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 arbitrage 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, program 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 collapse, critics of stock index futures have advocated restrictions on their trading. In response, certain brokerage 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 program trading and portfolio insurance provoked the stock market crash. They believe that the prices of stock index futures primarily reflect the same economic forces that move stock prices—changes in the market’s underlying assessment of the value of stocks.