Modules for Beginners
Navigating Bear Markets
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Exit and holding strategies for bear markets
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Now that you’ve gotten an idea of how to enter and make money off a bear market, it is equally essential for you to know when and if to get out of the market. And that’s what we’re going to be looking at in this chapter of Smart Money. Here, we’re going to see a few strategies that successful traders and investors use for exiting or holding their positions before the bear market gets a chance to affect them adversely. So, without any further ado, let’s get down to business.
1. The 40% rule
The 40% rule is a very famous exit strategy that’s used in the U.S. This can help you clear out all your positions and prevent them from going into a loss due to the impact of a bear market. According to a research conducted by a stock market website - TradeStops - it was found that whenever 40% or more of the Dow Jones Industrial Average (DJIA) index’s components see a fall in their stock prices, a bear market is likely to come along.
It was also found out that if the index, as a whole, is also in the red zone along with 40% or more of its components, then the likelihood of a bear market making an appearance becomes even higher. Once the 40% rule comes into play, traders or investors liquidate all of their positions and holdings just in time before the bear market swallows all the capital invested. Such a strategy, if executed right, can help reduce losses significantly.
Likewise, for the Indian stock markets, you could also adapt a version of this 40% rule to give you an idea of when a bear market is likely to make an appearance. For instance, if you observe that 40% or more of the constituents of either or both of the Indian broad market indexes - Sensex and Nifty - are in the red zone, it may be construed as a sign of an impending bear market. And once the rule comes into play, you could safely exit the market by selling off your holdings and closing out your positions.
2. The behavior of the major indices
Another great exit strategy that you can follow is by observing the behavior of the major indices, which would be the Sensex and the Nifty, for the Indian stock markets. A good way to measure the behavior of the indices would be to take a look at the various Moving Averages of the indexes. This includes tracking both the simple and the exponential Moving Averages of the indexes over multiple periods of time.
For instance, you could keep an eye on the simple and exponential Moving Averages for 50-day, 100-day, and 200-day periods of both the Sensex and the Nifty. This is simply because they’re commonly considered to be the major Moving Averages. If the major Moving Averages of both the broad market indices are in the red zone, it may be an indication of an impending bear market. And this would be the right time to exit your positions and holdings to stay protected from a bear market.
3. Selling out aka capitulation
While this might sound very obvious, selling out is arguably the most used strategy for bear markets. The other two exit strategies that we saw above hold true for pre-bear market conditions. This one, on the other hand, is put into motion during a bear market. So, if you fail to read the signs beforehand, or if a bear market catches investors unawares, capitulation is generally the natural course of action for most investors.
The capitulation strategy requires you to sell off all of your positions and investments as soon as the bear market is confirmed to have been formed. But be warned, this move would entail taking a hit on your profits or incurring a small loss. And once you’ve cleared out your holdings, you could invest it in other asset classes or stock classes, as we saw in the previous chapter. This would not only prevent your money from staying idle, but would also allow you to enjoy returns, however small they may be.
Alternatively, if you’ve invested your money during a bear market as entailed in the previous chapter, and are looking for strategies to exit, then this one's for you.
Every bear market and bull market undergoes a market correction at some point or the other. A market correction is nothing but a brief period of recovery before the prevailing trend continues. So, in a bear market, there may be a brief, insignificant rally before the prices dip again. It can be construed as a pause in the momentum - kind of like a breather. This is where short-sellers would cover their positions in a bear market, thereby leading to an increase in the stock price. You could use this brief window of market correction to exit from your positions and minimize your losses.
4. The sell and hold strategy
The sell and hold strategy is essentially a slight variation of the capitulation strategy that we saw above. It is basically a two-part strategy that’s executed as follows -
- Firstly, you’re required to sell out all of your investments. And instead of investing it right away like in the capitulation strategy, you hold on to the cash.
- And secondly, when a market correction happens, instead of exiting from your position like in the previous strategy, you buy stocks using the cash that you already hold instead.
Once you’ve executed this strategy, you hold onto these newly invested stocks and ride out the bear market. And when the tide turns in your favor and a bullish reversal happens, you could choose to sell your investments for a handsome profit.
Unlike the first two strategies that we’ve discussed above, which are predictive in nature, the sell and hold is a reactive strategy that requires you to wait until the bear market actually happens before taking any action. According to stock simulations and back testing, this strategy seems to produce reasonable returns and could be a very good way to navigate bear markets.
Well, that’s about it for the exit and holding strategies for bear markets. That said, here’s something that you should know. While these strategies are all known to produce results, it is always a good idea to take them with a pinch of salt. Bear markets can be quite volatile and hostile, and despite executing these strategies precisely, you could still end up with a loss. So, it’s best to have a financial plan that accounts for such instances.
A quick recap
- The 40% rule is a very famous exit strategy that’s used in the U.S. This can help you clear out all your positions and prevent them from going into a loss due to the impact of a bear market.
- According to a research conducted by a stock market website - TradeStops - it was found that whenever 40% or more of the Dow Jones Industrial Average (DJIA) index’s components see a fall in their stock prices, a bear market is likely to come along.
- Another great exit strategy that you can follow is by observing the behavior of the major indices, which would be the Sensex and the Nifty, for the Indian stock markets. A good way to measure the behavior of the indices would be to take a look at the various Moving Averages of the indexes.
- Additionally, selling out is arguably the most used strategy for bear markets.
- The sell and hold strategy, which is essentially a slight variation of the capitulation strategy, is also used as a way to exit bear markets.
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