6 Psychological Tips to Avoid a Market Crash

American stocks have generally been in a strong upward trend in decades as you can see in the long-term S&P 500 chart below.

However, while the long-term chart shows that the trend has been bullish, in reality, there have been a series of crashes.

In this article, we will look at some of the most notable market crashes in history and some of the psychological tips for traders.

Top market crashes in the US

There have been a few major market crashes in the United States. First, there was the Great Depression of the 1920s. This depression wiped out most of the gains that had existed in the financial market. As a result, the main indices like the Dow Jones declined sharply as investors exited stocks. This decline was attributed to the fact that stocks were overvalued.

Second, there was the dot com bubble that was caused by the elevated valuations of technology stocks. At the time, all companies that had a dot com suffix were in a strong bullish trend. When the bubble burst, investors lost billions of dollars.

Third, there was the housing bubble of 2008 and 2009 that is commonly known as the Global Financial Crisis (GFC). This crisis happened when the number of subprime mortgage bubble burst. The situation accelerated when Lehman Brothers went bankrupt.

The final major stock market crash happened when the Covid-19 was declared a pandemic. At the time, most stocks declined.

Other major crashes

The four crashes are the most popular ones in the US. However, beneath the surface, there have been more crashes in the financial market.

For example, there have been crashes that have involved specific assets. For example, the chart below shows the major crash that happened in the Docusign stock price. This decline happened after the company published weak earnings.

Second, you probably recall the several crashes that have happened in the cryptocurrency industry. The most memorable one happened in 2017 after Bitcoin soared to an all-time high of almost $20,000. The other one happened after the coin soared in mid 2021.

Third, some currencies have also crashed. For example, as shown below, the Turkish lira crashed hard in 2021 as the Turkish central bank implemented rate cuts as inflation surged.

Psychological strategies in a bear market

Trade the news

The first most important psychological strategy when trading in a bear market is to trade the news. This simply means that you should always be on the lookout for news in the market. As you will find out, there are usually many news events when the market is in a bear market.

For example, there could be mergers and acquisitions and even earnings. In most cases, these events will likely lead to more volatility in the market.

» Related: How to make profit in a bear market?

Overnight trades

Another important psychological strategy to use when trading in a bear market is to avoid leaving your trades open in the overnight market. Doing so could lead to substantial losses when there is a major move when the market opens.

A good example of this is Meta Platforms. As you can see below, in February 2022, the stock moved slightly higher as the month started. Shortly afterwards, the stock dropped by more than 20% when it published weak earnings.

Therefore, in such a situation, people who were long the stock made substantial losses.

Embrace bracket orders

Bracket orders are popular among experienced traders. These are pending orders that are surrounded with stops. Let us use Facebook as an exanple. As you can see, before the crash, the stock closed the day at around $320.

At the time, since the company was to publish earnings after hours, traders were aware about the likely volatility that will happen.

Therefore, in this case, one would have set a buy-stop at $325 and protected it with a take-profit at $350 and a stop-loss at $300.

At the same time, the trader would have opened a sell-stop at $300 and then protected it with a stop-loss and a take-profit at $270 and $330. In this case, since the stock crashed after the market opened, the short trade would have been triggered.

Limit your leverage

Another psychological tip to use when trading in a bear market is to reduce your leverage. For starters, leverage refers to the borrowed money that your broker offers you.

While leverage is a good thing, it is also highly risky. Therefore, since risks increase in a bear market, you should always limit how leveraged you are.

Be careful of dead cat bounces

A dead cat bounce is a strong rally that happens in a bear market. It is not uncommon for the Dow Jones to gain by 400 points a day after it fell by 600 points.

This increase usually happens when investors are attempting to buy the dips. However, as you will find out, the recovery rally tends to falter during a bear market. Therefore, you should be aware of when a dead cat bounce is happening.

Hunt for bargains

Finally, for long-term investors, a bear market presents an excellent period in which traders can easily find cheap bargains that they could not have bought when valuations were high.

For example, since Facebook is a good quality stock, sharp declines after earnings should be considered opportunities to buy the stock.

Summary

In financial markets every day is different, but looking at history is often useful (think also of chart analysis, to study recurring patterns).

Knowing the history and understanding the reasons of past market crashes is very important to avoid making mistakes that could really bring big losses to our accounts (look again at the example of Meta… an avoidable drop for a day trader).

In this article, we have also looked at some of the psychological steps that you can embrace during a bear market. You should seek to apply them when a stock or a commodity crashes.

External useful resources

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