Stock Market Crash Trading Strategy — What Is It?
Stock market crash trading strategy.
Volatility is a normal thing in the stock market — the prices of individual stocks and market indexes fluctuate all the time. But there are times when volatility is to the extreme, giving rise to a market crash.
A stock market crash is a sudden dramatic decline of stock prices and broad market indexes, resulting in a significant loss of paper wealth. There is no specific percentage decline that precisely defines a stock market crash, but it is generally a double-digit decline happening over the course of a few days. Market crashes often follow speculation and economic bubbles and are driven by panic selling and underlying economic factors. We end the article by looking at a specific stock market crash trading strategy.
Let’s take a look at some of the major crashes in the stock market.
What is a stock market crash?
A stock market crash is a rapid and often unanticipated decline of stock prices and broad market indexes, resulting in a significant loss of paper wealth. There is no specific percentage decline that precisely defines a stock market crash, but it is generally a double-digit decline happening over the course of a few days.
A stock market crash often follows a major catastrophic event, economic crisis, or the collapse of a long-term speculative bubble. It is a social phenomenon where external economic events combine with crowd psychology in a positive feedback loop characterized by reactionary public panic about a stock market crash inducing panic selling.
Typically, crashes usually occur under the following conditions:
- a prolonged period of rising stock prices (a bull market) with excessive economic optimism
- a market where price-earnings ratios exceed long-term averages
- extensive use of margin debt and leverage by market participants.
Other factors that can induce a market crash include wars, large corporate hacks, changes in federal laws and regulations, and natural disasters within economically productive areas.
What are the 5 most famous stock market crashes ?
There have been many stock market crashes in the US market, but the most famous ones include the following five:
The COVID-19 Crash in 2020
This is the most recent significant market crash. This was caused by the COVID-19 pandemic, which forced, many governments around the world to initiate a lockdown policy to slow the spread of the virus. The lockdown induced a mass panic, causing an economic shock that rattled investors.
The crash was remarkably very fast, as the market recovered in 33 days after a 34% drop in the S&P 500 index. That historically fast turnaround could be attributed to the U.S. government injecting trillions of dollars into the U.S. economy to support the economy during the pandemic.
Between printing money and stimulus payments, it was the most cash added to circulation since 1945. With so much money in circulation, what followed was an amazing upward run in the market as though the crash never happened.
The Subprime Mortgage Crisis in 2008
Also known as the Great Recession because of its ripple effect on the entire economy, it was the worst crash since the Great Depression. The crash was caused by a bubble in the US housing market brought about by banks’ loose lending practices for mortgages (particularly subprime mortgages).
Some banks declared bankruptcy, affecting the global markets. The S&P 500 fell nearly 57% from its peak and many lost their retirement investments. Recovery took around 17 months. It came from numerous government bailouts, fresh injections of cash into the economy, and interest rates slashed to historically low levels. There were also tougher regulations for financial institutions.
The market took around 17 months to recover, and what followed was one of the longest and most profitable bull runs in history began in 2009 and lasted all the way to 2020 before the COVID-19 pandemic crash happened.
The Dotcom Bubble Burst in 2000
The advent of the internet caused a bubble in tech companies in the 1990s, often referred to as the dotcom bubble, caused by the overvaluation of tech companies or anything that has dotcom in its name. Most of those companies had high valuations that couldn’t match their financial status. Investors were trying to chase the next big thing and were investing in companies that never had revenues.
Tech stocks are mostly listed on the Nasdaq exchange. Between 1995 and 2000, the Nasdaq rose more than 585%. By 2002, the Nasdaq composite index, fell nearly 77%, the first crash of the tech-laden index. It took almost 15 years for the index to reach its former peak again. Meanwhile, the S&P 500 index, (some of the biggest tech stocks are part of its components) fell by 49% during the crash.
The 1973 Oil Crisis and Economic Recession
The crash was caused by a series of events. One of them was the several financial reforms initiated by the Nixon administration, which included de-pegging of the dollar from gold; this undermined the dollar’s stability and contributed to runaway inflation. At the same time, there was an economic recession. Adding to all those was the 1973 oil crisis, in which the price of oil nearly quadrupled and sped up inflation much faster.
What followed all these events was a market crash that saw the S&P 500 decline by 48%. It took the market about 21 months to recover.
The Great Crash of 1929
The Great Crash of 1929 put an end to the roaring bull run of the 1920s and started the Great Depression. The Dow 30 fell by 89% by the time it bottomed in 1932; the market contracted so much that it would take over 25 years for it to fully regain its pre-crash value.
When was the worst and biggest stock market crash?
The worst stock market crash in history was the 1929 Great Crash, which triggered the Great Depression. The crash started in September, but it was on the 28th and 29th of October (dubbed the Black Monday and Black Tuesday) that the worst crash happened — the Dow saw a nearly 13% decrease and another nearly 12% dip, respectively, on those two consecutive days, which are still the biggest two-day loss in history.
With the resulting panic selling from those two days, the Dow lost half of its value (the S&P 500 and Nasdaq were not used as markers at that time) in the following weeks. A long bear market ensured, and by 1932, when the market bottomed, it had lost a staggering 89% of its pre-crash value.
The market wouldn’t recover until 1954. It was a horrible period in history, with the Great Depression, Dust Bowl, World War II, and other distressing international events.
Stock market crash summary
We have compiled 180 years of stock market drawdowns in a separate article, and in the article there is an illustration that lets you see all historical drawdowns and their length :
Stock market crash and drawdowns
If you want to reap the long-term gains from being invested in the stock market, you need to stomach all these drawdowns. Both Charlie Munger and Warren Buffett have repeatedly said that you need to accept a 50% drawdown.
Stock market crash trading strategy
If you are a trader and not a long-term investor (or if you are both), we believe there is no reason to fear a bear market. Quite the opposite! A bear market is (historically) beneficial for traders.
We have in a previous article looked at volatility and performance in bull and bear market. To get a better understanding of a stock market crash, we recommend to read this article:
Because stock market crashes lead to increased volatility, short strategies also tend to work pretty well. Opposite, in a bull market we rarely see short perform well. The best part with a stock market crash is that short selling strategies work! We have compiled a “bundle” with three short strategies in S&P 500:
A specific stock market crash trading strategy
Below is an equity curve of a stock market crash strategy that goes both long and short with opposite signals.
The trading system performance metrics look like this:
The strategy is invested just 4.78% of the time (look at the row called “exposure”), but has returned 5.4% annually. Long trades perform better than short trades, but this is to be expected, even in a bear market.
We don’t want to reveal the strategy because it’s planned as a monthly trading edge for our paying subscribers.
Stock market crash strategy – ending remarks
There is no reason to fear a stock market crash. If you are a long-term investor you get the chance to buy at much lower prices. If you are a short-term trader, you get the chance to make money on both sides – both long and short. However, you need to be prepared before a crash happens.
FAQ:
What conditions usually precede a stock market crash?
Crashes often occur after a prolonged period of rising stock prices, excessive economic optimism, high price-earnings ratios, and the extensive use of margin debt and leverage by market participants.
When was the worst and biggest stock market crash?
The worst stock market crash in history was the Great Crash of 1929, triggered by the Black Monday and Black Tuesday events in October. The Dow saw a nearly 13% decrease and another nearly 12% dip, resulting in an 89% loss of its pre-crash value.
How do long-term investors approach stock market crashes?
Long-term investors view stock market crashes as opportunities to buy at lower prices. Renowned investors like Charlie Munger and Warren Buffett emphasize the acceptance of a 50% drawdown as part of long-term investing.