What Is a Stock Market Crash?
A stock market crash is arapid and often unanticipated drop in stock prices. A stock market crash can be a side effectof a major catastrophic event, economic crisis, or the collapse of a long-term speculative bubble. Reactionary public panic about a stock market crash can also be amajor contributor to it, inducing panic selling that depresses prices even further.
Famous stock market crashes include those during the 1929 Great Depression, Black Monday of 1987, the 2001 dotcom bubble burst, the 2008 financial crisis, and during the 2020 COVID-19 pandemic.
Key Takeaways
- A stock market crash is an abrupt drop in stock prices, which may trigger a prolonged bear market or signal economic trouble ahead.
- Market crashes can be made worse by fear in the market and herd behavior among panicked investors to sell.
- Several measures have been put in place to prevent stock market crashes, including circuit breakers and trading curbs to lessen the effect of a sudden crash.
Understanding Stock Market Crashes
Although there is no specific threshold for stock market crashes, they are generally consideredas abrupt double-digit percentage dropin a stock index over the course of a few days. Stock market crashes often make a significant impact on the economy. Selling shares after a sudden drop in prices and buying too many stocks on margin prior to one are two of the most common ways investors can to lose money when the market crashes.
Well-known U.S. stock market crashes include the market crash of 1929, which resulted from economic decline and panic selling and sparked the Great Depression, and Black Monday (1987), which was also largely caused by investor panic.
Another major crash occurred in 2008 in the housing and real estate market and resulted in what we now refer to as the Great Recession. High-frequency trading was determined to be a cause of the flash crash that occurred in May 2010 and wiped off trillions of dollars from stock prices.
In March 2020, stock markets around the world declined into bear market territory because of the emergence of a pandemic of the COVID-19 coronavirus.
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Preventing a Stock Market Crash
Circuit Breakers
Since the crashes of 1929 and 1987, safeguardshave been put in place to prevent crashes due to panicked stockholders selling their assets. Such safeguards includetrading curbs, or circuit breakers, which prevent any trade activity whatsoever for a certain period of time following a sharp decline in stock prices, in hopes of stabilizing the market and preventing it from falling further.
For example, the New York Stock Exchange (NYSE) has a set of thresholds in place to guard against crashes. They provide for trading halts in all equities and options markets during a severe market decline as measured by a single-day decline in the S&P 500 Index. According to the NYSE:
- A market-wide trading halt can be triggered if the S&P 500 Index declines in price as compared to the prior day’s closing price of that index.
- The triggers have been set by the markets at three circuit breaker thresholds—7% (Level 1), 13% (Level 2), and 20% (Level 3).
- A market decline that triggers a Level 1 or Level 2 circuit breaker after 9:30 a.m. ET and before 3:25 p.m. ET will halt market-wide trading for 15 minutes, while a similar market decline at or after 3:25 p.m. ET will not halt market-wide trading.
- A market decline that triggers a Level 3 circuit breaker, at any time during the trading day, will halt market-wide trading for the remainder of the trading day.
Stock market crashes wipe out equity-investment values and are most harmful to those who rely on investment returns for retirement. Although the collapse of equity prices can occur over a day or a year, crashes are often followed by a recession or depression.
Plunge Protection
Markets can also be stabilized bylarge entitiespurchasingmassive quantities of stocks, essentially setting an example for individual traders and curbing panic selling. In one famous example, the Panic of 1907, a 50%drop in stocks in New York set off a financial panic that threatened to bring down the financial system. J. P. Morgan, the famous financier, and investor, convinced New York bankers to step in and use their personal and institutional capital to shore up markets. However, these methods are not always effective and are unproven.
I'm well-versed in the dynamics of stock markets and their crashes, drawing upon historical occurrences and mechanisms implemented to prevent or mitigate such events. The identification of stock market crashes involves sudden and substantial plunges in stock prices, often within a short timeframe. These crashes are frequently linked to major catastrophic events, economic downturns, or the collapse of speculative bubbles, such as the crashes in 1929, 1987, the dotcom bubble burst of 2001, the 2008 financial crisis, and the 2020 COVID-19 pandemic.
One crucial aspect is the psychological impact on investors, leading to panic selling and exacerbating the market's downward spiral. Herd behavior amplifies these crashes as investors react to collective sentiments rather than rational analysis.
Various historical examples, including the Crash of 1929, Black Monday in 1987, and the 2008 housing market crash, demonstrate the devastating consequences of such events on economies and investor portfolios. Moreover, specific triggers, like high-frequency trading contributing to the 2010 flash crash, highlight the complexities of modern market dynamics.
Efforts to prevent crashes involve measures like circuit breakers, introduced post-1929 and enhanced after the 1987 crash. These include trading halts triggered by significant declines in stock indices. For instance, the NYSE has established thresholds at 7%, 13%, and 20% declines in the S&P 500 Index, mandating trading halts of varying durations to stabilize markets during abrupt downturns.
Additionally, historical interventions like the actions taken during the Panic of 1907, where influential figures like J.P. Morgan orchestrated efforts to stabilize markets by infusing capital, exemplify attempts at 'plunge protection.' However, the efficacy of such methods remains debatable and unproven in all scenarios.
Understanding the implications of market crashes involves recognizing the risks associated with panic-driven selling, the perils of over-leveraging through buying stocks on margin, and the profound impact on retirement savings and economic recessions or depressions that often follow such crashes.
