Black Monday
The name is given to the dramatic, worldwide, and mostly unanticipated stock market meltdown.
What is Black Monday?
Black Monday, October 19, 1987, is the name given to the dramatic, worldwide, and mostly unanticipated stock market meltdown. An estimated US$1.71 trillion was lost globally.
Global economic concerns, program trading, and stock overvaluation are just a few of the many elements that contributed to Black Monday in 1987.
The Dow Jones Industrial Average (DJIA) had the greatest one-day stock market decline in history when it fell 22.6 percent in a single trading session in the United States.
The crash profoundly impacted the global financial markets, which increased public anxiety and concerns about an approaching recession.
The combination of geopolitical events and the introduction of automated program trading, which accelerated the selloff, has been blamed by economists for the disaster.
Some argue that Black Monday was a case of fear overtaking greed. In contrast, others attribute the event to recently developed automated trading systems that increased the decline in the markets by automatically selling equities as they fell.
Key Takeaways
- The stock market crash that occurred on October 19, 1987, is known as “Black Monday,” resulting in a loss of 22% in the Dow Jones, triggering a global sell-off in markets.
- The event signaled the start of a downturn in the world stock market, and Black Monday rose to prominence as one of the most infamous days in financial history.
- Two major factors that increased the severity of the Black Monday disaster were computerized trading and portfolio insurance trading strategies, which hedged stock market portfolios by selling short S&P 500 Index futures contracts.
- The necessity for investors and financial institutions to properly manage risk was brought to light by Black Monday.
How did Black Monday Happen?
Stock markets surged in the first half of 1987. Fears of an asset bubble were heightened by the DJIA's 44% increase in just seven months by late August. A deluge of news headlines in mid-October eroded investor confidence and caused more market instability.
The dollar dropped in value when the federal government revealed a bigger-than-expected trade imbalance.
This event signaled the start of market instability and hinted at the historic losses that would occur a week later. On October 14, several markets started to see significant daily losses.
The rolling sell-offs on October 16 took place in tandem with an occurrence referred to as "triple witching," which characterizes the situation in which monthly expirations of futures and options contracts occur on the same day.
By Friday, October 16, the DJIA had dropped 4.6% by the end of the trading day.
Only a temporary respite was provided by the weekend trading break. On Saturday, October 17, Treasury Secretary James Baker openly threatened to devalue the US dollar in an effort to close the country's growing trade deficit.
Asian stock markets started to plummet even before US markets opened for business on Monday morning. A cascade in stock markets resulted from more investors moving to liquidate positions and many sell orders exceeding the number of willing buyers near previous values.
The worst-case scenario saw a 60% decline in the stock market in New Zealand. Traders told stories of each other hurrying to sell at the pits. At the opening bell, the DJIA in the US fell 508 points, or 22.6 percent, and ultimately ended lower.
What Caused the Black Monday Crash?
No significant news event was published the weekend before the crash; thus, it is impossible to pinpoint a single event as the reason for the dramatic decline in the stock market. All of these things combined to make investors feel fearful.
Here are the causes:
1. Bull Market Due for Correction
A robust bull market that was past due for a significant price adjustment since 1982 was one of the primary causes of the Black Monday disaster. The stock prices have tripled since then, making a significant price adjustment inevitable.
2. Computerized Trading
The United States' trade deficit grew in relation to other nations. Though it was still not as powerful as it is now, computerized trading was becoming more and more noticeable at several Wall Street firms.
The 1987 stock market meltdown clarified how progress in finance and technology contributes to more market volatility.
The automated trading algorithms on Black Monday set off a chain reaction that caused the market to decline considerably more by continuously speeding up sales as it did.
Note
The first losses set off a chain reaction of selling, further reducing stock values and prompting subsequent rounds of computer-driven selling.
3. Portfolio Insurance
A program trading technique called portfolio insurance appears to be one of the main elements at the core of Black Monday.
By short-selling stock index futures, the approach seeks to protect a portfolio of stocks from market risk and reduce potential losses if stock prices decrease without requiring the sale of individual equities.
As specific loss objectives were reached, the computer programs started liquidating the stocks, which caused the prices to drop. As a result, bids ceased, and the declining markets prompted more stop-loss orders, creating a domino effect.
4. Mass Panic
Investors were especially uneasy during crises, such as the standoff between Iran and Kuwait that threatened to cut off the oil supply. Criticism has also been directed against the media's position as an exaggerating factor for these developments.
Although numerous ideas try to explain why the disaster happened, most concur that widespread panic amplified the severity of the crash.
The Aftermath of Black Monday
On October 20, 1987, the Federal Open Market Committee, or FOMC, issued a statement restating the bank's commitment to provide liquidity to support the financial system.
The Fed's solution to do whatever it takes to prevent a catastrophe was how the markets understood this comment. The Federal Reserve initiated quantitative easing and slashed interest rates by 50 basis points.
Regulators implemented new safeguards to stop program trading from causing flash crashes. Leading stock markets installed circuit breakers to stop trade automatically in the event of abnormal price swings.
If any specific index, such as the S&P 500, experiences an extraordinary decline, circuit breakers have the ability to stop all trade on the exchange. Each stock has a circuit breaker that stops trading in that particular securities alone. This is meant to stop traders from selling in a panic during brief declines.
Lessons Learned from Black Monday
For all its mayhem and upheaval, Black Monday was also a driving force for good, forcing investors, regulators, and lawmakers to reconsider their strategies and implement new ones to improve market stability.
Here are some lessons the world learned from Black Monday:
1. Risk Management
Black Monday highlighted the importance of risk management in the financial system. Institutions and investors must efficiently measure, analyze, and control their exposure to market risks. Diversification, portfolio hedging, and comprehension of market dynamics are crucial to minimize possible losses.
2. The Impact of Program Trading
The emergence of program trading has the potential to magnify both positive and negative market movements due to its ability to execute big orders quickly.
Note
Program trading highlights the necessity for rigorous algorithmic trading system design and monitoring to minimize destabilization, even though it can increase efficiency.
3. Market Psychology
The outlook of investors has a big impact on how the market behaves. Panic and fear can lead to illogical decisions, which exacerbate market downturns. Preserving investor trust and averting large sell-offs need efficient communication, openness, and investor education.
4. Regulations
During excessive volatility, authorities put measures like circuit breakers and trading limits in place to stop trading. These controls aid in preserving market stability and averting losses that compound over time.
5. The Resilience of Financial Markets
Even with Black Monday's severity, the financial markets have proven remarkably resilient over time. After earlier crashes, markets have recovered and are still essential to the world economy.
Conclusion
The term "Black Monday" describes the disastrous global stock market crisis that occurred on October 19, 1987, during which the DJIA dropped 508 points, or 22.6%, in a single day. It's still the biggest one-day drop in history. There were similarly large drops in other major stock markets.
Most of the losses incurred by the stock markets on Black Monday were swiftly recovered. The DJIA recovered 288 points, or 57%, of the total losses from Black Monday in just two trading days. The US stock markets had eclipsed their pre-crash highs in less than two years.
In response to Black Monday, the SEC has deployed strategies in case of a stock market crash, like circuit breakers and more regulations.
It will not be possible to ignore the lessons of Black Monday as financial markets and technologies change. To keep the global financial system stable and thriving, careful regulation, efficient risk management, and investor education will all remain crucial.
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