess the current trend. If the market index in question is presently above its respective 200-day moving average, conventional wisdom suggests the current overall market trend is bullish, and as a result a bearish trader may wish to be very selective in choosing stocks to sell short.

On the other hand, if the market index in question is presently below its respective 200-day moving average, the general thought is that the current market trend is bearish, and a bearish trader may consider being more aggressive in searching for opportunities to sell short individual stocks.

The strength of the overall bullish or bearish market trend can also be measured by considering how many of the major market averages are presently above or below their respective moving averages. For example, if all four of the indexes listed earlier are above their 200-day moving averages, it may be logical to deem the major trend as bullish. If one of the indexes subsequently falls below its moving average, this may serve as an early warning sign. If all of the indexes fall below their respective moving averages, then the trend-following trader would likely designate the trend to be bearish. Logically, it would make sense for a bearish trader to trade the short side of the market more aggressively when the trend is clearly bearish than when the trend is clearly bullish.

Major stock market indexes and their respective 200-day moving averages 

Market Trend

No trend lasts forever

Although we have extolled the potential benefits of simply going with the flow - as opposed to attempting to identify turning points in the market-, it can also be a mistake to assume that the current trend is destined to continue for any meaningful length of time. One mistake that some traders make is to fall in love with a particular trend and to ignore evidence that the trend they prefer is no longer in force.  

Remember that any trend following method – such as a moving average – tells you only what the trend is currently, and there is never any guarantee that the next change in trend isn’t just around the corner.

Summary

The overall market trend is important in bearish trading. It can be an extremely useful piece of information to have some ideas as to whether the current trend of the stock market – or any tradable asset - is presently bullish, bearish or neutral. This piece of information tells a trader if he or she is “going with the flow“, or “fighting the trend and attempting to swim upstream” prior to entering into a bearish trade. It is typically much easier to succeed in the long run doing the former rather than the latter.

Industry Group Action is Important in Bearish Trading
Timeframe Considerations for Bearish Trading
Timeframe Considerations for Bearish Trading

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Short selling is an advanced trading strategy involving potentially unlimited risks, and must be done in a margin account. Margin trading increases your level of market risk. For more information please refer to your account agreement and the Margin Risk Disclosure Statement.

Schwab does not recommend the use of technical analysis as a sole means of investment research.

The information here is for general informational purposes only and should not be considered an individualized recommendation or endorsement of any particular security, chart pattern or investment strategy. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

Past performance is no guarantee of future results.

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