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Program Trading and Portfolio Insurance: Were
They to Blame for the Stock Market Crash of 1987?
In the aftermath of the Black Monday crash on
October 19, 1987, in which the stock market
declined by over 20% in one day, trading strategies
involving stock price index futures markets have been
accused (especially by the Brady Commission, which
was appointed by President Reagan to study the stock
market) of being culprits in the market collapse.
One such strategy, called program trading, involves
computer-directed trading between the stock index
futures and the stocks whose prices are reflected in the
stock price index. Program trading is a form of arbi-
trage conducted to keep stock index futures and stock
prices in line with each other. For example, when the
price of the stock index futures contract is far below
the prices of the underlying stocks in the index, pro-
gram traders buy index futures, thereby increasing
their price, and sell the stocks, thereby lowering their
price. Critics of program trading assert that the sharp
fall in stock index futures prices on Black Monday led
to massive selling in the stock market to keep stock
prices in line with the stock index futures prices.
Some experts also blame portfolio insurance for
amplifying the crash because they feel that when the
stock market started to fall, uncertainty in the market
increased, and the resulting increased desire to
hedge stocks led to massive selling of stock index
futures. The resulting large price declines in stock
index futures contracts then led to massive selling of
stocks by program traders to keep prices in line.
Because they view program trading and portfolio
insurance as causes of the October 1987 market col-
lapse, critics of stock index futures have advocated
restrictions on their trading. In response, certain bro-
kerage firms, as well as organized exchanges, have
placed limits on program trading. For example, the
New York Stock Exchange has curbed computerized
program trading when the Dow Jones Industrial
Average moves by more than 50 points in one day.
However, some prominent finance scholars (among
them Nobel laureate Merton Miller of the University
of Chicago) do not accept the hypothesis that pro-
gram trading and portfolio insurance provoked the
stock market crash. They believe that the prices of
stock index futures primarily reflect the same eco-
nomic forces that move stock prices—changes in the
market’s underlying assessment of the value of stocks.
Access
www.usafutures.
com/stockindexfutures.htm
for detailed information
about stock index futures.
G O O N L I N E
604
Part 7 The Management of Financial Institutions
a security. Cash settlement gives these contracts the advantage of a high degree
of liquidity and also rules out the possibility of anyone’s cornering the market. In the
case of the S&P 500 Index contract, at the final settlement date, the cash delivery
due is $250 times the index, so if the index is at 1,000 on the final settlement date,
$250,000 would be the amount due. The price quotes for this contract are also
quoted in terms of index points, so a change of 1 point represents a change of $250
in the contract’s value.
To understand what all this means, let’s look at what happens when you buy or
sell this futures contract. Suppose that on February 1, you sell one June contract
at a price of 1,000 (that is, $250,000). By selling the contract, you agree to a deliv-
ery amount due of $250 times the S&P 500 Index on the expiration date at the end
of June. By buying the contract at a price of 1,000, the buyer has agreed to pay
$250,000 for the delivery amount due of $250 times the S&P 500 Index at the expi-
ration date at the end of June. If the stock market falls so that the S&P 500 Index
declines to 900 on the expiration date, the buyer of the contract will have lost $25,000
because he or she has agreed to pay $250,000 for the contract but has a delivery
amount due of $225,000 (900
⫻ $250). But you, the seller of the contract, will have
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