Warrior Trading Blog

Black Monday – The Stock Market Crash of 1987

black monday crash

Stock Market Crash of 1987 or Black Monday crash was a severe and rapid downturn in stock prices. It occurred in late October 1987 over several days and affected stock markets universally. At the hit on this crash, the Dow Jones Industrial Average (DJIA) tripled more in the prior five years.

  • On Black Monday, October 22, 1987, the Dow then plunged 22%. This steered subsequent intervention by the stock exchanges and the Federal Reserve to limit the damage by invoking circuit breakers, a move aimed at slowing down future plunges.
  • The Federal Reserve played a significant role in offering highly visible liquidity support aimed at strengthening market functionality. Besides, it eased short-term credit conditions by more extensive open market operations, temporarily liberalizing the regulations guiding the lending of Treasury securities from its portfolio and dispensing public statements upholding its commitment to offer liquidity.
  • The Federal Reserve was well received and crucial in assisting financial markets to embark on normal functioning.

The Explanation

  • Selling pressure hit a peak on October 19, after five days of intensifying stock declines. On that day alone, DJIA fell a record 22% (exactly 508 points to 1,738.74).
  • Many stocks stopped on this day as order imbalances hindered real price recovery.
  • The following day, the selloff halted, and the market recovered most of its losses swiftly, thanks to the support from the exchange and Fed lockouts.
  • As speculations persist as to what caused the crash, most people zero down to automatic trading programs in place during that time and lack of trading curbs which modern market have as possible culprits.
  • The era just before October 1987 led the DJIA more than triple in the five years, as mentioned above. Consequently, valuations escalated to excessive levels, with the total market’s price to earnings ratio rising above 20, signifying very bullish sentiment.
  • Although the crash started as a U.S. phenomenon, it immediately affected stock markets globally; out of 20 large markets, 19 saw the stock market decline of 20% or more.

Trading and the 1987 Crash

  • Regulators and investors from the 1987 crash were engulfed with the risks of the program or automatic trading. In this kind of programs, human decision-making is set aside, and buy or sell orders are automatically generated based on the price level of specific stocks or benchmark indexes.
  • Soon after the crash, exchanges installed circuit breaker rules as well as other precautions to slow the impact of trading irregularities hoping that markets would gain sufficient time to correct such problems in the future.
  • While program trading can be highlighted as a major cause of this crash, the majority of trades at this time were executed through a slow process that often required multiple interactions and phone calls between humans.
  • In modern times, the heightened computerization of markets, with the inclusion of the advent of high-frequency trading (HFT), processing of trades takes place within milliseconds.
  • Following exceptional rapid feedback loops among the algorithms, the selling point can amount to a tidal wave within movements, phasing out fortunes in the process.

Why the Black Monday Crash Happened

There are numerous causes for the crash, with a number of key triggers that contributed to the havoc on the Black Monday crash. The following topped the list:

Dollar Decline

  • During the weeks that led up to the 1987 crash, the federal government indicated an enlarging trade shortfall. This deficit agitated economic markets and diminished the U.S. dollar.
  • As a result, a shaky dollar prompted a run-off from assets denominated by the currency. In the process, the interest rates skyrocketed.
  • Despite the fact that the news was not wide-reaching, it was sufficient to set things in motion as traders stomped the stock market in pursuit of unloading shares on October 16.
  • Notably, the Dow had decreased 4.6% then, which was a predecessor to the larger regression on Black Monday.

Extensive Media Reporting

  • The media may not be directly blamed for the stock market failure.
  • It is a fact that this was the first time television audience across the globe was able to view a crash in the market as and when it happened.
  • Viewers saw the events of the collapse develop before them on CNN as well as the local news. In 1987, that was, indeed, a great deal.
  • Furthermore, the traders’ visual images in anguish on the universal trading ground proved significant, and the response was anticipated.
  • As average investors kept an eye on the Black Monday news, they increasingly desired to sell out their portfolio spots.

Program Trading

  • This was a target of critique under computerized trading. Wall Street insiders referred to this computerized form of transaction as program trading.
  • The concept was adopted largely by renowned institutional firms, and it permitted massive stock orders to be carried out in precise market situations –even in volatile conditions, which was so for Black Monday.
  • The bulky stock trades, a majority of them being sell orders, exploded on the market at an era of major turmoil; the 1987 incident became more threatening.

Portfolio Insurance

  • Some critics also highlighted this as a reason for Black Monday.
  •  This form of investment tool encompassed the transaction of risky alternatives and derivatives, which resulted in further market declines.
  • Portfolio insurance had become “quite popular” in 1987, and the market was quite solid nearly five years prior to the crash.
  • Essentially, investors utilized it as a hedging technique to shield stock catalogues against huge market failures.
  • As finance managers from pension funds, insurance firms, mutual funds, and others assessed the terrain, they started getting apprehensive that their profits would not continue through the remaining part of the year.
  • The trade of vulnerable securities became a considerable danger to the stability of the market. For that reason, the regulators of the stock market engaged in measures to discontinue trading when exchanges faced intense volatility and significant losses.

Did you know? Prior to 1987, investors embarked on the aggressive trade into a deteriorating market because they had no option. During that decade, many deals involved harsh takeovers. The underlying reasons for crashes are not reduced economic growth or poor earnings. The major cause is forced selling.

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