Causes for stock price crash

A sudden crash in stock prices is very painful for investors and traders, and since we trade with options – Unexpected crush could be amplified and cause a lost of 100% of the money allocated to that position. In an article by Korcan Ak, Steve Rossi, Richard Sloan and Scott Tracy titled “Navigating Stock Prices Crushes” the authors examine stock crushes (in one day) and try to understand the reason behind these crashes.

There are many ways to measure stock price crush, but they are VERY common: About 10% of the stocks will suffer a daily drop of 20% or more every year. If we change the threshold we might get a higher percentage.

Predicting stock price crashes:

When trying to protect ourselves and predict price crashes, research show 4 variables that are correlated with increase probability for crush:

  • Abnormal high volume
  • ‘Glamour’ stocks with high past returns and low book-to-price ratio
  • Higher analyst coverage (usually help surface bad news faster)
  • Accounting opacity – meaning rapid changes in accounting accrual.

Stock crashes hurt investors performance, and if we are able to avoid them, our yield will be higher:

Russell3000 return with low crush risk vs high crush risk
Russell3000 return with low crash risk vs high crash risk

 Causes for price crashes:

Crashes are caused due to the uncovering of bad news about the stocks. The number one reason for crashes is earning reports. The following Chart shows the main causes:

Reasons for stock crushes
Reasons for stock crushes

Avoiding stock price drops and increasing our profit:

We can see that about 70% of the crushes are happening during earning announcements. As options traders we can take measures to limit our risk during this time, for example:

  1. Close positions before earnings
  2. Buy put options to increase protection
  3. Sell options as hedge – enjoying from the high IV and limiting our downside risk.

You can easily see which companies have upcoming earnings report and decide how to trade them:Earnings

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