Investing Insights

BEAR MARKET PROFITS  •  September 30, 2021  •  Jon Wolfenbarger

How To Trade ETFs To Maximize Bear Market Profits

CHARLESTON, SC — We recently discussed our concerns about the next bear market in our Investing Insights article “Here’s Why The Next Stock Bear Market Will Likely Be The Worst Since The Great Depression”.

To prepare to profit from this major bear market when it arrives, we recently detailed how to use the simple technical analysis tool of moving averages of different time frames to identify the beginning and end of bear markets in our Investing Insights article “How To Identify Bear Markets With ETFs And Basic Technical Analysis”.

We also recently detailed how to profit during bear markets with ETFs in our Member Q&A "How can you make money — instead of lose money — in a major bear market with ETFs?”

In this Investing Insights article, we will provide detailed instructions on how to maximize profits during bear markets with some simple trading rules.

While we use a variety of technical analysis indicators to maximize profits in both bull and bear markets, there are two technical tools we find particularly useful for trading bear markets: Percentage Price Oscillator (PPO) and Relative Strength Index (RSI).

PPO is a momentum oscillator that measures the difference between two exponential moving averages (EMAs) as a percentage of the larger moving average, usually the 12 and 26 period EMAs. It is shown with a Signal line, which is usually the 9 period EMA of the PPO.  When the PPO is above the Signal line, it shows bullish near-term price momentum. When the PPO is below the Signal line, it shows bearish near-term price momentum.

RSI is an oscillator ranging from 0 to 100. Values below 30 are considered oversold and are usually a positive near-term signal, values above 70 are considered overbought and are usually a negative near-term signal and values in between are neutral.

PPO and RSI On Daily Charts

The chart below shows the SPDR S&P 500 ETF (SPY) during the early 2000s bear market. On the top main chart, the daily price is the black line, while the 250-day moving average (250-dma) is the blue line. The second clip is the daily PPO and the third clip is the daily RSI.

Generally, when the SPY price is below the 250-dma, it is considered to be in a bear market and profits can be made by buying an inverse (short) ETF such as ProShares Short S&P 500 (SH).

To make even higher profits than simply buying an inverse ETF when the price of the underlying ETF (such as SPY) is below its 250-dma, we recommend the following trading rules when investing in inverse ETFs during a bear market.

Exit the inverse ETF when one or both of the following happens:

1. When the price becomes “oversold”, as shown by the daily RSI falling below 30. Oversold situations almost always lead to strong bear market rallies in a short period of time. We have placed red vertical lines on the chart for those instances. That is the first signal to look to “cover the short” by exiting the inverse ETF.
2. When price momentum turns positive, as shown by the PPO line (black line in second clip) rising above the Signal line (red line in second clip). We note those instances on the chart with a red arrow pointing upward. This is the second signal, which confirms the prior oversold signal, to exit the inverse ETF. Some profits may be sacrificed waiting for this signal, but this signal provides strong evidence that a bear market rally has started.

Buy the inverse ETF when one or both of the following happens:

1. When the price becomes “overbought”, as shown by the daily RSI rising above 50 or 60. RSI rarely, if ever, rises above 70 (the traditional “overbought” level) during a bear market. However, when RSI rises above 50 or 60 in a bear market, that usually signals “overbought” prices.
2. When price momentum turns negative, as shown by the PPO line (black line in second clip) falling below the Signal line (red line in second clip). We have placed green vertical lines on the chart for those instances. Since the overbought signal is a bit less clear in a bear market, negative price momentum is the primary “buy” signal for an inverse ETF in a bear market.

The idea behind these trading rules is to profit from typical investor psychology, which includes: 1) herding, which leads to prices trending in the same direction for a period of time and 2) emotional swings between fear — as investors become too bearish, causing stocks to become “oversold” — and greed — as investors become too bullish, causing stocks to become “overbought”.

The chart below of SPY during the Great Recession shows these simple trading rules also worked very well during that brutal bear market.

PPO and RSI On Weekly Charts

While we focus primarily on daily price charts, weekly price charts are also very helpful in providing additional conviction for trades during a bear market.

The charts below of SPY on a weekly basis during these last two major bear markets show that weekly “oversold” situations (red vertical line) signaled strong bear market rallies to come.

Momentum signals on a weekly chart are more delayed than on a daily chart, so waiting for price momentum to turn positive (red up arrow) before exiting an inverse ETF usually gives up more profits than it does using daily charts, but the weekly charts help provide confirmation of a major rally. The same is true for buy signals of inverse ETFs on negative price momentum (green vertical line). They give up some profits, but help provide additional confirmation of bear market downtrends.

Implications For Investors

Using simple technical analysis tools like moving averages, PPO and RSI can help smart active investors create significant wealth during bear markets, while most other investors are suffering significant losses and stress. Importantly, there are no fundamental, valuation or sentiment indicators that can help you trade bear (or bull) markets with this level of precision.

This is the truth of bear market investing that Wall Street will never tell you about. This truth can make you wealthy and set you free.