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How to take advantage of a stock market crash

Stock market crashes usually follow a period of uncertainty, speculation, excessive optimism or an economic bubble. Learn about how to spot characteristics of a stock market crash and how to take advantage of declining share prices when trading. We run through a timeline of major historic stock market crashes that have had an impact on the economy, both nationally and worldwide.

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What is a stock market crash?

A stock market crash is usually defined by a drop of at least 10% on a stock exchange or major stock index within a single trading day. This usually starts within a particular sector or industry but can expand to the wider stock market, depending on the situation.

Stock market crashes are a social phenomenon that can be caused by a number of economic and political factors. ‘Flash crashes’ represent a sudden volatile fall in share prices, which tend to only last for a short period of time and don’t have a lasting impact, whereas some stock market crashes have a much longer-term effect on the financial markets. These days, the creation of electronic trading systems and the popularity of online stock trading allows investors to gain exposure to global assets, meaning that a stock market crash is much more likely to be widespread across the world.

Key characteristics of a stock market crash

  • Drop in share prices, especially within a short timeframe
  • Increase in margin calls for investors
  • Negative market sentiment
  • Decline in major stock indices​, such as the Dow Jones Industrial Average or S&P 500
  • Volatility within other financial markets as a secondary effect

What causes a stock market crash?

There are many factors that can lead to a stock market crash, including the following:

Economic bubbles. When there is excessive optimism in the stock market and a large number of investors are all purchasing the same stocks that they predict to have growth potential, this leads to a sharp increase in share price, which often doesn’t match up to the stock’s intrinsic value. This can lead to a stock market bubble​, which will eventually burst and cause a market crash.

Speculation. Investors purchase stocks with the hope of them becoming more valuable in the future, or short selling stocks to profit from short-term fluctuations. This is often focused on a particular sector or industry. For example, the dot-com bubble focused on speculation of technology stocks, whereas the global financial crisis originated from the real estate sector.

Political uncertainty/tension. The stock market usually thrives when political ties and international relations are strong. Therefore, if there is any threat of political tension, war or terrorism, this can drive stock market prices down.

Excessive leverage. Trading on margin comes with many risks, and one of them is that when the markets drop, investors are forced to short sell their assets, which can bring prices down even further.

Panic selling. Panic can usually be attributed to one or more of the above factors, as a stock market crash is rarely caused by one factor alone. When investors realise that financial institutions in the country could collapse, this increases negative market sentiment​ and sends them into a frenzy of selling off their assets in a hurry.

What happens if the stock market crashes?

Usually, when the stock market crashes, this can halt economic growth throughout the region. This means that the government may choose to reduce spending, companies may not have access to funding for expansion or operations, and investors may run into many losses on their open positions. Banks and other financial institutions also come under pressure to provide a larger amount of loans and debt relief, which can lead to a credit crunch due to a shortage of funds.

Investors often worry that a stock market crash will lead to a recession. However, this usually comes with other economic indicators​ such as declining GDP levels, rising inflation or interest rates and low consumer confidence.

Timeline of historical stock market crashes

Panic of 1907

The Panic of 1907, also known as the ‘Knickerbocker Crisis’ was a financial crisis that took place in the US in mid-October. It started with a group of investors that borrowed money from banks in order to purchase large units of copper-mining business, United Copper Company, in order to manipulate its share price. The stock did increase for a short period of time but then crashed under heavy speculation. This was possibly magnified by unregulated gambling businesses that were selling the shares.

As a result, there were a number of bank runs from financial institutions that had lent money to the investors, leading to the downfall of the Knickerbocker Trust Company, which was the third-largest trust in New York City. Investors started to panic sell stocks and between the years of 1907 and 1908, stock prices declined by almost 50% on the New York Stock Exchange.

The Panic of 1907, though disastrous at the time, eventually led to the creation of the Federal Reserve System, as politicians realised that solutions needed to be made for future occurrences. It also led J.P. Morgan to finance large sums of his money into reviving the US banking system.

Wall Street Crash of 1929

In the US, following WWI was the Roaring Twenties, which was a period of heavy speculation, over-indulgence and excessive optimism for the stock market. Investors believed that asset prices would continue to climb and this led consumers to take on too much debt. In particular, pioneers of various advances in technology such as radio, aviation and electric power experienced a soar in their share prices. The New York Stock Exchange reported an overall rise of almost 300%. However, this led to the Wall Street Crash in October 1929, which is considered the greatest market crash in US history.

Eventually, investors began to doubt the intrinsic value of their holdings and began to sell stocks. On 24 October, over 10m shares were sold on the exchange, leading to a rapid decline in share prices. On 28 October, which is known as ‘Black Tuesday’, investors were forced to liquidate positions due to the large number of margin calls. Across two days of chaos, the Dow Jones fell by 23%, and the market lost approximately 85% of its original value.

The years that followed the stock market crash were known as the ‘Great Depression’, a severe economic depression that spread worldwide throughout the early 1930s, impacting mainly the US and Europe. This marked the origin of the Securities and Exchange Commission (SEC) to oversee the stock market and protect investors from bank failures.

Black Monday, 1987

Although the 1980s were generally seen as a period of optimism for the stock market, Black Monday was one of the worst trading days since the Wall Street crash. A number of factors led to this stock market crash, such as declining oil prices, an overly optimistic speculative bubble, tensions between the US and Iran and rising interest rates. The markets started to decline on 14 October, where the NYSE was plagued with trading halts and delays, and the NASDAQ market system failed, causing liquidity for stocks to dry up.

It came to a climax on 19 October, causing the Dow Jones index to drop more than 20%, which was the single-biggest percentage decline in its history. This sent the stock market into a bearish downtrend, and international markets were also affected, such as London, Hong Kong and Singapore. Black Monday can also be attributed to the rise of electronic programs and automated systems that allowed investors to place larger and faster orders. Once prices started to decline, it was harder for high-frequency traders to exit their positions, meaning that they were driving down stock prices even further.

Luckily, this stock market crash didn’t cause a national or global recession, and the markets rallied soon after. As a result, the SEC implemented circuit breakers to halt trades when a stock exchange declines by a determined amount. The Federal Reserve also slashed interest rates and ensured that credit was available to ensure liquidity of the markets.

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Japanese asset price bubble crash, 1992

Throughout the 1980s in Japan, real estate and stock market prices were massively inflated and had reached new heights. A speculative bubble was created from overheated economic activity, where supply couldn’t keep up with demand. Other factors that caused this bubble were an uncontrolled money supply and credit expansion which many believe was the fault of the Japanese government.

By August 1990, the Nikkei 225 index had dropped to half of its original value. The speculative bubble burst in early 1992, causing Japan’s economy to stagnate, starting a slow recession that remained in place until 2011. Investors refer to this period of time as the ‘Lost Decade’. The decline in asset prices caused a build-up of non-performing assets loans (NPLs), which caused problems for many financial institutions, due to the knowledge that these would unlikely be paid back by the borrower.

Although Japan was greatly affected by the asset price bubble crash, its recession didn’t have a huge impact on the international markets. This could be because US or UK-based investors didn’t have a large amount of Japanese stocks in their portfolios. There wasn’t a large amount of business closures or reported bankruptcies either, in contrast with the previous US-based stock market crashes.

Dot-com bubble burst, 2000

The dot-com bubble refers to the surge in technology companies that were involved in revolutionising the internet. During the late 1990s, companies with the top-level domain ‘.com’ were in high demand by investors, who wanted to capitalise on this new development and trend. In particular, the tech-focused NASDAQ exchange rose five times in value between 1995 and 2000. However, investors soon started to realise that not every technology company could sustain its growth in the future or retain consistent profits. After new monetary policies were introduced by the Federal Reserve, investors started to sell their stocks in March 2000.

Not only small-cap and start-up companies were affected by the Dot-com market crash. Blue-chip stocks such as Cisco, Qualcomm and Oracle lost more than 80% of their original value. Panic selling by investors led popular companies to go out of business completely, such as Pets.com and Webvan, whereas some managed to survive and thrive in the years to come, including e-commerce platform Amazon.

Between March 2000 and October 2002, the NASDAQ index had fallen more than 75% in value, which it only managed to regain 15 years later. In recent years, the technology sector has proven valuable once again, with companies such as Apple and Microsoft having some of the world’s largest market capitalisations.

Global financial crisis, 2007-2009

The global financial crisis, also referred to as the ‘Great Recession’, focused on the real estate markets. In particular, the subprime mortgage crisis originated in the US throughout the mid-2000s as housing prices were reaching extraordinary levels. Investors started to realise that a number of financial institutions and mortgage lenders had issued large loans to homeowners that couldn’t afford to make the repayments. This triggered panic within the stock market and investors started to close out their positions on these financial organisations.

The stock market crash came to a climax in September 2008, after major companies such as Lehman Brothers, Merrill Lynch and American Insurance Group (AIG) filed for bankruptcy. Furthermore, the US Congress rejected a bank bailout bill, causing major US stock indices to fall sharply in price. By the end of 2008, the US was in a recession and the economy had weakened by 0.3%. As a solution, the SEC created a temporary restriction on short-selling financial companies so that the industry could recover.

The Great Recession had a ripple effect on other countries, causing widespread panic and stock markets to collapse across the world. It also impacted other financial markets such as commodity trading, where crude oil prices fell from $100 to $30 per barrel. Many investors placed their capital into safe-haven assets such as gold, the US dollar and the Swiss franc during this period.

Covid-19 stock market crash, 2020

At the start of 2020, news of the novel Coronavirus (COVID-19) started to circulate. After a few months, the virus had spread across the US and Europe, affecting countries such as Italy and the UK. Governments for each country began to announce national lockdowns and investors realised the extent to which the economy would be negatively affected, causing the stock markets to decline. In particular, the travel, retail, leisure and hospitality sectors were shut down for an indefinite period of time, causing share prices to plummet.

The S&P 500, NASDAQ 100, Dow Jones 30 and FTSE 100 all reported record daily declines since the Black Monday crash of 1987. Some countries decided to close their stock exchanges and national banks put in place measures to counteract the effects of the market crash. The CARES Act was a $2.2trn economic stimulus bill passed by the US government that helped to subsidise businesses, create unemployment benefits and fund families in need.

The Covid-19 stock market crisis also coincided with the oil-price war between Russia and Saudi Arabia. As a response to the falling demand for crude oil, OPEC proposed oil-production cuts until the end of 2020, but Russia refused to agree, suggesting that the US could fill the gap. Saudi Arabia then initiated a price war on 8 March 2020, causing a 65% quarterly fall in the price of crude oil, and this price became negative in April. This price war is seen one of the secondary causes and effects of the 2020 stock market crash.

How to take advantage of a stock market crash

In order to take advantage of a stock market crash, you could follow the steps below. Remember that this will not guarantee you success in the financial markets, but it may be a more risk-adverse way of trading.

  1. Practise trading with a demo account. This gives you time to practise trading on volatile assets with virtual funds before committing to the live markets.
  2. Focus on trading on companies that give reliable dividend payouts. See a list of the highest-yielding dividend stocks in the UK that are listed on the FTSE 100.
  3. Open positions on stocks that are known to survive periods of economic downturn. These are known as defensive stocks and can include consumer staples such as pharmaceuticals, groceries, utilities and personal care products.
  4. You could short sell stocks that are underperforming or pose risks in the long-term. However, short selling comes with many risks and is generally used by more experienced traders, so read our risk-management guide before opening short positions where you could potentially lose a large amount of capital.
  5. Open a live account. This will give you access to 11,000+ instruments that we offer on our platform, 9,000 of which belong to the stock market.

How can I protect myself from stock market crashes?

There are many ways in which you can protect yourself and your capital from a future market crash, which are explained as follows:

  • Invest in low-risk assets, such as bonds, certificates of deposit and treasury notes or bills.
  • Rebalance your portfolio after the market has stabilised. For example, you could trade on a mixture of blue-chip stocks, defensive stocks, bonds, high-yielding dividend stocks or exchange-traded funds (ETFs). This helps to spread risk across multiple assets.
  • Invest in safe-haven assets such as gold, the US dollar (USD) or Swiss franc (CHF). Of course, the stability of these assets will depend on other economic factors and the country that the stock market crash originated in.
  • Use hedging strategies to protect your positions against negative events. For example, pairs trading​ is an effective strategy that allows you to open one long position and one short position for two securities by acting as a hedge against each other.
  • Use risk-management controls on your positions. Stop-loss orders​ can help to close out your positions if your chosen buy or sell price levels are crossed, reducing the risk and likelihood of losses.
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Predictions for the next stock market crash

It is very difficult to predict when the next stock market crash will be. In general, the stock markets can be volatile at any point of the day, month or year, and it is only after a longer period of time or a significant drop in the markets (at least 10%) that a collective acknowledgement can be made. It is tough for investors to predict stock market crashes and almost impossible to avoid them, as these have often happened throughout history.

FAQS

Should I buy stocks when the market crashes?

When the market crashes, it could be a good idea to buy shares that thrive during periods of economic uncertainty or a recession. However, some traders will also choose to short their stocks if share prices are declining and they believe that it will cause more loss than gain.

Can you lose money if the stock market crashes?

Investors can lose a large amount of capital when the stock market crashes. However, those that have diversified their portfolio with lower-risk securities such as gilts or ETFs may not notice the effects of the market crash as much as others. It is still wise to consider risk-management tools and orders to counteract potentially harmful effects of a stock market crash.

What goes up when the stock market crashes?

When the stock market crashes, safe-haven assets such as gold or certain currency pairs such as USD, JPY or CHF can increase in value, as more investors tend to capitalise on these assets. Learn more about forex trading and the commodity market.

What is affected by a stock market crash?

A stock market crash can cause a major economic recession, where banks and other financial institutions are most affected, as well as individual investors and businesses. These can all lead to changes in key economic indicators, such as lower GDP and PPP levels, higher interest and inflation rates, and higher unemployment levels. Read about economic indicators.

What are the best investments during a stock market?

Some investments that may provide positive returns during a stock market crash can include safe-havens such as gold and the US dollar. Companies related to consumer staples also tend to rise in value, such as utility, food or pharmaceutical stocks.

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