What Causes the Stock Market to Crash? A Look at Black Monday

black mondayAre you expecting logic when it comes to the stock market? Well don’t. Your sanity and your pocketbook depend on it.

What causes the stock market to do anything hinges on three things – fear, greed, and manipulation. The stock market is a zero sum gain, one person buys a stock for a dollar while another sells it for the same. The consistent winner in this game of ups and downs is the house…your broker. Sure you made some money if you sell it for more than you purchased it. This is what we’re all shooting for. But on the other end someone is usually selling at a loss.

What you really want to know is, what causes the stock market to crash? Or better yet, how can you avoid a stock market crash?

Black Monday

It was Monday, October 19, 1987, stock markets in Hong Kong, Europe, and the United States were falling like bricks. In the United States it was called ‘Black Monday’. The Dow Jones Industrial Average, by the close of business had dropped 508 points, which on a percentage basis was 22.60 percent. As October came to a close markets in Hong Kong and Australia had dropped more than 41 percent from their highs. A stock market is crash is defined as “a one day drop in the market of 20 percent or more.” October, 19, 1987 definitely fits the profile.

What Triggered the Crash?

Computers were in play in 1987 and something called program trading was part of the problem. Program trading is where large brokerage houses use computer programs to automate buy and sell signals. When a particular stock hits a specified price, the program will automatically buy that stock. The same is true if a stock falls in price, the program will automatically sell the stock. On October, 19, 1987, automated sell programs worked overtime, and this was one part of the puzzle that contributed to the crash.

Margin calls are another thing that play a role in selling momentum. Margin is another word for borrowing money from the house to buy stocks. You have $1000 in your broker account and the house loans you another $2000, this allows you to purchase $3000 worth of stock. When the stock market falls precipitately, the client has to come up with cash to cover the loan or the brokerage house will force sell stocks owned by the client. In a rapid, market decline, margin calls are quickly executed by the broker and contribute to the plunging market.

Emotions get the best of us.

Market Psychology(fear) is generally the final piece of the puzzle. The final phase of a stock market crash is the bottoming out process. People that don’t understand the market, or just can’t take the mental anguish of losing, give up and sell at the most inopportune time. In some cases they are forced to sell due to personal circumstances, but in most cases the client is just mentally wore out.

‘Cooling Down Period’

Since the crash of 1987, stock markets around the world have implemented many new changes to their program trading rules. In the U.S. stock market, when the market drops a certain percentage the market will close for a cooling down period. This stop gap was put in place to prevent what happened in 1987 from happening again. It also gives time for traders and investors to take a deep breath and refrain from panic selling. These measures have been successful in preventing most unwarranted market crashes, and kept some sanity in global stock markets where computers still run the world.

Featured image by http://dribbble.com/Pal_Tsin

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