You don’t want a stock market crash to happen, and neither do I. In fact, a stock market crash is the one thing NO ONE wants to happen.
Yet, these events occur every decade approximately.
It is extremely difficult to predict a stock market crash, but it is not difficult to protect yourself and even make money as markets drop. The key is that you stay prepared and have a plan.
In this article I will teach how you can actually make money on the way down, and why it’s often much quicker than a bull market.
Timing a Stock Market Crash
It is nearly impossible to time when a market will end a great rally and come to an end. The good news is you don’t have to try.
There are many people who have earned their reputation in big crashes, like Michael Burry. He even had a big movie made about him called the Big Short. It was fun, and it made him seem like a hero.
However, what you don’t realize is that for that one accurate prediction, he has been wrong over a dozen times.
So let’s agree that if Mr. Short himself cannot predict crashes with consistency, we aren’t going to be able to either.
The trick is not to predict a crash, it is to be prepared in the event it happens with a plan and to know exactly when to trigger that plan.
What Causes Market Crashes
One of the most misunderstood concepts is what actually causes a crash.
Imagine you are a fund manager and you are long $100BN in stocks. You have spent all your cash on the upcycle and have no more money to purchase stocks.
As the market makes new all-time highs, you decide to start trimming your position and taking profits. This is because you’ll later need money to buy stocks on the way down.
In the early stages of a market crash, what you are seeing is actually profit-taking. This is simply institutions realizing their gains while they have them.
Typically, institutions are buyers of stocks as long as the market drops less than 10%. In stock markets, we call this a “correction”. The price corrects from overvalued, back to value. When it gets back to value institutions again become buyers.
Market corrections and continuations are all part of a good bull market.
This is the typical bull market cycle:
The market crash moment happens when we break away from this bull market cycle. Typically, there is some sort of catalyst in the economy.
The catalyst then forces institutions to not only avoid buying the dip but also to sell more of what they own and buy insurance policies on the way down.
Consequently, buying insurance policies, ultimately, is shorting some assets that will appreciate as the market drops. However, this shorting then causes EVEN MORE selling, and the stock market plunges. When everyone is a seller, and no one wants to buy – stocks get devalued very quickly. These are the conditions that cause a swift and lethal stock market crash.
Imagine that your entire bedroom is full of dynamite. Is it scary? Kind of. But what makes it a REAL problem? A source of ignition. A lighter!
The markets are the same, at any given moment there is a lot of dynamite you can find. Reasons you would think that it cannot continue to go up, yet it does. But without a sudden ignition, there is no real problem of concern.
The trouble is that when an ignition does eventually come, most retail investors are too slow to recognize it and start hoping things come back. Even though deep down, we know we are in trouble.
Ignition Sources of Past Crashes
- 1987 Black Monday Crash – the introduction of computerized trading caused massive and sudden volatility that was self-fulfilling.
- 2000 Tech Bubble – the Fed started to raise interest rates and triggered massive selling.
- 2007/08 Mortgage Crisis Housing Bubble – borrowers began to default on mortgage obligations that securitized big transactions.
- 2020 COVID Pandemic Crash – this one was a black swan event that came out of nowhere, and was not economy-related. Pretty suddenly news of a deadly virus swept the news, and that it had spread to multiple continents.
Every market crash needs ignition. When that happens, it’s time to start taking cover and activating your downside protection plan. I will share mine with you after the next section.
Assets that Increase in Price as Stock Market Crashes
When a stock market is going up, it is cheap to buy an insurance policy in the event of a reversal. As the stock market dips, the cost begins to go up.
Imagine calling your insurance company for a fire protection house policy in the middle of a raging, uncontrollable forest fire in your neighborhood? Never mind paying a higher price, you would be declined. The cost has gone up, because the disaster IS already happening, NOW.
One lesson you need to learn is that insurance and crash protection in the stock market costs the most when the crash is happening. The least when no one is thinking of the crash.
Here is a list of some assets that increase as the stock market is dropping:
- Put options – whether it is on individual stocks or indices.
- Equity futures – they drop in perfect correlation to the market and can be very lucrative because of their leverage.
- Safe haven assets – anything that has historically increased as stocks dropped. Gold and the US dollar have been traditional safe-haven assets in the past. Many wonder if Bitcoin could be the ultimate safe-haven play now? This will be tested in the next stock market crash.
- Defensive / Utility Stock Companies – these are the companies that provide utility services that would be the last you would cancel in a recession. Think heat, electricity, grocery stores – the essentials for survival.
Which assets should you buy in a market crash?
This really depends on what your portfolio assets are. If you are long-growth stock, you would want to get insurance by purchasing puts on the Nasdaq stock index. Nasdaq is very concentrated in growth companies.
If you are exposed mainly to small capitalized companies, you would look for puts on Russell 2000, a small-cap index.
If your portfolio mirrors the entire S&P500 large-cap index, then put options on the SPY index. Or you can opt for a short on the futures contract and not only make back what your stocks are losing – but earn a profit!
The goal of investors in a stock market crash is to protect their portfolios. This is a nest egg they have built up over a decade, and they just want to hedge themselves out. You can still own the stocks, and even buy more when they get cheap later. But in a stock market crash, YOU want PROTECTION! Safety.
On the other side, day traders want to speculate and make money on being short outright.
If you are both an investor and a day trader, you will have a much heavier workflow and stress in a crash scenario. You have a book to work, plus volatility to exploit for profit.
Market Crash Selling Triggers
This topic is the most exciting for day traders. It is also the scariest for investors.
When should you start executing your stock market crash strategy?
I have a set of conditions and criteria that are unique to me. This is my strategy in the event of a crash. The important part is to create YOUR very own. No one’s money management strategy will work for your hard-earned money.
The quickest way to panic and stumble in a high-stress situation like markets dropping is to try to follow something you didn’t create for your unique needs.
With that being said, here are my portfolio triggers for protection:
- Less than 5% drop in stock market: Do nothing… it’ll come back
- More than 5%, less than 10%: Buy more of what’s losing (buy the dip). Ride the move down with aggressive day trading shorts and positions in the above-mentioned assets.
- More than 10% drop: Hedge portfolio by shorting assets and buying insurance. I look to do this when the market rebounds a little bit, so you can buy the insurance cheaper as retail traders get hopeful for a rebound. Still aggressively shorting on a day trade basis.
- More than 20% drop: Full hedge or sell everything in the portfolio and stay in cash. I will need this money to buy stocks cheaper. The average stock market crash is 50%, so you will likely get an opportunity of a decade if you wait patiently. A full hedge means that no further drops will cause losses to my long term portfolio.
Stock Market Crash Conclusion
At the end of the day, no one knows when the next stock market crash will be. However, people like myself who have been in this business over 20 years know, it is definitely coming.
How do we know?
I have experienced three crashes personally in my career. No one expected any of them, which is why they happened so suddenly.
When the next one comes, you don’t need to panic. You need to have a plan, and to make sure you follow it. The next market crash will be a learning opportunity for many new investors who have entered the market since the COVID19 pandemic.
Preparation pays. In the next market, be sure to be ready with a plan. And lastly, make sure you have the plan BEFORE the crash happens. Always plan for a rainy day when it is the sunniest.
I would love to hear from you, what is your market crash plan?
Good luck and good trading and investing.
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The information contained in this post is solely for educational purposes and does not constitute investment advice. The risk of trading in securities markets can be substantial. You should carefully consider if engaging in such activity is suitable for your own financial situation. TRADEPRO AcademyTM is not responsible for any liabilities arising as a result of your market involvement or individual trade activities.