By now, the huge sell-off on August 5 has become just another “shock” from the past. I doubt many people even remember it.

That was the day volatility spiked as markets everywhere tanked. The major indexes recorded their biggest one-day losses in nearly two years.

The VIX, the market’s “fear index,” jumped more than 40 points that day, hitting levels not seen since March 2020 at the start of the pandemic.

All day, I was getting phone calls from old trading pals and other investors. They worried that we were watching a crash unfold right before our eyes – just like in 1987.

As a young trader in my 20s, I saw the 1987 crash firsthand. The Dow Jones fell 22.6% in a single day.

Standing there on the trading floor, it felt like I was witnessing the whole world collapsing.

August 5 was way different than 1987, though. For a start, the markets recovered by the end of the following week. They have since gone on to hit record highs.

But moments like these reinforce something that the 1987 crash – and other market downturns – taught me.

And I want to share that with you today…

Out of Nowhere

It’s rare to see a crash coming. Often, the catalyst is something few expect.

We saw that in August. Most folks didn’t know much about the “yen carry trade.”

In a nutshell, big investors like to borrow money at a low rate and invest it in an asset that generates a higher yield.

In the case of August 5’s meltdown, the carry trade was between the Japanese yen and the U.S. dollar.

Institutional investors would borrow yen due to low interest rates in Japan. Then they swapped their yen for U.S. dollars to invest in assets like stocks and bonds.

But at the end of July, the Bank of Japan unexpectedly raised rates for the second time since 2007.

Adding to the turmoil, weak jobs data had put the prospect of multiple rate cuts in the U.S. back on the table.

Higher Japanese rates coupled with likely rate cuts in the U.S. caused the yen to rally against the U.S. dollar.

That upset the relationship between the two currencies… as well as the profitability of trades tied to the yen and dollar.

So those highly leveraged institutions had to unwind their positions… fast.

That’s why markets tanked and volatility spiked. Investors rushed to dump their positions so that they could close out their yen loans.

It was a double whammy that nobody foresaw.

And that’s where a key lesson comes in…

It’s Always About Risk

When you see massive volatility, it’s not only a few affected institutions feeling the pain.

In a moment of chaos, retail investors can blow up their accounts too – often by selling in a panic.

Throughout my nearly 40-year career, I’ve seen countless other random events rock the markets…

Just think of the Russian debt default, the Greek debt crisis, and COVID.

Plus there have been plenty of other global geopolitical events along the way…

There’s always something coming around the corner that we just can’t see.

And that’s why you need to have a risk management plan that doesn’t depend on your emotions.

If you see markets plummeting, that’s not the time to decide on an exit plan. You should already know what you’re going to do long before that point.

That could be a stop loss – where you know to get out once your losses reach a certain level.

Or you could control your risk through position sizing, putting up only enough capital that you’re comfortable even if a trade goes to zero.

But one way or another, you need to have a plan.

Otherwise, when a shakeup hits, those with poor risk management will come undone in a big way.

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Protect Your Capital

In many ways, the crash of 1987 early in my career still defines me…

It taught me to be cautious and bank profits when I see them. That’s worked very well for me over the decades.

The crash also taught me the most important lesson of all…

Your capital is all you have as a trader.

You have to protect it zealously with strict risk management.

Otherwise, you can be sure that an unexpected event will eventually come along and put you out of the game.

Happy Trading,

Larry Benedict
Editor, Trading With Larry Benedict