After the Wall Street crash in October 1973 due to unprecedented surge in crude oil price; there was lull for little more than a decade. The Wall Street rocked again on October 19th, 1987,the Monday. The US stock market indices, the DOW Jones Industrial Average lost 508 points. That means on a single day the stocks lost 22.6% of their values! This day was also termed as another “Black Monday”.
Two of the potential culprits behind this crash were identified. One was, as the gift technology; the program trading and other a new financial hedging method called portfolio insurance. Both of them together caused the sharp fall of stock prices for massive sell offs. Of course there other factors like US trade deficit, weakening of dollar and overvaluation of stock values played its roll with investor’s sentiments. But in a single day, a fall that sharp could never take place unless the traders used computers for stock trading. Program trading is that when a trader can book order to sell or buy stocks on a predetermined price. Say, you can sell a stock when it falls to certain price. So, a situation arose when stock price dropped to certain level and huge sells were automatically triggered by computer trading system. That flooded the market with sell orders, which furthered the drop of prices steeper.
The portfolio was mooted by two young professors Hayne Leland and Mark Rubinstein from Berkeley. They contrived a way to insure portfolio investments of stocks similar to the way other assets are insured. They claimed that for a price like insurance premium, their trading system can provide protection to portfolio investment that will never lose more than a pre-set amount. A new financial instrument was called derivatives brought into the game. Generally people buy a stock and sell the same. When they sell at a price more than their purchase price, they profit. When they sell at a lower price than their purchase price they lose. That has been the rule of the game for centuries. Derivatives let you speculate a future price without actually buying them. Say, you buy a stock a week from now for $5. After a week if the price of the same stock is more that $5 you gain, if it is lower than $5, you lose. Mind you, at no point of time you actually hold the stocks.
With portfolio insurance, say, you have bought stocks worth $1000 and you wish to safeguard the value of the stocks say for a week. Then you sell a future contract and that would work in the way as stated earlier. But as simply it is stated, it is not that. The promulgators of portfolio insurance could not foresee that at the time of panic selling there is no buyer! So, the system simply does not work. This caused the crash on “Black Monday” October the 19th.
The market learned a lesson from this crash. In the computerized trading system "circuit breaker" was introduced, to arrest free fall of stock prices. That is observing a brief pause during trading hours in a day. There were few more preventive measures evolved over the time. It will be discussed in the next article.