Editor’s note: This article was first published in September 2014. The author says he has been bearish on the IBEX 35 since Friday over weak Spanish and European recovery data, and the sector picks of property developers, builders and small and mid-sized banks reflect Spain at that time.
Although people without much experience in the markets should treat bearish positions with respect (just as much as bullish ones), the truth is that short selling is not a type of investment reserved for professional investors.
You could start trading short in less than five minutes just by opening an online brokerage account (at most Spanish banks).
Some time ago, by way of motivation, we explained that anyone can make money during a crisis if they know their way around the markets and use some products that are within everyone’s reach.
There is no need to explain to trading enthusiasts what kinds of products they can choose from: CFDs have become their favourite for speculating on the markets.
Personally, though, I prefer options and even warrants for playing a falling market. Buying puts on these investment vehicles is open to everyone, and you also get good leverage.
We can go bearish on anything: individual stocks, an index, commodities and so on. We can also buy puts on exchange-traded funds, although that may be somewhat more complex.
The science of bearish positions
While most traders tend to rely on charts, personally, although I keep the charts in mind to confirm trends, I find the science of the bearish position works best when you look for the right moment to commit capital based on fundamentals and macroeconomics.
*I should say that I have been bearish on the IBEX since Friday. I suppose I turned bearish after coming across, by chance, certain reports and data showing that Europe in general, and Spain in particular, are not on the right track to recovery. But that’s another story.
First, when we suspect a downturn, we should turn to the chart of the global markets. European indices are falling, Wall Street is falling, and the Japanese market is stalling. The mood is in the red. We take a close look at the chart, and you don’t need to be an expert to spot a trend. When the time comes, anyone can tell whether a chart is bullish or bearish.
We can even use the three technical indicators we discussed in a previous article, although in many cases moving averages are enough on their own.
The best way to work out where to go bearish is to use a “funnel analysis”, that is, moving from the general to the particular.
Once our instinct and common sense have spoken, we look for confirmation in the chart. The usual advice is not to get ahead of the move, but to wait until it is already under way. Sometimes, though, anticipating it is possible and workable. It is also more profitable, although it carries more risk.
Even though we are gambling (speculating), with options and warrants on bearish positions you shouldn’t gamble. In other words, since these are “one step forward, two steps back” products, when the move turns against us at times, the point is to close the position as quickly as possible if the entry fails.
We look for the weakest
That means an index, commodity or sector that will be hit hardest by the correction we expect. Within the index we can see which sector is falling the most. In Spain’s current case, for example, and given the news of economic stagnation, anyone betting on individual stocks would bet against property developers, construction companies and small and mid-sized banks.
Within the sectors that are falling the most, or will fall the most, we look for companies that have no profits and, if possible, carry heavy debt. A business model highly exposed to a country in recession is also a gift for a bearish position. With a bit of luck (please note the irony), the company won’t make it, and then we’ll make a great deal of money.
There is always risk
No matter how sure you are that everything is going to collapse, as Keynes is often quoted as saying: “Markets can remain irrational longer than you can remain solvent.” And bearing in mind that we are using leveraged products with an expiry date, as that date approaches the derivative will lose value, and we may find it worth nothing.
That is why, once a bearish position with a derivative is in profit, we should place a stop-loss and never let a gain turn into a loss. Sometimes it isn’t a matter of squeezing out every last bit of profit either. Leave the last euro for someone else to earn, so that we don’t end up like Jim Paul, who went from making 7 million to losing 1 million.
A clearly defined strategy
Just as with a bullish position we need an entry plan and an exit plan, having studied every possibility, the same goes for bearish investing: we have to plan for the two possible scenarios. 1. The stock is doing what I expected, and 2. The stock is not doing what I expected.
We must have considered both scenarios and know in advance at what price we will take profits and at what price we will cut our losses.
Avoid greed when you’re bearish
Take profits as soon as you have reached the profit target you had in mind. Give yourself a margin of error, but try not to widen it too much, because sometimes we are so sure the trend will continue that, before we know it, we discover that in stock market investing nothing is ever as clear as it seems.
Above all, it is better to cut a loss and get back in the next day or two days later than to pile up several days of losses, which sometimes leaves the investor psychologically unwilling to accept the loss and inclined to put their faith in the god of luck and hope.
Further reading
Featured image: Stang_wm, CC BY 2.0, via Wikimedia Commons.
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