Turning a Profit in a Bear Market

Bear markets can be disheartening but they can also be very profitable. There are four ways you can make a lot of money off of bear markets:

1) Short term plays on over-panics. You'll notice that small issues in unpopular sectors tend to have incredible volatility. This means that, generally speaking, there's a lot of movement and options are priced highly. As a result you can either buy stock directly or buy call options at extremely depressed prices and turn a profit in a day or two when the market realizes its error. See my E*trade transaction from November for an example. This tends to be purely technical so your mileage may vary. (A nice example of this today is CFC, which dropped 17% on an unsubstantiated rumor that the company will file for bankruptcy this week.)

2) You can short securities. I wouldn't do this on single issues because on a day to day basis its tough to time properly and almost all the action happens pre-market or post-market. As a result you're day trading and when some surpise information comes out you'll wind up getting caught on the wrong side of the trade and eroding all your profits in trading costs. Rather, I'd consider trading QID (Powershares UltraShort ETF). Its a leveraged ETF that amplifies the inverse of the market. In other words, if the market goes down 1%, QID goes up 2%.

3) Instead of shorting securities you can buy long term put options. A put option contract is a contract to allow someone to sell a given security to someone at a pre-determined price by a given date in the future if it is profitable for them to do so. As an example right now you can buy BIDU Jan 2009 $350 put contracts for about $86. That'd be $8600 per contract plus brokerage fees. If BIDU were to drop 10% the option contract might go up by over 30%, since now it'd be profitable to use right away. Options unlike stocks themselves however can become worthless, which means the risk can be total. (As a sidenote its worth noting here that the options market has Baidu priced at $110 in January 2010, which says a lot about smart money's view of Baidu in the long term.)

4) High yield securities. This is my personal favorite since they are relatively easy to find. I'm currently scooping up various bond funds and most of all, a small diversified selection of REIT's (real estate investment trusts). Some REIT's right now are paying out yields of over 20% thanks to their stock depreciation overshooting their earnings. The way an REIT works is that pay out at least 90% of their profits as dividends; its like a mutual fund that allows you to get into the real estate market as a landlord or loan originator. As a result, their dividend is entirely based on their earnings. In essence, a yield of 20% would indicate the market believes their earnings will be impaired by roughly 40-60%. If you choose a commercial oriented REIT do you really believe the earnings will face 40-60% impairment?