Why we say 1987 Market Crash is caused by derivatives?

By Dongliang “Larry” Yi

Black Monday

On Oct. 19^th, 1987, Dow Jones Industrial Average(DJIA) fell 508.53 points from 2247.27 to 1738.74, which is equal to a 22.61% one-day loss. Until now, it is considered to be the largest one-day percentage decline in the DJIA history^[1][2]. The S&P 500 Index lost 20.5% of its value and the NASDAQ lost 11.3% during the same day^[3].
In addition, this severe one-day US stock market meltdown also affected other international stock markets, including New Zealand, Hong Kong, Australia, the United Kingdom, etc. The worst hit New Zealand’s stock market, fell about 60% from its 1987 peak, and took several years to recover^[4].

After the Black Monday, about $500 billion in market capitalization was evaporated from DJIA^[1].  When individual investors heard a massive stock price decline was occurring, they rushed to call their brokers to sell their equities. This panic selling caused a large-volume selling and rapid market meltdown. Many people lost millions of dollars instantly. Some individuals who has lost large amounts of money went to their broker’s office with a gun and started shooting brokers^[5].

The cause

The most cited reason is overvaluation of US Stock market before 1987. In the five years preceding the crash, equity market was supported by new entrants into the market (pension and 401(k) plans), which drove up stock prices. The DJIA bottomed out at 776 in August 1982 and achieved a high of 2722 in August 1987, which is a 250.77% increase^[7]. The P/E ratio of the New York Stock Exchange composite index had a high of 23 on Aug. 12, which is far higher than the index’s average of 12.7 during the preceding 15 years of its existence (1972-1986). The conventional idea is that when P/E ratios are above the long-term average, stocks are going to fall, and that when they are below it, stocks will rise. The Oct. 19 market meltdown decreased the P/E ratio to 17.3 which is still higher than average^[6].

The second most cited reason is the massive use of innovated ‘Portfolio insurance’. Portfolio insurance is a method of hedging a portfolio of equities against the market volatility by short selling stock index futures. On Oct. 19^th, the initial stock price decline ignited price-insensitive selling by some institutions who took portfolio insurance strategies and some mutual fund groups reacting to redemptions. The selling by these investors, and the prospect of further selling by them, encouraged a lot of aggressive trading-oriented institutions to sell in anticipation of further market declines, and then cause further more selling from institutions and mutual funds^[8]. Normally, this transmission mechanism is not so smooth unless the market consensus of further stock price decline. Unluckily, this cascade effect occurred on Oct. 19 1987, and it caused the well known largest one-day loss of DJIA.

Automated trading systems are also considered to be a cause to investor panic and this historic drop in the stock market. In 1987, the program trading was a little bit primitive, and not as complicated as today. At that time, brokers would set a certain price and once the stock reached that price, the computer would automatically be trained to buy or sell without human’s order. So when equity price decrease heavily, this automated trading system reacted to sell equities, dry up liquidity and drive the market price decline more than expected^[9].

There were also other reasons mentioned in many articles including deteriorating US current account deficit, escalating US government debt, rapidly increasing short term US interest rates, etc^[3].

Subsequent impact

In order to manage potential panic caused by sharp and quick market decline, in 1990, Rep. Markey authored the Market Reform Act, which gave support to the New York Stock Exchange’s system of “circuit breakers”, a mechanism that stops trading when abnormal market spikes occur. “What we learned from the 1987 crash is that computers and telecommunications technology are no substitute for sound human judgment”, says Markey^[9]. This circuit breakers system was later introduced to other countries like China and Japan.

The 1987 stock market crash also highlighted the structural flaws of the Black-Scholes-Model(BSM) which was used to price the portfolio insurance in 1987 market crash. Traders realized that BSM undervalued the out-of-money put options, which is used to protect portfolio value^[10]. Later, there are more research on implied volatility and related volatility smile. 

References:

[1] Jesse Colombo, “Black Monday – the Stock Market Crash of 1987”, http://www.thebubblebubble.com/1987-crash/

[2] Browning, E.S. (2007-10-15). "Exorcising Ghosts of Octobers Past". The Wall Street Journal (Dow Jones & Company). pp. C1–C2. Retrieved 2007-10-15.

[3] “Stock market crash - Black Monday - October 1987”, http://www.sniper.at/stock-market-crash-of-1987.htm

[4] "Commercial Framework: Stock exchange, New Zealand Official Yearbook 2000.". Statistics New Zealand. Retrieved 8 December 2014.

[5] BARRY BEARAK, “Stock Market Loser Kills Brokerage Manager, Self in Shooting Rampage”, October 27, 1987, http://articles.latimes.com/1987-10-27/news/mn-16905_1_stock-market

[6]  LEONARD SILK, “Economic Scene; Taking a Look At P/E Ratios, November 27, 1987”, http://www.nytimes.com/1987/11/27/business/economic-scene-taking-a-look-at-p-e-ratios.html

[7] “Revisiting October 1987 Stock Market Crash”, https://new.tradingview.com/chart/SPX/WwN6HHVe-Revisiting-October-1987-Stock-Market-Crash/

[8] Robert Shiller, “Portfolio Insurance and Other Investor Fashions as Factors in the 1987 Stock Market Crash”, http://www.nber.org/chapters/c10958

[9] C.G. Lynch, “Remembering Black Monday, When Computers Traded Too Many Stocks and Wall Street Crashed”, Oct 18, 2007 8:00 AM PT, http://www.cio.com/article/2437854/it-organization/remembering-black-monday--when-computers-traded-too-many-stocks-and-wall-street-cras.html

[10] Pablo Triana, The Day When Black Scholes Made Black Scholes, August 2, 2007 1:02 AM, http://www.wilmott.com/blogs/PabloTriana/index.cfm/2007/8/2/THE-DAY-WHEN-BLACKSCHOLES-MADE-BLACKSCHOLES