How To Play The Market Bottom Without Landing On Yours

How To Play The Market Bottom Without Landing On Yours
Stéphane Renevier, CFA

about 2 years ago5 mins

  • If you’re looking to play the bottom, you can gradually buy in as prices fall, but you’ll want to make sure you don’t want to buy too little, too late.

  • You can use momentum to time your entry, just be aware of its susceptibility to “fake rallies”.

  • Or, if you’re a more experienced investor, you could use options to limit your downside in case you’re wrong.

If you’re looking to play the bottom, you can gradually buy in as prices fall, but you’ll want to make sure you don’t want to buy too little, too late.

You can use momentum to time your entry, just be aware of its susceptibility to “fake rallies”.

Or, if you’re a more experienced investor, you could use options to limit your downside in case you’re wrong.

You might’ve had a bumpy landing a couple of weeks ago, when stocks slipped up and left behind a lot of sore portfolios. But let’s face it: it’s hard to know when prices have reached their lowest point, and even more difficult to know how to play the situation for a profit. So that’s what I have for you today: three strategies that’ll help you play the market bottom, even if you don’t know when exactly it’ll arrive.

Strategy 1: Enter the market gradually

By gradually adding to your position as prices fall, you’ll lower your average entry price and maximize your long-term returns as a result.

There are different ways you could buy in as prices fall. Let’s say you want to make a total investment of $500. If you think the market’s close to bottoming, you could buy $300 now, $100 when it hits a predefined lower level, and then another $100 further down. If you think the drawdown might have further to run, you could start with $100 and gradually buy $150 and $250 each time prices reach a lower level. If you don’t have a strong view, you could buy $100 in the first instance, and then an equal amount at the four lower price levels.

Of course, the process of building gradually bigger positions as prices fall will minimize your average entry price, but it also makes it more likely you won’t be fully invested if a rally materializes. The decision about how you implement this strategy, then, depends on how you feel about this trade-off.

What are the pros and cons?

This approach is straightforward and mechanical, and each level can easily be defined in advance with “limit buy orders” – an order to buy an asset at a specific price or better. It’ll also not only force you to develop a game plan, but to respect it by reducing the impact of your emotions. Plus, if prices do fall further before recovering, you’ll have entered at a much more attractive average price, which could increase your long-term returns quite significantly (the power of the compounding is quite magical over a long horizon).

The main drawback is that you have to select at what price you’ll buy and how much. And it’s a fine balance: invest too little too late and you might give up too much of the upside if prices recover sooner than expected, but invest too much too early and you’ll remain exposed if prices fall a lot further.

Strategy 2: Follow price momentum

I demonstrated in a previous Insight the power of using price momentum as an exit signal. But it also works well as an entry (or re-entry) signal.

With this “enhanced momentum” indicator, you’d look at whether a market’s current price is currently higher than its price four months ago, eight months ago, and 12 months ago. If the answer is yes more than once, the price is said to show positive momentum and you should buy the market. If the answer is no, you should either stay away from it, or go short.

Of course, you can play with different time periods by reducing or by adding more of them, by extending or reducing them (the shorter the period, the more reactive the indicator to smaller rebounds), or even by, say, buying as soon as the current price outstrips its historic price in just one of the periods.

What are the pros and cons?

Just like with the first strategy, this one will improve the chances you’ll make the right – but difficult – decisions. You never really know how low markets could go, and relying on an indicator to tell you when to go back in means you’re much more likely to remain out of the market for the majority of the fall – particularly if it’s a significant one.

The main drawback is that this indicator is particularly exposed to fake rallies: when prices rise and trigger a buy signal, before reversing and falling again. Momentum’s also a lagging indicator, which means it’ll always give you a buy signal after prices have started to recover and you’ll never precisely invest at the bottom.

Strategy 3: Buy options

The easiest way of profiting from a potential rebound is to buy call options. If prices recover, you stand to make a big profit. And if prices fall, your loss is limited to the premium you pay for the option itself.

Of course, that premium rises in line with volatility, which is likely to be at its highest if you’re buying the option when prices are falling. So even if you’re right and prices recover, the high option premium will offset some of your gains.

Fortunately, there are ways to limit your exposure to volatility and reduce the premium you pay for the option. The first is to implement a bull call spread, which involves buying one call option and selling another at a higher “strike price” – the price at which you have the right to sell. The only trouble with this is that while it reduces your cost, it reduces your upside too: the call you sold will limit your gains if prices rise above your higher strike price.

If you want a more aggressive exposure to a rebound, the 1x2 call ratio back spread is a really interesting option. It offers a way to benefit from a sharp rebound at zero cost: if prices fall, you don’t lose anything, and if prices rise strongly, you stand to benefit strongly. The catch is that you can lose some money – albeit a limited amount – if prices only rise by a small percentage. That means this trade is suitable only if you think prices will fall a lot further, or rebound strongly.

What are the pros and cons?

The main advantage of the options strategies we’ve covered is that you get an asymmetric profile: you’ll get full exposure to the upside while limiting your losses in case you’re wrong. The main disadvantage is that you are paying for that optionality one way or another: through a higher premium in the case of the call option, through a capped upside for the bull spread, or through a loss if prices rise slightly in the case of the 1x2 call ratio back spread. They’re also not so easy to implement and manage, making them only appropriate for more experienced investors.

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Disclaimer: These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment advisor.

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