Bear markets can be very appealing to traders. Volatility is very high during bear markets, with the market often moving up and down a few percent in any given day. Short term and swing traders dream of vast profits when they try to catch these fast uptrends and downtrends.
Although it is possible to make vast profits from trading bear markets, the risk is also much higher. Trading on the side of the long term trend is much easier than trading against the long-term trend. That’s why it’s easier to profit from shorting the market’s downtrends than going long the market’s rallies in a bear market.
The safest thing to do is not trade the bear market’s rallies. Profit from the short side and don’t go long until you think the bear market is over. Going long in anticipation of a bear market rally can be very dangerous if your timing is too early. (Here’s the optimal way to trade a bear market).
Nevertheless, many traders still want to make money from “catching the falling knife” and trading the bear market’s rallies. That’s because the market can have fierce 20%+ rallies within a bear market. Here’s an example.
Notice how the S&P 500 made 2 very quick 20%+ bear market rallies in 2008. These rallies lasted just a few days. The thought of 20%+ profits in just a few days makes some traders’ mouths water.
So if you’re one of those traders who just has to trade bear market rallies, here’s how you should do it to protect your risk.
Trade rallies differently depending on what stage of the bear market you’re in
Bear markets tend to have 3 stages: a beginning, middle, and end. The way you go long in anticipation of bear market rallies depends on what market stage you’re in.
The beginning of the bear market.
The first decline in a bear market can happen in 2 ways, depending on what the last leg of the previous bull market was like.
Here’s an example of the first case. This is the Nasdaq in March 2000. Notice how the Nasdaq crashed in the first leg of its bear market because it went parabolic before topping in March 2000.