The 1987 Crash

Why this matters

On October 19, 1987, the Dow Jones Industrial Average fell 22.6% in a single trading session, still the largest one-day decline in its history. The Fed's historians call it the first contemporary global financial crisis: markets around the world fell within hours of each other.¹ Yet it was followed by no recession and no banking crisis. It's the best case study of a crash caused more by the mechanics of markets than by the economy.

The run-up

Stocks raced upward in the first half of 1987. By late August the Dow had gained 44% in seven months, raising concerns about a bubble. In mid-October, news unsettled investors: a larger-than-expected trade deficit and a falling dollar. Markets began taking large daily losses from October 14, and on Friday, October 16, a day when monthly options and futures contracts expired together, the Dow fell 4.6%. On Saturday, the Treasury Secretary publicly threatened to devalue the dollar to narrow the trade deficit.¹

Black Monday

Before US markets opened on Monday, stock markets in Asia were already plunging. Sell orders vastly outnumbered buyers near earlier prices, and the selling cascaded from market to market; in the most severe case, New Zealand's stock market fell 60%. In the US, the Dow crashed at the opening bell and finished down 508 points, or 22.6%.¹

Why it fell so far

Regulators and economists identified several likely causes.¹

• Portfolio insurance. A popular new product from investment firms, it used options and other derivatives to limit losses and accelerated the crash, as initial losses triggered further rounds of selling.
• Mismatched plumbing. Stock, options, and futures markets settled trades on different timelines, which could leave trading accounts negative and force liquidations.
• No pause button. Exchanges had no way to intervene in the face of heavy selling and rapid declines.
• New money from abroad. International investors had become increasingly active in US markets and had contributed to the rapid rise before the crash.

Step	What happens
1	Prices fall 3% on bad news.
2	Insurance strategies are programmed to sell more as prices fall, so they sell.
3	Their selling pushes prices down another 3%.
4	That triggers more programmed selling, and margin calls force other holders to sell too.
5	Buyers step back, unsure where the bottom is, and the gap between bids and offers widens.

Each strategy makes sense for one investor. When many follow the same rule at once, their combined selling moves the price they're reacting to. That's why risk managers recalibrated how they valued options after 1987.¹

The rest of this lesson is for members

Still to come in this lesson: The Fed's response, What changed, the key takeaways, and 2 quiz questions with explanations.

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