Most investors are familiar with the phrase “bear market,” a term typically used to describe a period of time when the major stock market indexes, and the majority of stocks, experience an extended and meaningful decline in price.
If a trader is “bearish” on the outlook for a given security, then he or she will likely choose to either:
- Stand aside with no position
- Sell an existing position in order to lock in a profit or realize a loss
- Look for an opportunity to sell short in order to benefit from a decline in price
- Consider bearish options strategies
The first two choices in the list involve exiting or staying out of bullish positions in order to avoid the risk of loss. The third choice, selling short, involves borrowing stock shares from your broker, selling those shares in the market and then buying back the shares later to replace the borrowed shares. If the shares are bought back at a lower price than for which they were originally sold, the trader earns a profit. The fourth choice may involve (among other strategies) purchasing put options on the underlying equity in the hopes of capitalizing on bearish price action.
Homing in on a potential reason
Before assuming a bearish position in any security, it is important to have an identifiable reason to do so. Simply relying on a whim or a passing notion can be a very risky approach. Because shorting stock involves unlimited risk, a trader should be able to point to some concrete reason the price of a given security is likely to decline. Many look at several different factors for potential reasons.
A trader might identify a security that is already in an established downtrend, expecting that the trend is likely to continue. As a result, the trader will either stand aside or enter a bearish short position and hope to ride the trend as long as it appears to remain in force. Another trader may see a stock that has advanced sharply and decide that the buying has been overdone and expects the stock’s price is due to top out. Other traders may look at chart patterns, or momentum indicators to determine when the time is right to enter a bearish position.
Many traders focus on the performance of the underlying company when considering individual stocks. A trader may hold a bearish opinion of a company that is performing exceedingly poorly in regards to growing its earnings and sales, or is trading above its actual underlying value. In either case, a trader may stand aside with the stock in question, or may examine actual performance data to determine if a short position in the stock is warranted.
When the underlying fundamentals for a given sector (technology, financial, utilities, etc.) change for the worse, it can take a long time for this to be recognized by the majority of investors and for the negative effects to play out. As a result, many traders will pay close attention to the fundamental and technical action of various market sectors and/or industry groups to forecast areas where below average and/or persistent price weakness may likely occur.
One of the biggest mistakes that traders make is to buy or sell something just because it “seems” like the right time to do so. For traders seeking long-term success one litmus test they should consider each time they plan to buy or sell short a security is to spell out exactly what factor or set of factors led them to take action at this time. This action can help a trader become more consistent and decisive when making investment and trading decisions.