How to trade a stock market crash

What is a stock market crash?

A stock market crash is a fast, substantial drop in the prices of large number of shares listed on a stock market, resulting in a drop in price of the overall index. There is no precise definition of the required dip, but it would usually require at least a double-digit percentage drop over a matter of hours or days to be described as a ‘crash’.

It’s different to a ‘correction’ (where prices fall 10% from their 52-week high as investors reassess the value of the underlying market), because a crash generally occurs over a much shorter period of time.

Can we predict the next stock market crash?

Stock market crashes are notoriously difficult to predict, though they often follow a period where bulls have dominated the market for some time, driving prices to unsustainable levels. This bull market is sometimes fuelled by excessive debt and leverage, and usually drives price-earnings (PE) ratios to levels exceeding the long-term average.

While these factors could indicate that a correction is on the cards, what separates a crash is that it is usually driven by panic selling as much as economics. The initial sell-off of stocks creates a negative feedback loop that sustains further sell-offs, going far beyond what would be expected if all the actors in the market were fully rational. This human element is what makes it so difficult to predict when a crash might happen or how long it will last.

Markets to trade in a crash

While they can be difficult to predict, the effects of a crash are likely to ripple across the financial markets. For savvy traders, that means an opportunity to profit from price movements both during and after the crash. Here are some markets you may want to consider:

Stocks and indices

The most obvious markets to trade during a stock market crash are – unsurprisingly – stocks and indices. There are two main strategies:

• Go short before the dip: This involves taking out a short position to profit from the initial dip. However, it can be very difficult to predict when a stock market crash will happen and perhaps even harder to predict how long the downward trend will last, making this a daunting proposition for many traders.
• Go long after the dip: The easier of the two strategies involves waiting until prices have settled or are just beginning to recover, before taking out a long position on some shares or the index as a whole. If going long on individual shares, you should conduct a thorough fundamental analysis to find companies that may recover value quickly – for example, those with strong revenues, profit and loss accounts, and projected growth.

It may be necessary to hold positions for a few days or weeks to get the full benefit of any price movement, so make sure you factor in the additional costs and risks of holding positions overnight.

Forex

While stock market crashes do not always lead to a recession, they have often preceded recessions in the past. For this reason, the government of the country where the crash occurs may look to pre-emptively stimulate its economy by cutting interest rates, which is likely to cause its currency to devalue, relative to those that are more protected from the fallout.

Look to trade the currency’s pairings with ‘safe-haven’ currencies like the dollar (USD), pound (GBP), euro (EUR), or yen (JPY) depending on the origins of the crash. Crashes and recessions can spread globally, so you should be prepared to react quickly as the situation develops.

Bonds

Government bonds are the traditional safe-haven asset, with high-quality bonds like US treasuries considered by many to be a ‘risk free’ because they offer a guaranteed fixed return. For this reason, the price of these bonds is likely to rise as stock markets fall and vice versa. To take advantage of this trend, consider going long on government bonds as the market falls and short as they recover.

Corporate bonds, on the other hand, may follow the reverse pattern – tracking the markets – as they are often considered less safe than their cousins in government. Consider shorting a corporate bond exchange trade fund (ETF), for example, Invesco Fundamental High Yield Corporate Bond Portfolio as the stock market crashes, and going long as it recovers.

Commodities

Another safe haven, gold often rises in value as a result of a stock market crash. And where gold goes, other precious metals – including silver – tend to follow suit. These may prove to be good long trades if you can get in quickly as the markets are crashing.

You may also want to consider going long on shares in companies that mine precious metals (once prices have levelled out) as these could benefit from increased demand in the short term. Prices of commodities used in industry, however, may fall as companies are likely to have less capital to invest in infrastructure and consumer spending is likely to fall.

Volatility

It is possible to trade stock volatility on futures markets like the Volatility Index and EU Volatility Index, which track the volatility implied by S&P 500 (US 500) and EU Stoxx 50 options respectively. If you’re able to go long on these markets as stock prices are crashing, you may benefit from a rise in volatility – provided this rise is sustained until the future’s fixed expiry.

Utilise proper risk management tools

Those looking to speculate on price activity following a stock market crash should tread carefully, as the markets are likely to be very volatile. It is important to assess your risk appetite and set out a plan that includes the risk-reward ratio for your trades and the risk-management strategies you will use. Consider using:

Stops

Stops minimise losses in the event that a market moves against you by a certain amount. IG offers three types of stops:

• Basic stops, which are free but may be closed at a worse price than requested if the market moves quickly, or ‘gaps’
• Guaranteed stops, which incur a fee if triggered but will always close your trade at the specified level
• Trailing stops, which follow positive price movements to lock in profits and minimise losses. Again, these may be closed at a worse price than requested if the market gaps.

You may also want to consider using a limit, which works like a stop but closes your trade if its price moves to a more favourable position. If triggered, limits are always filled at your chosen price or better.

Options

If you are a more advanced trader, you may want to hedge your risk by trading options during a crash. Options can act a bit like an insurance policy as they give the holder the right, but not the obligation, to trade a financial market at a specified price before a set date in the future.

For example, if you were long on gold following a crash but were concerned that the price might drop, you could buy an option to sell gold at a set price. If the gold price drops before the option expires, you could exercise your option and minimise the downside of your losing trade. If the gold price rises, however, you can simply let your option expire. Here, you would only lose the premium you paid for the option, and keep the profit from your original trade.

You may need to act quickly to buy useful options in the event of a crash, as premiums often rise in response to uncertainty. Learn more about options trading.