A stock market sell-off is a situation where stocks drop suddenly over a daily, weekly, or monthly timeframe. In most cases, the term refers to a sudden decline of the main indices like the S&P 500, Dow Jones, and Nasdaq.
A good example of a stock market sell-off is what happened during the dot com bubble in early 2000s, during the Global Financial crisis, and during the peak of the coronavirus pandemic (here the best Covid Stocks to trade).
In this report, we will look at the causes of a stock market sell-off and the few strategies to trade when it happens.
Causes of a stock market sell-off
There are several factors that lead to a stock market sell-off. Among them are:
Bursting of a bubble
In the dot com bubble, the sell-off happened as investors started to worry about valuations in the stock market. At the time, many tech companies with no earnings were valued at billions of dollars.
Major natural event
This year’s sell-off happened because of a natural event, the coronavirus pandemic. A few years ago, Japan stocks sold-off because of the earthquake.
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At times, a sudden change of monetary policy tends to lead to a sell-off. For example, if the Fed decides hike rates, the market can react by selling-off.
A stock market sell-off can happen when companies report weak earnings and weak forward guidance.
A technical hitch in a major exchange like Nasdaq or the New York Stock Exchange can lead to a sell-off. A good example of this is what happened in 2010’s flash crash.
Difference between a stock market sell-off and a stock sell-off
There is a difference between a stock market sell-off and a stock sell-off. As mentioned above, a market sell-off is usually viewed in form of the indices like the Dow Jones, DAX, and the S&P 500.
However, a stock sell-off is a situation where traders sell shares of a specific company. A good example is recently, when the market sold shares in Wirecard, the giant German payment processing company.
They did that after EY, the firm’s auditor said that it couldn’t trace $2 billion in its balance sheet.
What causes a sell-off in the stock market
The causes of a stock market sell-off and that of a stock sell off are similar. But a stock sell-off can happen because of other reasons like:
- Failed M&A deal – A few months ago, shares in Tiffany dropped sharply after LVMH ended its planned acquisition.
- Accounting issues – An accounting issue, like it happened in Wirecard and Enron can lead to a major sell-off.
- Sector issues – Challenges in a sector can lead to a sell-off. For example, in 2020, oil companies dropped after the price of crude oil dropped.
- New competition – A new entry by a major company can lead to a sell-off. For example, shares of grocery companies dropped after Amazon acquired Whole Foods.
- CEO resignation – Shares of a firm can drop after a beloved CEO resigns or when an influential investor exits his position.
Why traders should not worry about a market sell-off
A market sell-off is usually a bad thing for long-term investors, who see their holdings decimated. Indeed, many long-term investors lost money when stocks fell by more than 20% in 2020.
However, traders rejoice during a market sell-off as evidenced by the recent trading profits by big banks like Goldman Sachs and Morgan Stanley. At DTTW, our traders have had their best years this year.
This is because day traders are usually not focused on the long-term. Instead, they are mostly focused about the short-term performance of a market chart. It is also because sell-offs are usually associated with a significant jump in market volatility.
Better still, traders can make money when the price of a financial asset rises by buying and when the price falls by shorting. Shorting is the process of borrowing shares, selling them, keeping the cash, and buying them back when the price falls.
Although it sounds complex, shorting is usually executed electronically just like buying.
A stock market sell-off is a period when the overall stock market drops. While it is usually a difficult period for investors, traders are relatively immune since they can make money when stocks are moving in either direction. They also make more money during sell-off because of more volatility.
Still, it is important to always use the best risk management strategies such as position sizing and having a stop loss on all your trades.