What Causes a Stock Market Crash?

Stock market crash
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In 1602, the Dutch East India Co. established the Amsterdam Bourse, now recognized as the world's oldest stock exchange. However, it wasn't until 1720 that the first recorded stock market crash occurred. Since then, every investor hoping to time the market has been trying to predict when the next crash will arrive.

Ask a dozen people what causes markets to plummet, and you'll likely get a dozen different responses, many with conspiratorial undertones ranging from government manipulation of central banks to extraterrestrial, mass mind-control experiments.

The real reason markets crash is much less exotic, but understanding the mechanics behind it can help you steer clear of the market at the most dangerous times.

First, let's consider how a normal market operates.

Imagine you own a dress shop that sells frocks in three colors: red, white and blue. When you take your weekly inventory, you find that the red dresses are hot -- you can't keep them in stock -- while the white dresses are selling moderately, and the blue dresses barely at all.

Based on your analysis, you decide to discount the price of the blue dresses to try to get them moving, raise the price of the red dresses to make more profit, and leave the price of the white ones alone. These are the normal dynamics of supply and demand: Items in high demand cost more, items in low demand cost less.

Now, imagine that after a few weeks you notice that none of your dresses are selling, no matter what the color. At first you think it's just a temporary phenomenon so you discount each color slightly, but a week later you still haven't sold any dresses. Now you start to get a bit panicky and cut prices even more.

Then a news story breaks saying that dresses are out of fashion. Suddenly not only are you trying to discount your dresses heavily, but so are your competitors -- even the factories that make dresses. The price of dresses plunges in a free-fall, or crash. This is exactly how a market crash works -- just substitute individual stocks for the different colored dresses.

In a normal market, prices rise and fall based on supply and demand for individual stocks. But when investors as a group start to close their wallets and sellers can't find buyers, prices will drop more generally. This type of action is typical of a pullback in an otherwise healthy market, but when combined with a negative piece of news or data, it can intensify selling.

If those early rounds of selling cause stocks to breach certain technical indicators, %VIRTUAL-article-sponsoredlinks%like the 200-day moving average -- the gauge some large institutions use to define a bull or bear market -- then selling can become widespread and relentless, quickly driving prices down further. And as investors' accounts lose value, those who have bought on margin will often have to liquidate more of their holdings to cover their loses, spurring new waves of selling.

So at the end of the day, crashes happen when there are more sellers in the market than buyers. This imbalance is caused by the perceptions of market participants, and can be based on analysts' estimates, corporate earnings, macro political or economic events, or a thousand other bits of data.

The important thing to remember is that, at some point, it doesn't really matter what the catalyst for the selling is, because as it increases, the mechanics of the markets eventually take over and the trend will continue until it's exhausted. Understanding those mechanics and recognizing them when they begin will help you to step aside in time to avoid the carnage of a market crash.

No man is an island, or even a peninsula, so I encourage your feedback in the comments below. And don't forget to pick up my book, "Trading: The Best of the Best - Top Trading Tips for Our Time" via Amazon.

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