This article defines a general, simple plan to exploit bear markets for profit.
A simple scheme exists to invest with medium-term holding periods for a net profitable expectancy. This one involves exploiting high volatility off bear markets with respect to liquidity common sense.
Liquidity Logic
For every sell order, initiated by either a retail or institutional trader, someone must stand on the other side to accept the transaction (i.e. provide liquidity). With each bull market, increasing numbers of public investors look to become shareholders of various corporations, pushing prices up along the way, and vice versa for bear markets.
Like most resources on Earth, the number of public buyers remains limited and as initiated buying orders slow down so do the stock prices. Liquidity squeeze then commences as the amount of willing buyers lessens, forcing sellers to settle for lower prices.
Consequentially, bargain hunters arrive and the so-called liquidity cycle begins again. As rationale affirms, higher liquidity allows for price rallies, and lower liquidity periods tend to cause swift price declines.
Volatility
Volatility simply means the rate or speed of market movement. Mentioned above, price drops occur from a shortage of buyers, where shareholders resort to settling at increasingly falling prices for cash. As panic induced influences tend to transpire more often with selling, the average rate of stock price drops remains greater than that of growth.
Naturally, exploiting downside movements offers an adequate statistical edge. If the market has a 50% chance of upside or downside moves, then making purely downside bets would end profitably due to the larger sizes off price dips. Unfortunately no evidence exists to prove the market operating in a random, 50/50 fashion.
Probabilities & Timing
With the last several decades, the American stock markets have experienced corrections following roughly two to six years of consecutive bullish years. This suggests that as public investors take interest and buy up on stocks, it takes an average of four years to exhaust liquidity where a market decline becomes inevitable.
A few conclusions result from the above. Rallying or falling markets function in a collectively exhaustive manner, where bullish periods occur more often than bearish, and one always leads to the other. With this logic, a numerically-based timing of trading entry and exit plans come to form.
General Strategy
With each consecutive bullish year further than four, the next year carries a higher probability of general stock index decline as the very limited liquidity fades. With added volatility in panic selling modes, the investor could survive rallying periods easily and the downside moves result in potentially much greater rewards.
The exit plan could revolve around statistical means (e.g. at the end of the consequential bearish year, when volatility levels reach historical highs, etc.). It could also center at a fundamental path, where company insiders and institutions begin to buy heavily, or economic figures look to make a come back.
Patience
The simple scheme provides a positive expected return, and it requires a lot of patience to pull off. Like anything else good in life, it pays to stay disciplined and persistent.
