How Does a Stock Market Crash Occur?

by Elliott Taylor

    A stock market "crashes" when there is a sharp, sudden drop in prices throughout an entire stock index such as the Dow Jones Industrial Average or the Standard & Poore 500. Markets are generally thought to have crashed when prices drop by 10 percent or more in a given day. While many factors may lead up to or set off a market crash, the crash itself is created by widespread panic, which prompts massive selling activity among investors.

    Sequence of Events

    Generally, a crash is precipitated by an event or news item that incites panic in an already shaky market. Investors who believe the market is about to go down begin to sell their shares of stock in an effort to avoid losing money. Other investors, seeing prices begin to drop in response to the number of shares now available for sale, follow suit. As prices begin to drop even faster and panic grips the entire market, thousands more stock owners attempt to sell their stocks before the dropping prices reduce the paper value of their holdings even further. This phase often is exacerbated by margin calls on heavily leveraged investors who have no choice but to liquidate stocks in order to bring their cash reserves up to required levels. With almost everyone wanting to sell and few wanting to buy, supply so far exceeds demand that prices plummet across virtually the entire stock index.

    Contributing Factors

    Periods of strong optimism among investors can artificially inflate stock prices, creating a "bubble," which has the potential to burst, causing a crash just by virtue of dropping back toward normal pricing. Investors may take on excessive risk through leverage (investing with borrowed money), which makes them unable to avoid selling if prices drop below a certain point. World events that undermine the confidence of investors can set the stage for the panic-induced selling that creates a stock market crash. The widespread, instant availability of market information can cause panic on a faster and more widespread scale than ever before. Finally, since many of the trades executed in a day are now done by computers based on predetermined parameters, computer trading itself can cause or at least accelerate dropping prices in the market as thousands of transactions are conducted in a very compressed period of time with no human input.

    Effects

    A stock market crash reduces paper wealth, thus significantly reducing the overall monetary value of investors' holdings. This can reduce the income of a retiree or other entity that depends on residual income from its investment portfolio. In addition, because many consumers view the stock market as a leading indicator of overall economic conditions, consumer spending may be reduced, further contracting the economy and slowing recovery of the stock market itself. One of the worst effects of the 1929 stock market crash prior to the Great Depression was the failure of multiple banks that had loaned money to speculators but could not collect when the stocks they invested in became worthless.

    Countermeasures

    Rule 80B, enacted in 1988, established criteria under which the market would be closed for trading in an effort to halt the avalanche of falling prices caused by panic. Each quarter, the Securities and Exchange Commission calculates the thresholds past which a market freeze would occur. While these have not prevented subsequent crashes entirely, they have helped to mitigate the consequences. Even though the U.S. stock market has had several crashes since Black Tuesday in 1929, these countermeasures have helped to prevent another crash as devastating as the one that preceded the Great Depression.

    Photo Credits

    • Stock Market Crash image by Paul Heasman from Fotolia.com

    About the Author

    Elliott Taylor has been a writer and blogger since 2009. His articles have been published in the "Arbiter" and "Messenger Index" newspapers, as well as online venues. Taylor holds a Bachelor of Business Administration in marketing from Boise State University.

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