The 1987 Crash
OBSERVATIONS FROM THE TRADING FLOOR
DURING THE 1987 CRASH
2007 Introduction: The “Classic” pattern for major crashes is a market high in summer followed by a substantial drop and then a retracement upwards into early October leading to the crash type activity in late October.
These observations show
Why its foolish to believe the hype from “hedge” funds
that they will provide liquidity!
Because the American Monetary Institute works in the monetary area, its not unusual for people to ask us where the markets are going? As a publicly supported charity we don’t give investment advice. But we do have an awareness of these matters and we tell friends the following:
Where the market will go is more a political matter than an economic one. For example:
* If corporations had to properly fund their retirement promises to working people, that could easily knock 25% off the market’s total valuation.
* If the corporations were paying their fair share of taxes in this country, that could easily knock another 25% off the market’s total valuation.
* Proper cost accounting for pollution, and its health effects could knock another
25% off the markets total valuation.
*Removal of special privileges unfairly granted to business, serving to concentrate wealth into the wrong hands could easily remove 25% of the markets value.
* Providing universal health care to all Americans through non-profit governmental programs would probably increase the markets total valuation by 25%!
* Continuing to have the banking system provide almost unlimited funds to the corrupt American financial system is the only reason the stock and real estate markets are at these high levels. If that support increases, it can continue to maintain these high levels.
It is mainly politics and a corrupt media that determines which
of the above take place. And that is what makes it extremely difficult to find any secure values to place ones savings into. If one stays out of the madness, prices can still keep going up out of sight, leaving one “behind.” If one enters the madness, there is always the risk of major crashes, wiping out savings.
That’s what happened in 1987 (written in 1997):
In 1987, I was a floor trader on the New York Futures Exchange (NYFE), a subsidiary of the New York Stock Exchange. I remember well how that crash looked from the floor of the Exchange the week of October 19-23, 1987. The previous week had seen a large drop, with the various indexes closing the prior Friday, right at their long, long term trend lines. Many traders considered this a support level, but at the Monday opening, the market gapped down strongly. …
The two big crash days were Monday and Tuesday, with the bottom arriving on Tuesday. The market had its worst drop ever in one day, falling 508 points on Monday alone.
At that time, the NYFE pit was located adjacent to the New York Stock Exchange. The main contracts traded were the NYSE Composite Index, and the CRB Index.
In my mind’s eye, I remember the trading room those two days, with its high ceiling, as containing a large diffused, electrically charged storm cloud. It was over twenty years ago yet the psychological cloud is still there! So much devastation was occurring all around.
At various stages of the panic, Partners from the major NYSE member firms came down into the futures trading room, looking like death, to check on their agents. I remarked to X, who represented the largest of them that they’d do better to stay in their offices, rather than display that much evident fear.
During the day on Monday the NYFE pit got thinner and thinner as floor traders either got smashed, scared, or had their trading badges revoked by representatives of the clearing houses, who came to the floor to pull out traders they had previously guaranteed. All traders without years of experience were summarily removed. Without a clearing house guarantee they had to stop trading.
Others were allowed to continue trading only “for liquidation”; to make trades which would liquidate their existing positions. One “out-trade” (mistaken trade not later confirmed by the opposing trader) could be devastating under such conditions, where the traders were expected to split the loss (or profit) involved in the disputed trade. They were usually losses because if it was profitable, the opposing brokers trade checker was usually sharp enough to accept it as valid, especially if he heard no other trade checker in the trade checking room calling for the trade as one of theirs.
By Tuesday the NYFE pit opened in the morning with only about 20 “locals” present, compared to a normal number of around 110 persons in the pit. I remember one character was humorously wearing a football helmet. By the end of the day, and on Wednesday there were only from 8 to 12 people in the pit, most of them acting as brokers rather than trading their own accounts. The football helmet had been exchanged for a Samurai headband. That day one of the old standing insults against the NYFE was actually true – that “you could fire a shotgun into the NYFE pit and not hit anyone!”
The CRB (commodity futures index) pit was adjacent to the NYFE pit. Tuesday was the big day in the CRB pit…. The CRB contract closed as usual, at 2 PM on Monday, and almost half of the damage to the stock market had occurred afterward from 2 PM to 4 PM. I had gone short the CRB on Mondays close; but the added severity of the stock market drop left me concerned that gold would react upwards, counter to the stocks.
The CRB index is complex to trade, because prices change in the morning as one or another commodity market opens for trading. Gold is among the first commodities to open, and I thought I could be knocked out of the short position on the opening. But Gold opened limit down.
At the end of the day Tuesday, virtually all the CRB traders deserted the pit, and ran for the hills. Convinced of an imminent banking collapse they withdrew their funds from their clearing houses, thereby losing their trading privileges. One of the clearing houses, unsure of its position, issued them checks which were not signed!
That clearing firm had guaranteed an options market maker who had sold lots of out of the money puts, and had been “blown out” on Monday with a $20 million loss, when those far away puts came into the money. This was a clear demonstration of the limitation of the “Black – Shoales” option valuing system he had used. The error of that system was that those far out puts had been valued at zero, requiring no offset; but there is no such thing as a zero in nature.
It was an interesting case. That options trader had been one of the NYFE’s greatest success stories, having gone in the previous 5 years from $10,000 net worth to $10 million, and was then wiped out in a day, with the clearing house suing him to recover its losses. He had grown very sure of himself, and became convinced of his invincibility, like many involved in today’s markets.
One Problem With Correlation
Six months prior to the crash he had made some errors in the CRB pit over a period of 3 months, dropping several hundred thousand dollars, in a stubborn attempt to hedge a large short position in oil, with long positions in the CRB. He thought this would work because the two contracts had a high positive correlation in the past.
It is always tricky to make that sort of bet, based merely on correlation numbers without real cause and effect connections, or only partial ones. Almost every day for two months that trader bought 10 to 20 CRB futures contracts, paying a premium of 150 points on each contract. His long CRB position was transparent to the pit, and the CRB just kept falling slowly, until the day he sold it out in February 1987.
What probably happened to that trader was that as XX sold him CRB futures, instead of offsetting his position by buying the underlying CRB elements, which would have pushed the price up, XX may have just offset his CRB shorts by buying the oil futures that the trader was short. In other words taking the exact opposite side of the traders position, but having the advantage of the 150 point premium he was charging.
This also points out the problem of transparency. Some brokers made no effort to hide the source of their orders, which would sometimes be raped by the pit. Large orders going into a thin pit (30 or more contracts) should include advance notice of extra compensation for the broker as a reward for good execution. An extra $3 to $8 per contract goes a long way with most brokers, and could save thousands in execution prices.
There were also big success stories from the crash. XXX, who handled the orders for the far away months, was said to have been able to hit a large standing buy order for an out month future on Monday’s opening, and apparently was $5,000,000 richer by Tuesday’s close. Not bad for a twenty two year old kid with no college education, and little prior capital. XXX was truly a success story – he quit the exchange and went back to school.
Wednesday, there were only two traders left in the CRB pit, XX, (who was a major arbitrageur and broker) and myself (I was not a broker). Since XX was the only broker in the pit, when orders to buy or sell came in, he had to pull in a broker from the Composite pit to handle the other side of it, or broker both sides of it, by repeating aloud three times the buy or sell order, and only then, filling it himself.
One thing that the 1987 crash made very clear was that there was no real liquidity in the markets, when it was needed. Virtually all the fund managers tried to do the same thing at the same time: to sell short the stock index futures, in a futile attempt to hedge their stock positions.
They created a huge discount in the futures market, varying from 10 to $12,000 per contract, on a contract which only had a total value of $98,000 at the end of August, and $51,500 at the low point on Tuesday. The S&P futures contract went to a discount of nearly $20,000. The arbitrageurs who bought futures from them at a big discount, turned around and sold the underlying stocks, pushing the cash markets down, feeding the process and eventually driving the market into the ground.
The liquidity situation today would most certainly be similarly inadequate if everyone tries to do the same thing.
Some of the biggest firms in Wall Street found they could not stop their pre-programmed computers from automatically engaging in this derivatives trading. According to private reports they had to unplug or cut the wiring to computers, or find other ways to cut off the electricity to them (there were rumors about fireman’s axes from hallways being used), for they couldn’t be switched off and were issuing orders directly to the exchange floors.
The New York Stock Exchange at one point on Monday and Tuesday seriously considered closing down entirely for a period of days or weeks and made this public. For some reason, it was pretended that such a closure was unprecedented (they were probably ignorant of their own history). It was at this point, in consultations with the Federal Reserve System’s Alan Greenspan, that Greenspan made an uncharacteristic announcement. He said in no uncertain terms that the FED would make credit available to the brokerage community, as needed.
This was a turning point, as Greenspan’s recent appointment as Chairman of the Fed in mid 1987 had been one of the early reasons for the market’s sell off. Greenspan’s extreme concern in “fighting inflation” was known, and this translates in the mind of market participants into monetary contraction and higher interest rates. Apparently he redefined how the money supply would be calculated, for policy decision purposes.
Greenspan’s crucial announcement was, as I characterized in the first report, in “Benjamin Strong fashion”, since Strong had realized his power as a central banker to break any money panic. Market participants began to realize that their brokerages and clearing houses wouldn’t fail due to a liquidity crisis.
The visible cause of the recovery was when the MMI future (Major Market Index) of blue chips began to trade at a premium, midday Tuesday, at a time when one after another Dow stock had been closed down for trading. The meltdown began to reverse. Arbitrageurs bought the underlying stocks, re-opening them, and sold the MMI futures at a premium. It was later found that only about 800 contracts bought in the MMI futures was sufficient to create the premium and start the recovery.
Soon after the crash, maximum daily trading limits and circuit breakers were established by the Stock exchanges; a solution which the agricultural and other commodities markets had used successfully for decades. These limits were a good idea, and I have personally witnessed them in action on several occasions, bringing an end to wild over reactions in the stock index futures. Its remarkable how much panic can be dissipated in a 15 minute breather. However, if there were some factual causal reason for a major sell off, those limits would be only temporary band aids.
This whole experience was very instructive and helpful to me, in accelerating my dropping an ideological commitment to “laissez Faire” free markets. Life became more complex – I no longer had the simple “one theory fits all situations” formula suggested by Ayn Rand’s novels! Unfortunately most libertarians still view those novels as historical “evidence!”
After the trading limits were imposed, an article by a free market ideologue criticized market participants for compromising the free unrestricted market and knuckling under to government in establishing the trading limits! It’s not the first time that those with real experience with market behavior were criticized by ideologues, for accepting compromises and controls on markets. Those with the experience know firsthand some of the limitations of markets and know that at the crunch times, the markets must be able to come back for government help.
One other factor which the crash demonstrated is still not fully appreciated by economists, traders, and investors alike: That the futures “tail” was quite capable of wagging the stock market “dog”. I had learned this earlier in the CRB pit, watching how a purchase or sale of just 10 CRB futures contracts, led within three to five minutes to changes in the prices of the underlying commodity prices. It was a causal relationship, as arbitrageurs who took on the futures long or short position then had to offset these positions in the underlying commodities.
Another important lesson to learn from the 1987 crash was to suspend the normal concept of time, and to follow the rules for support and resistance levels without any consideration for how fast they were being reached.
HOW WE PREDICTED THAT NO DEPRESSION WOULD FOLLOW
The severity of the 1987 crash led immediately to comparisons with 1929, and to questions whether an economic depression would follow. Many traders, who thought of themselves as fearless, had even withdrawn from their clearing houses, fearing that the clearing houses, if not the banking system, would fall.
I told one of them – XXXX – a friend of mine, that if he really planned to be a broker, he had to come back in, with at least the minimum required reserve, and just view it as a necessary part of professionalism in doing his business. He came back on Thursday, and we had three or four people in the CRB pit. So the fear of collapse was real and palpable at the nation’s exchanges.
On Wednesday October 21st, the day after the crash lows, the New York Composite futures had recovered exactly one half of the entire fall from the August highs. It was exactly one half, to the nearest tick! (a tick is the smallest unit of change allowed in the futures contract – $25 in the NYFE Composite) In 1929 the DJIA topped out at 381 in August. After the October 1929 crash bottomed in November at 199 in the DJIA, it took until April 1930 to make a 52% recovery, before going down for 2 ½ more years to new lows, at 41 in the DJIA. Clearly the situations were different.
On the exchange floor a number of CRB traders especially wanted to have some guide from the past, as to what could be expected to happen to commodity prices. We did something unheard of for floor traders – we commissioned research which I supervised, of the 1929 crash, which mainly uncovered the fact that commodity prices had been slowly but persistently falling, for several years prior to 1929. After the crash they continued to fall, for three more years, at a more rapid rate.
In 1987 the situation for commodity prices was very different (see chart # 4, CRB 1985-88). The CRB index had made its all time high of 338 in 1980, a year of surging metals prices, and a 20% prime rate. But the price action since then was not in a consistent decline, but erratic with large rallies and declines, and from August 1986 it had been rising strongly. Furthermore after two wild days in the CRB pit caused by the stock exchange crash, the CRB index resumed its erratic rise.
Commodity prices both before and after the 1987 crash were therefore a strong indication that the crash problem was specific to the mechanics of the stock market, and not a general monetary or economic phenomena. In particular it was related to derivatives trading. The money managers had not fully understood the lack of liquidity in the futures pits. Their rush to sell created 10, 15, and 20 and even 40 handle discounts in the futures pits, compared to cash prices (a “handle” represents 100 points in the index).
Those who bought futures from them at these discounts, then rushed to offset their positions by selling the underlying stocks, “at the market.” This process was repeated all day for two days, and that’s what caused the meltdown of the New York Stock Exchange in October 1987.
Also attached are chart #5 – the US Dollar Index, 1987 crash; and chart #6 – the % year Treasury bond, 1987 crash, for your information on their behavior during this crisis.
The daily trading limits established by the Stock Exchange and the Chicago Mercantile Exchange (the S& P pit) as a means of breaking panics gave participants a moment to think about what they were doing.
One last unfortunate 87 crash incident from the NYFE floor should be mentioned to Europeans, to show the mentality of much of the exchange trading community. On Friday afternoon the week of the crash, one of the NYFE clerks hired a professional stripper, to perform in the NYFE Lounge. I watched most of the traders and clerks again abandon the exchange floor to mob the lounge entrance to ogle the stripper. They considered this a “cool” event. Their mentality was as shallow as the exchange’s liquidity.