1929 and 1987 stock market crash
The October crash was marked by a few up days and many down days, whereas the October crash occurred primarily in just one day. Despite this difference, on closer examination, we find that these two stock market crashes have much in common.
In both crashes the underlying dynamic that caused the demand for risky assets to decline as the price of those assets declined which is the opposite of the usual relationship between price and demand was essentially the same.
Uncovering the parallels between these two crashes provides valuable insight into the current market crash.
In previous posts, I argue that the October crash, and, in particular, the instability created by the widespread use of portfolio insurance, offers a paradigm for how and why markets crash. But how could a crash caused by portfolio insurance help to explain the crash in October , which occurred half of a century before portfolio insurance was created?
While portfolio insurance did not exist in , a practice much older than portfolio insurance did: Both purchasing portfolio insurance and buying stock on margin follow the same basic strategy: The underlying similarity between portfolio insurance and purchasing securities on margin warrants careful examination.
This put option entitles the investor to sell the bundle of stocks at a given price the strike price , regardless of the actual market price. Such a put becomes more valuable as the market price falls below the strike price. In fact, the gains on the put exactly match the losses on the underlying bundle of stock.
This offset between the gains on the put and the losses on the underlying risky asset explains why the portfolio insurance investor is not exposed to further losses as the price of the assets falls below the strike price. The net effect, then, of the purchase of portfolio insurance is that the demand for risky assets becomes zero for all prices below the strike price.
Consider the situation when an investor borrows funds to purchase a whole bundle of stocks. If the price of the bundle of stocks remains above the value of the loan, then the investor keeps the bundle of stocks and still has the loan outstanding. However, if the value of the bundle of shares falls below the amount of the loan, then the shares are sold by the lender to insure that the full loan amount is repaid. The investor who used borrowed funds to purchase the bundle of stock ends up not holding any shares.
Black Monday () - Wikipedia
Thus, the investor who purchases a bundle of stocks on margin only ends up owning the stocks when their price is high and sells when prices decline, again the opposite of the usual relationship between price and demand.
To make the similarities between portfolio insurance and using borrowed funds to purchase a bundle of stock more transparent, we can compare the payoffs from using each of these strategies to purchase equities.
What caused Black Monday, the stock market crash of ? | Investopedia
What happens if prices go up? Both the investor using portfolio insurance and the investor using borrowed funds own the risky assets.
And what happens if prices go down? Neither the portfolio insurance investor nor the investor using borrowed funds to purchase stocks end up holding any of the risky assets.
Stock Market Crash of Causes, Effects and Timeline | Stock Picks System
This similarity between purchasing portfolio insurance and purchasing stock on margin is crucial. It explains why both portfolio insurance and purchasing stock on margin may lead to increased sales of risky assets as prices fall. If enough investors follow either or both of these strategies, the aggregate demand curve for risky assets can start to slope upward, and equities start acting like Giffen goods, creating fertile ground for a market crash. It should be noted I am not arguing that portfolio insurance and stocks purchased on margin are identical transactions.
Portfolio insurance and stocks purchased on margin differ in a number of respects, including differences in their duration, the extent to which the decision to exercise the embedded put is voluntary or mandatory, whether the party on the other side of the transaction has recourse against other assets of the investor, and, of course, an investor who is buying stock on margin is using borrowed funds in a way that the portfolio insurance investor is not.
Stock Market Crash Chart and What Caused the Crash | Stock Picks System
My point is that both purchasing portfolio insurance and buying stock on margin follow the same basic strategy, combining the purchase of risky assets with the purchase of a put option. If enough investors follow this strategy, then the aggregate demand curve for risky assets begins to slope upward and the demand for risky assets can evaporate as prices fall.
Just such a dynamic can lead to a market crash similar to those seen in October , October and October TrackBack URL for this entry: Links to weblogs that reference October and October The Link between Buying Stock on Margin and Portfolio Insurance:.
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