Here’s a known fact – The stock market crashes from time to time. When and why would it happen? No one knows. In the aspect of the economy and financial markets, we can only predict the future by looking at the past.
The right question to ask would be – how often does the stock market crash? Well, the data shows that every eight years on average (more or less), stock markets around the world are facing one major crash, not including minor corrections and downtrends in between.
While long-term investors fear the unknown – for short-term traders, a stock market is, in fact, an opportunity. There’s high volatility and some assets are supposedly desirable during a market crash. But regardless of the type of trader you are, you need to keep in mind some crucial factors about a stock market crash – how to predict and identify a crash in the stock market, what assets to buy and trade, and what to do during and at the end of the crash.
How to Predict or Identify a Stock Market Crash?
Predicting a crash in the stock market is not an easy thing, and usually, there must be a trigger to change the market sentiment that causes fear in the markets.
If you’ve watched the ‘Big Short’ movie, then you probably remember the character of Christiane Bale, Michael Burry who was one of the first people in the industry to predict the economic crisis in 2008. Burry was betting against mortgage securities before the financial crisis had begun and had to wait for several months until his prediction became true. Luckily for Burry, it worked. But for retail traders, trying to predict the exact timing of a crash in the markets could end up in losing money. Forget about Black Monday, Black Tuesday, and the horrible ‘late October‘ – usually, it doesn’t work this way. Predicting the exact day or week when stocks experience a sharp decline is almost an impossible thing to do.
But while predicting a stock market crash would be an extremely difficult thing to do, you might be able to identify the beginning of the crash. Typically, there are two warning signs that a crash in the stock markets is coming – panic selling, and a big drop in share prices. In some cases, stock exchanges may announce a trading halt, which is a temporary suspension of trading on an exchange for a particular day. These circuit breakers, also known as trading curbs or trading halts, are measures taken by regulators to stop panic-selling on stock exchanges, and typically indicate the beginning of a bear market.
Another useful tool to follow is the VIX index, which is the CBOE volatility index and measures the expectations for volatility in the US stock exchange over the upcoming 30 days. When VIX rises, it’s a strong indicator that the markets are about to get volatile and the uncertainty in the markets rises. Evidently, this is what happened in the 2008 crash and in the Covid-19 pandemic mini-crash in 2020 (as you can see in the chart below).
Another important asset class to follow and check in order to be able to identify a drop in stock prices is Bond yields/prices. Generally, the fixed income market and the stock market are in a sort of competition. Thus, lower bond yields lead to higher stock prices, and vice versa.
Therefore, because bond yields are normally the first financial instruments to react to any macroeconomic developments, every trader must add bond yields to its watchlist and follow these assets on a daily basis. Additionally, when there’s uncertainty in the market (like the current situation), it is important to be alert to any meetings by the Federal Reserve Bank and other leading Central Banks around the globe.
What to Trade If the Stock Market Crashes?
The financial system is based on trust, more than anything else. When the stock markets crash, the global economic system is in an unsustainable situation, which raises lots of questions and doubts from ordinary people. Consequently, people are looking for ‘safe-haven assets, or in other words, the most needed and rare assets on our planet.
So, with that in mind, here are some financial assets that are expected to face high volatility and rise in times of a stock market decline.
- The US Dollar – The USD is still the most dominant currency in the world and is known as the most stable currency in times of economic downturn.
- Precious Metals – Precious metals are considered to be the most valuable assets in nature and therefore, the demand for these assets increases in case there’s a crisis in equity markets. Some of these assets include Gold, Silver, Copper, Aluminium, Platinum, etc.
- Grains – Even though grains’ prices are expected to slightly drop at times of crisis due to a decrease in demand, they are still some of the safest assets to buy and hold during a recession. These assets include Wheat, Corn, Soybean, Rice, Rapeseed, etc.
- Bitcoin – Yes, this strange cryptocurrency which many people still don’t understand the logic behind it somehow has become a safe haven asset. You may like it or not, but it seems that Bitcoin is now a protection asset against inflation, uncertainty, and stock market crash.
But making profits in times of a stock market crash is not only by finding good assets to buy. Instead, you can also bet against the stock market and the economic growth in general (much like Muchael Burry). By choosing the right brokerage firm you can short sell assets, meaning you borrow the asset from your broker and send it back at a later date. This way, you can also make profits in the markets by betting that prices will decrease in value.
If this is the case, you can short sell stock indices like S&P 500, DAX30, Nasdaq100, Dow Jones Industrial Average 30, and Nikkei225. What’s more, you can short sell individual shares via a traditional brokerage firm or via CFDs. You should be aware that there are pros and cons to each way of short-selling assets, which we outlined in detail in this guide. (we’ll make another guide on this topic).
How to Trade a Stock Market Crash?
Frankly, there’s no decisive answer to this question. There are plenty of asset options out there to trade during a stock market crash. You can buy put options on indices, short indices via CFDs, buy the US dollar, and invest in valuable commodities. The trick is not what to buy but when, and how to do that?
In essence, a market crash is a short-term phenomenon that happens quickly. And during a market crash, almost any asset out there in the markets moves in a certain direction. This means that there’s high volatility and high risk, but also lots of opportunities. Personally, I’ve heard many stories of traders that made nice profits at times of falling markets, including…. Osama Bin Laden who allegedly shorted the market before the 9/11 attack.
But that’s not a good example, right? For the average trader, the best thing to do is to focus on 1-3 assets, understand the implication of a stock market on the particular asset, and trade every day as a routine. The good thing in times of high volatility is that you can bounce back from a losing trading day in the next trading day, finding new trading opportunities and catching another trend.
Bear in mind, however, that there are no specific rules of how to trade correctly during a stock market crash. Having said that, in my opinion, it’s better to focus on a trend trading strategy rather than a range trading strategy. Further, it’s also a good idea to occasionally ‘leave the charts’ and search for relevant market news and fundamental analysis. In times of uncertainty, these are the main factors that impact the markets – economic events, statements from politicians, financial leaders, central bankers, and of course, Elon Musk.
What to Do When A Stock Market Crash Ends?
Ironically, stock market indices are designed to rise in value over the long term. After all, the S&P 500, for example, represents the largest 500 US corporations at any given time. So, if a company is no longer successful, it will be removed from the index and replaced by another profitable company.
A lot of investors, therefore, see a market crash as great timing to buy stocks and indices. Last year, for example, stock markets saw a record crash in March when the Coronavirus pandemic emerged followed by a record rebound in the following months. The surprising recovery has expanded the disparity between markets and the real economy, which by many opinions, is the main catalyst for the ‘upcoming’ market collapse.
Since the fear of a stock market crash grows lately, it would be a smart idea to know what to do during a market crash, but far more importantly, what to do when the stock market crash ends. If you are a long-term investor, then the end of a stock market crash is clearly the best time to buy stocks, as well as stock indices.
If you already have a portfolio of stocks, retirement funds, etc – then you need to decide whether you stay in markets during the crash or take all your money out and reinvest your funds when the stock market crash ends. From my experience, this depends on two factors – the type of investor you are and the complexity of your portfolio. If you are not an active investor and you have a diversified and well-managed portfolio, the best thing to do is to… do nothing. After all, the stock markets rebound quite quickly over the last two decades with the help of central banks and the policy of quantitative easing.
On the other hand, if you have the ability to close all your positions, then it would be best to close all your positions, sit on the fence, and get into the markets again at a later date. There’s no reason to see your portfolio reduced by 40%-50% in a short period of time.
Right now, there are mixed opinions about whether the markets are close to another major crash or there’s more room for stocks to rise, or at least stay in the same levels for the next year or two. In my view, where there’s smoke, there might be fire – so, every trader or investor should be ready for a significant drop in stock prices in the near future. After the unprecedented recovery in stock markets over the last year and a half, the markets are expected to at least correct, if not more than that. A quick look at the S&P 500 all-time chart shows us a remarkable uptrend without any major correction in between since the Covid-19 recovery has started.
Looking ahead, there are lots of speculations that the stock market is heading for a crash. According to a survey by Allianz Life, 54% of Americans believe that stock prices can no longer rise, largely due to concerns over the Covid-19 pandemic, the rising inflation in the US and globally, and the expectation for an increase in interest rates. One analyst that joins this prediction is Robert Kiyosaki, the author of Rich Dad Poor Dad, who recently said we are heading for the ‘biggest crash in world history’.
Still, over the last decade and especially over the last year, there’s a gap between predictions and reality. The markets can consolidate before making the next big move, and the next crash could eventually happen in 2022 or…
One thing is certain – a stock market crash is expected to come at some point in time. And, unlike long-term investors, for traders, a stock market crash is an opportunity and is an exciting period to trade. Do it, get in, and trade. Even if you lose money when trading during a crisis, it’s a lesson you must learn very well. Perhaps you’ll be ready for the next time the stock market will crash…