using portfolio insurance strategies tried to sell index futures to protect
their clients’ profits that the futures market collapsed. There were ab-
solutely no buyers, and liquidity vanished.
What the overwhelming majority of stock traders once believed
was inconceivable became a reality. Since the prices of index futures
were so far below the prices of the stocks selling in New York, investors
halted their buying of shares in New York altogether. The world’s largest
corporations failed to attract any buyers.
Portfolio insurance withered rapidly after the crash. It was dramat-
ically demonstrated that it was not an insurance scheme at all because
the continuity and liquidity of the market could not be assured. There
was, however, an alternative form of portfolio protection: index options.
With the introduction of these options markets in the 1980s, investors
could explicitly purchase insurance against market declines by buying
puts on a market index. Options buyers never needed to worry about
price gaps or being able to get out of their position since the price of the
insurance was specified at the time of purchase.
Certainly there were factors other than portfolio insurance con-
tributing to Black Monday. But portfolio insurance and its ancestor, the
stop-loss order, abetted the fall. All of these schemes are rooted in the
basic trading philosophy of letting profits ride and cutting losses short.
Whether implemented with stop-loss orders, index futures, or just a
mental note to get out of a stock once it declines by a certain amount, this
philosophy can set the stage for dramatic market moves.
CIRCUIT BREAKERS
As a result of the crash, the Chicago Mercantile Exchange, where the
S&P 500 Index futures traded, and the New York Stock Exchange imple-
mented rules that restricted or halted trading when certain price limits
were triggered. To prevent destabilizing speculation when the Dow
Jones Industrial Average changes by at least 2 percent, the New York
Stock Exchange’s Rule 80a placed “trading curbs” on index arbitrage be-
tween the futures market and the New York Stock Exchange.^4
But of greater importance are measures that sharply restrict or stop
trading on both the futures market and on the New York Stock Exchange
when market moves are very large. When the S&P 500 Index futures fall
by 5 percent, trading in futures is halted for 10 minutes. If the Dow In-
276 PART 4 Stock Fluctuations in the Short Run
(^4) The New York Stock Exchange Index replaced the Dow Jones Industrials to compute the 2 percent
collar in 2005.