On the 19th of October 1987, the Dow Jones Industrial Average (DJIA) suffered the largest single day stock market decline in history.
Now known as Black Monday, this historic and terrifying day saw the DJIA fall a staggering 22.6 percent. Black Monday led to a chain reaction of falls that reverberated around the world, with most global stock exchanges plunging due to the intertwined nature of markets and technology in an era of globalisation.
It would take two years for the market to return to where it was before the crash.
While the stock market crash was a source of incredible distress for investors and traders, it led to a number of reforms and precedents that have informed government responses during subsequent crashes such as the GFC and COVID-19 falls.
Traders benefit from understanding past stock market crashes, so that they can protect themselves in the lead up to a crash and then capitalise on opportunities presented by government intervention.
The Events Leading Up To The Crash
The first half of 1987 was a great year for the stock market, seeing prices race upwards by 44% in the first seven months of the year. This naturally started to stoke fears of an asset bubble, with an increasing number of news reports starting to demonstrate that risks were increasing.
Investor sentiment started to shift negatively towards mid-October, with increasing pessimism triggered by the US federal government disclosing a much larger than expected trade deficit, resulting in weakness in the value of the US dollar.
Beginning the 14th of October, investors began selling their positions, with increasingly larger losses developing in the markets. This was compounded by the Government passing a bill on October 15th that eliminated corporate takeovers funded by the government.
By the end of the week, on the close of trading on Friday, October 16th, the DJIA suffered a single-day loss of 4.6 percent. This was to be a foreshadowing of the week ahead.
Over the weekend leading up to Black Monday the then Treasury Secretary James Baker gave a public threat that he would de-value the US dollar as a response to the widening trade deficit.
This simple threat sent stock markets plunging in the Asia-Pacific region, which open before the US stock market. The benefits of globalisation that connected the world and propelled it upwards in recent decades started to work against it.
Investors in the US woke to real-time data showing markets crashing across the globe as panicked investors rushed to liquidate their positions. By the time the US stock market opened on Black Monday the fear was at fever pitch.
Black Monday
With investor fear running high, there were several factors that when combined, contributed to the large falls on Black Monday:
Factor 1: The dollar was weakening.
The federal government’s news about the widening trade deficit caused the dollar to weaken, which in turn made investors fearful of holding dollar-denominated assets (as these would be worth less as the dollar fell) and fearful of interest rate rises being needed (which is bearish for stocks).
Factor 2: Media showed the carnage in real time.
This was the first major global market crash that gave the general population the ability to see events unfold around the world in real-time. Television studios and news programs around the country showed scenes of devastated investors and traders around the world reacting in fear.
After seeing these images, retail investors were desperate to get out, demanding their brokers sell their shares, further exacerbating the stock market fall.
Factor 3: Hedging using derivatives.
Many traders use derivatives to protect themselves in case they were wrong about a directional bet. In the case of Black Monday, as prices began to fall, traders opened up more hedging positions.
Traders began to go ‘short’ in increasing numbers, to protect themselves against greater falls. This led to a domino effect of further selling and further hedging.
Factor 4: Automated trading
Advances in computer technology meant that institutional traders had the increasing ability to automate their trading. While today we might take ‘stop losses’ for granted (the broker sells our stock when it reaches a designated low), in the late 1980s this was still a fairly new phenomenon and as such, it had never been tested in an extreme market environment.
As the markets fell on Black Monday, stop losses were triggered. This in turn created a cascade of further selling which led to further stop losses being triggered in a horrific downward loop.
The Aftermath of Black Monday
Fortunately for the US, the government had learned many lessons from the stock market crash of 1929 that led to the Great Depression.
Unlike 1929, the US Federal Reserve quickly stepping in to cut interest rates aggressively and stabilise the market with assurances of loans and capital for firms at risk of collapsing. This served to avoid a major economic downturn and gave a boost to the economy so that within two years, the stock market was able to regain all of its losses.
At the same time, new regulations were introduced in the form of ‘circuit-breakers’ which would halt all trading activity for a period of time if there were large falls in prices. This helped to settle markets and prevent further larger falls in the years and decades to come.
Conclusion
The stock market crash of 1987 caused the biggest single day decline in stock prices in history, with the DJIA falling over 22%. With asset prices rocketing in the seven months leading up to the crisis, it was ripe for disruption.
The coalescence of a weakening dollar, real-time global media, derivatives and automated trading resulted in accelerated price falls until the US Federal Reserve was able to step in and help the market stabilise.
Trade safe!
Disclaimer: The information above is for educational purposes only and should not be treated as investment advice. The strategy presented would not be suitable for investors who are not familiar with exchange traded options. Any readers interested in this strategy should do their own research and seek advice from a licensed financial adviser.
