A stock market crash means a sudden, sharp and unanticipated drop in the price of stocks across sectors. An isolated large-scale event or a series of events and processes can cause dramatic panic selling, triggering a stock market crash.
The reasons that trigger a stock market crash can be global or domestic, or both, and can be of political or economic, or both. A dramatic collapse of a long-held speculative bubble can also trigger or contribute to the market crash. In the event of a market crash, the regulatory bodies are required to immediately step in to lessen the impact of the crash and prevent panic selling that can spiral out of control and worsen the crash.
In India, Securities and Exchange Boards of India (SEBI) is authorised to take preventive measures against stock market crash. The regulatory body is also tasked to take initiatives to stablise the market and maintain investor confidence in case the crash happens.
There is no officially mandated, predefined parameter to declare a market crash. However, the term commonly applies to a sudden and significant decline of over 10% in a major stock index over a period of a few days. This distinguishes a crash from a bear market, which is a prolonged period of decline (typically 20% or more over months or years), and a market correction, which is a 10% decline from a recent high.
Reasons for Stock Market Crash
A stock market crash can occur for a variety of reasons which can be of domestic or global nature.
- Domestic causes: A stock market crash can occur due to economic scams, policy changes, or banking disorders.
- Global causes: A market crash can be caused by international events, like economic meltdown in another country, global tariff wars, conflicts of severe nature, and pandemics.
- Bursting of Bubble: A market crash can be caused when the longheld bubble around overhyped stocks bursts.
How to Prevent a Stock Market Crash?
Since the first major market crash happened in the US in 1929, the science of stock market and trading has evolved considerably. Though the mechanisms to prevent a market crash are not foolproof, as the markets continue to crash from time to time, these preventive measures serve as an early warning system and limit the scope of the crash, stopping the market from going into a whirlwind fall.
Some of the key preventive measures against a stock market crash are listed below.
Circuit Breaker or Circuit Filter
It is a percentage-based regulatory mechanism which prevents extreme price fluctuations in the stock market. The circuit breaker or circuit filter automatically and temporarily shuts the trading when an index makes a sharp marathon run, either in bullish or bearish direction, within a short span of time and breach a predesignated percentage increase or decrease. In India, the index-based circuit filter is activated at 10%, 15% and 20% price change within a trading day, leading to trading halts of varying time periods.
Plunge Protection
It refers to the intervention by government, central banks, or financial institutions to stabilise or prevent the market fall. The government intervention can be in the form of major bailouts while financial institutions can intervene by largescale buying of the stocks, which boosts the investor confidence and inspires them to continue investing in the market. A pitfall of the plunge protection, however, is that it can be a temporary relief.
How to Prepare for Stock Market Crash
A trader or an investor should always keep in mind that investing in securities carries an underlying risk of varying intensity, depending on the nature of the securities, the market sentiment, and the possibility of a major disruption like a market crash.
The traders and investors can, however, invest in a way which will protect them even in a worse case eventuality of stock market crash. Here are the tips to follow to prepare for a stock market crash.
Count it a Risk
The stock market crash is a scenario which is difficult to predict with decisiveness, so the best way to prepare for a market crash is to acknowledge it can happen anytime – even tomorrow – and count it as a real risk. One of the strategies to prevent losses from the market crash is to accordingly create a diversified portfolio which can withstand the crash.
Watch for Early Signs
Though a stock market crash happens suddenly and dramatically, the signs and indicators that it might be coming are there for keen observers. So keeping a watch for early signs is crucial in forecasting a market crash, which gives a window of opportunity for the traders and investors to redesign their portfolio to include more low-risk and stable securities that can survive the crash without causing much monetary losses.
Set Stop Loss Limit
The stop loss limit is the loss prevention and profit securing mechanism in which a trader or investor sets a conditional order to buy or sell the securities at the predetermined price. By placing a stop loss limit order, the stocks are automatically sold when the prices fall below the stop price, which protects the trader during the market crash.
Diversified Portfolio
A diversified investment portfolio allows traders and investors to invest in multiple securities from different sectors, market caps, which gives an opportunity to balance the potential for growth and manage the risks. By diversifying your investment with a focus on low risk and high stability securities, you can manage to limit the impact of a market crash on your investment.
Conclusion
A stock market crash is a possibility which can happen anytime. Traders and investors must account for it in their risk assessments and plan their investment portfolios by considering the risk of market crash. There are several strategies which can be implemented to mitigate or limit the impact of the crash on the investment, which includes a diversified portfolio with a focus on low risk and highly stable securities.
FAQs
What is a share market crash?
A share market crash is a sudden and sharp fall in the market within a few days, which is caused by a dramatic domestic or global event, or when the long-term bubble around overhyped stocks bursts.
When was the last time the stock market crashed in India?
The last time the Indian stock market crashed was on March 23, 2020, when breakout of COVID19 pandemic forced a sudden lockdown of the country. The Sensex that day had plummeted by over 13 percent.
What is the main impact of a stock market crash?
The main impact of a stock market crash is that it causes a wealth wipeout as the stock prices fall dramatically and investment value is considerably reduced.
What are the measures to prevent loss during a stock market crash?
Though a stock market crash is sudden and sharp, there are preventive and preemptive measures that can be taken beforehand to prevent losses during the crash. A trader or investor can set a stop loss limit and diversify the portfolio with a focus on less risky stocks.
Can I invest during a stock market crash?
Many long-term investors consider a market crash an opportunity to invest in quality stocks at a lower price, a strategy often called ‘buying the dip.’ However, this strategy carries significant risk and should be approached with caution. The ‘dip’ can easily turn into a ‘falling knife,’ where prices continue to fall much further than anticipated. It is crucial to have a long-term investment horizon, a high risk tolerance, and a robust research-based approach.
