What Caused Black Monday in 1987

What Caused Black Monday in 1987

6 min read

What caused Black Monday in 1987? A growing sense of dread washed over stockbrokers on Monday, October 19,1987. On that day, also known as Black Monday, the walls came crashing down. Stock markets from New York, London, Hong Kong, Berlin, Tokyo and pretty much every other city in the world came crashing down. The million-dollar question remains:

  • “Black Monday” referred to the catastrophic stock market crash on Monday, October 19, 1987
  • During the ominous “Black Monday” stock market crash, the U.S. markets fell more than 20% in one day.
  • It’s thought that computerized trading and portfolio insurance trading strategies were to blame. Both hedged stock market portfolios by short-selling S&P 500 Index futures contracts.

Why The Dow Matters

What caused Black Monday in 1987To understand a stock market crash, you must understand the Dow Jones Industrial Average, “DJIA.” The DJIA is a price-weighted index. It tracks 30 large, publicly-owned blue-chip companies trading on the New York Stock Exchange (NYSE) and the NASDAQ. The index represents the significant areas of the U.S. economy: industrials, transportation, and utilities. To many, a strong Dow means a strong economy, while a weak-performing Dow means a slowing economy.

A Very Black Monday Indeed

What caused Black Monday in 1987? Let me give you some perspective on the severity of the 1987 crash. The Black Monday crash of 1929, the worst one-day drop in the DJIA was just over 12%. However, that was barely more than half of the decline that occurred on Black Monday in 1987.

On that Black day in May, sell orders piled up as the S&P 500, and the DJIA crashed more than 20%. Perhaps another important point to mention is that the bull market had been running since 1982.

Clearly, they’d been whispers about an impending bear market, but no one suspected its entry would be so swift and fierce. The markets gave very little warning, which forced the then-new Federal Reserve Chair Alan Greenspan to go on the defense.

Greenspan’s first act of defense was to slash interest rates. With this in mind, he asked banks to flood the system with liquidity. Easy access to cash at low-interest rates would encourage people to buy, build and invest. In theory, this move should have worked. But the reality was a slap in the face. 

At the same time, an international tiff over the U.S. dollar’s value was taking place. Greenspan expected the U.S dollar to lose value. What he didn’t expect was the worldwide financial meltdown. Apart from this, brokers were relying on computers to execute large-scale trading strategies. It’s important to keep in mind that this approach was relatively new to Wall Street. Because of this, no one knew the consequences of a system placing thousands of orders during a crash.

The Portfolio Insurance Trading Strategy

Developed by Mark Rubinstein and Hayne Leland in 1976, the portfolio insurance trading strategy was based on short-selling stock index futures. Fundamentally, the intent was to limit a portfolio’s losses and risk when its stock prices went down. By being short futures, it would prevent the need to sell off those declining stocks. In fact, Portfolio insurance is a hedging technique frequently used by institutional investors when the market direction is uncertain or volatile. 

While at a glance, this makes sense, however, this automated trading strategy was at the center of the Black Monday Crash. 

Portfolio Insurance And Black Monday Crash Of 1987?

Due to the way the portfolio insurance trading strategy was structured, computer programs started to automatically liquidate stocks once certain stop-losses got triggered.

Beyond even that, prices pushed lower as more stop-loss orders got triggered. Consequently, this “program trading” led to a frantic domino effect in which the market entered into a downward spiral.

If it wasn’t bleak enough, these programs automatically turned off all buying orders. Basically, all buy orders disappeared from all the stock markets at the same time worldwide. 

Ironically, the intention of the portfolio insurance trading strategy was to protect every single portfolio from risk. But in fact, it became the largest single source of market risk. 

How Long Did It Take to Recover From Black Monday 1987?

It took two years to recover from October 19,1987. It wasn’t until 1989 that the DOW finally recovered what was lost in one day 2 years prior. In 1987 the DOW only gained 0.6% on the year. It didn’t matter if it had a great first 9.5 months. All it took was one day to wipe it all away. That’s a little scary to think about. So make sure you know how to trade in any market!

A Very Black March

Monday, March 16, 2020, will forever be seared into the minds of traders and investors. It was on that fateful day, the largest single-point plunge of the Dow Jones Industrial Average (DJIA) happened. Only two other dates in the U.S. history books had more unsettling one-day percentage falls. Rewind to the so-called Black Monday on October 19, 1987, which saw a 22.6% drop, and December 12, 1914, with a 23.52% fall.

The Good From the Black

The devastating fallout of Black Monday leads us to the groundbreaking development of “circuit breakers.” Just like when your home electrical panel trips when overload, “circuit breakers” temporarily halt trading.

As of 2019, the first circuit breaker trips any time the S&P 500 Index falls more than 7% from the previous day’s close price. In turn, this halts all stock trading for 15 minutes.

More importantly, the second circuit breaker kicks in when there’s a 13% drop in the index from the previous close. Finally, the third circuit breaker trips with a 20% decline and trading gets halted for the rest of the day.

The idea behind the circuit breaker system is to avoid a panic sell-off where traders recklessly start selling out all their holdings. To be honest, it’s thought that this general panic is to blame for much of the severity of market crashes. 

To avoid making rash decisions in life, it’s best to take a time out and a deep breath. And the circuit breaker system just does this. By giving traders space to catch their breath, hopefully, they can take the time to make rational trading decisions, thereby avoiding a blind panic of stock selling.

Bottom Line

Unexpected events – wars, shortages, pandemics – can take even the most conscientious investors by surprise and plunge the entire market or particular sectors into free fall. During these times, emotions and volatility are high, which means money is to be made. 

Now is the time to sign up and learn how you can capitalize on stock market swings. Almost everything that goes down must go back up, and with the right strategies, you can be profitable in times of great loss. 

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