The two main market trends are bull and bear markets. A bull market is the most favorable market to trade and the one that most people know how to trade. However, markets also trend down and these markets are called bear markets. What will you do when the markets change and a bear market hits? What level of exposure will you have in the market during this time?

What is a Bear Market

Share prices across the entire market generally fall during a bear market. These markets can be fast and furious and are usually shorter in duration than a bull market, wiping out a lot of profits and turning profitable trades into losses very quickly. It is impossible to predict how low prices will fall – once the panic hits, fear spreads very quickly and drives prices down fast.

Trading a bear market is also known as going ‘short’. This is when you have a bearish view on a share. Basically, you sell a share that you do not own with the goal of buying it back at a lower price in the future. Aim to trade short if you want to profit in a bear market, or sit on the sidelines and wait it out until favourable market conditions re-emerge. A bear market is usually the hardest market to trade because short selling is not a common strategy in Australia. Yet it is a strategy that professional traders undertake to profit during a bear market. You can short sell through derivative instruments (by purchasing put options or put warrants), through shares or CFDs.

What is short selling?

Short selling is similar to buying a share, only the buying and selling order is reversed. Instead of buying a share and then selling it, you actually sell the share first and then buy it back at a later date.

How to short sell shares

To short sell shares you need to use a broker that offers this facility. The broker actually borrows the shares from somebody who owns them (possibly a large institutional investor) and you sell them in the market to open a short trade. For example, let’s say you want to short sell 5000 XYZ shares. You will actually borrow those 5000 XYZ shares and sell them in the market. You sell them with the expectation that the share will fall in price and you will buy it back at a lower price when you exit the trade. The shares will then be given back to their original owner.

In effect, you are actually borrowing shares that you do not own and your broker organises this for you. You usually have to pay a borrowing fee to do this and put up some money for margin. Your profit or loss is the difference between your sell price and your buy price. So if you exit at a lower price than you opened the trade, you will make a profit. If the share increases and you exit at a higher price than you entered, you will incur a loss. In the Australian market you can usually only short sell the top 200 shares.

How to short sell CFDs

With CFDs this is very easy. When you short sell with CFDs you actually place a sell order in the market to open a short trade. Then you set a buy stop order for the same quantity for your stop loss and change this as the share moves your way making lower lows. Then when your stop is hit you actually buy back the same quantity of CFDs and it closes out the trade. And like with short selling shares, your profit or loss is the difference between your sell price and your buy price. So if you exit at a lower price than you opened the trade you will profit. If the share increases and you exit at a higher price you will incur a loss.

Implications of Dividends

Be aware that when you short sell there are dividend implications. You will be required to pay out the dividend (plus possibly franking credits) if the share goes ex-dividend while you have a short position open. This is because the original owner of the share will want to receive their dividend and franking credits. You have only borrowed their shares to short sell and they still have the rights to the dividend and any franking credits. Ensure you are always aware of the upcoming dividends for shares when you are short selling. If a share is due to pay a dividend in the next few days, you may consider holding back on the trade and short sell it after this occurs.

There is, however, one benefit when a share does go ex-dividend – if the share is in a downtrend (which it should be if you are planning on short selling it), it can drive more momentum into the fall and cause it to fall further. So, how will you handle a bear market?

You have two choices and simply hanging on in hope is not one of these – well, not for me anyway! You can:

* Act on stop losses for long trades and keep out of the market until conditions become favorable again. This is a strategy that long-term investors are most likely to use.
* Act on stop losses for long trades and start short selling – professional traders use this strategy because their goal is to be profitable in all kinds of markets. Prepare yourself for a bear market and pre-plan how you will handle it.

Justine Pollard is the best selling author of Smart Trading Plans. She is a successful private Australian stock market and CFD trader, experienced trading educator and sought after trading mentor. Justine specializes in supporting traders to become peak performers in the market.