“the worst day in U.S.equity markets.”On Tuesday, October 20, 1987, the U.S. financial system almostseized up and ceased to function. After rising almost 200 points asmeasured by the Dow Jones Industrial Average shortly after theopen, stocks fell by an even larger amount by midday and threatenedto fall further. Although the New York Stock Exchange technicallyremained open during the day of the crash and on Tuesday, October20, effectively it was closed as many of the largest stocks were notopen for trading due to delayed openings and temporary closings.32At one point, both the Chicago Mercantile Exchange and the ChicagoBoard Options Exchange temporarily halted trading in stock indexfutures and equity options, respectively, under the assumption thatthe New York Stock Exchange would soon close. The Chicago Boardof Trade remained open as did its thinly traded Major Market Indexfutures market. (The Major Market Index resembled the Dow JonesIndustrial Average.) Suddenly, stock prices rose. The catalyst for theturnaround was a sharp inexplicable rally in the thinly traded MajorMarket Index stock index futures contract traded on the ChicagoBoard of Trade. (To be sure, a number of announcements of stockbuybacks by corporations may also have played a role.) Someobservers contend that the Major Market Index futures contractprice may have been manipulated to induce substantial buy orders ofmajor stocks.33 The Dow Jones Industrial Average closed up 102.27points or 5.9% on record trading volume. The S&P 500 stock indexclosed up over 5%. The rally was not broad-based in that NYSE losersfar outnumbered NYSE gainers and the Nasdaq Composite Indexclosed down 9.9%.34
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The October 1987 crash has been much studied. Not surprisingly,the causes of the October 19, 1987 stock market crash remain controversial. Many academic studies suggest that the event was consistentwith informationally efficient capital markets.35Other market observers dispute that point. For example,legendary trader George Soros argues that reflexive (i.e., positivefeedback type) behavior among market participants makes “financialmarkets inherently unstable.”36 Mr. Soros goes on to argue that“trend-following speculation (such as indexing, performance measurement, and technical analysis) and trend-following devices (such asportfolio insurance and option writing) disrupt the balance” betweenbuyers and sellers on financial markets.There are several lessons from the crash of October 19, 1987.1. There may not be any apparent fundamental economic reasonfor a crash.2. Institutional considerations such as trading strategies and positions of key market participants can play an important role.3. Selling may be concentrated among a few market participants,rather than widespread, and still have a significant adverseimpact on market prices if the orders are insensitive to transaction prices.4. Other financial markets may not react immediately to news of acrash in equity prices. For instance, Treasury bonds were downfor most of the day and did not start to rally until after stocksclosed 508 points lower on the day. The magnitude of the subsequent rally was enormous. Treasury bonds had their biggest oneday rally ever. The move was not approached until October 31and November 1, 2001 when Treasury bonds rallied sharply onthe news that the 30-year Treasury bond would be discontinued.
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5. Trading theses may change suddenly. After the 1987 stock market crash, Treasury bond prices became linked to stock marketprices. If stock prices rose, bond prices would fall, and viceversa. Once again, traders did not want to miss out on a bondmarket rally as large as occurred after the October 1987 stockmarket crash.6. Another sobering lesson from the crash and the days immediately following it is the fragility of the financial system. TheU.S. Treasury bond market dwarfs the stock market in tradingvolume. Yet, none of the major commercial and investmentbanks would make a market on Tuesday, October 20, 1987because the CBOT Treasury bond futures market was locklimit up.37 Although some might cite counterparty risk, theunwillingness of dealers to make a market in Treasury securities was true for any of their customers including the WorldBank whose obligations are guaranteed by the member countries who own it. The unwillingness of dealers to make a marketin U.S. Treasury securities to even the World Bank illustratesthe hesitancy of many financial institutions to take on directional risks outright. Put differently, the amount of risk takingwas dependent on the relatively thinly capitalized locals on thefloor of the Chicago futures markets.On Friday, October 13, 1989, the U.S. stock market fell sharply inwhat came to be called the mini-crash. The DJIA closed down 6.9%with most of the190-point price decline occurring in the last hour oftrading. Although there was an external trading catalyst for theevent—the collapse of the proposed buyout of United Airlines(UAL)—many market observers attributed the sharp decline towaves of selling from computerized program trades. Given the sharprise in Treasury bond prices that followed the 1987 stock marketcrash, Treasury bond prices were bid up in an apparent flight to safetywhile junk bond prices fell.38
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As is readily apparent, the preceding paragraph discusses howmarket participants reacted to the sharp declines in equity prices onFriday, October 13, 1989 by bidding up Treasury bond prices. This iswhat happened on a delayed basis after the crash of 1987. Notice thatboth the dollar and junk bond prices fell.
Asian Financial Crisis and MarketContagionFinancial crises may be localized to a single market or affect severalmarkets. As was noted in an earlier chapter, the effects of the AsianFinancial Crisis extended beyond Asian financial markets. Pricedeclines on Asian markets affected emerging markets in Central andEastern Europe and Latin America. To be sure, the U.S. dollar roseagainst several Asian currencies and the stock prices of individualcompanies were affected. However, the overall U.S. stock market waslargely unaffected by the Asian Financial Crisis. Arguably, the mostsignificant single impact of the Asian Financial Crisis on the U.S.stock market occurred on Monday, October 27, 1997 in the wake ofsharp declines in the Hong Kong stock market. U.S. stocks fell 554points, or over 7%, as measured by the DJIA. However, the durationof the impact was essentially limited to a single day. On Tuesday,October 28, 1997, the U.S. stock market rose sharply.Not only was the impact of falling Asian stock prices on the U.S.stock market short-lived, the magnitude of the decline in the DJIAwas significantly lower than other markets. Brazilian markets wereespecially hard hit. For instance, Brazilian stocks fell 6% on Wednesday, October 29, 1997 and 9.8% on Thursday, October 30, 1997.39Again, the trading catalyst was sharp (but smaller) declines in Asianstocks. In this case, the contagion of the Asian Financial Crisis waslargely limited to emerging markets. The trading lesson that emerges
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is that foreign financial market crises are less likely to affect U.S.financial markets than U.S. financial market crises are to affect otherfinancial markets.
Trading LessonsLarge price changes can occur in financial markets without anyapparent fundamental economic reason. This was illustrated by thecrash of October 19, 1987 (“the worst day in history for the U.S.equity market”) and the subsequent rally on Tuesday, October 20,1987. It was also apparent in the attempted silver corner during 1979and 1980 and in the prospective unwinding of the corner duringMarch 26 and 27, 1980. In the preceding incidents, the tradingactions of key market participants exerted substantial impact on thebehavior of market prices. These episodes were also characterized bysubstantial volatility in prices. Although the trading catalysts wereoften localized to one market, the impact of the resulting pricechanges spread to other markets. This does not mean that fundamental economic information does not matter; rather, in the short run,other considerations—namely, market dynamics or the trading positions and strategies of key market participants—may play a large rolein determining price changes.Moreover, such incidents are not a phenomenon of the seemingly“distant” past but remain a recurring feature of financial markets. Amore recent example in this regard is the nearly 14% decline inNYMEX April 2006 silver futures prices on Thursday, April 20, 2006,which is depicted in Figure 9.7. Despite a 15-minute trading halt, thedecline in silver futures prices continued after trading was allowed toresume. Contemporary news accounts attributed the decline to“profit-taking.”40 The steep price decline in New York silver futuresprices precipitated an even larger, almost 16% decline in the frontmonth April 2006 silver futures contracts traded on the Tokyo Commodities Exchange (TOCOM) on April 21, 2006.41
296
1500.01450.0
4/20/06date.open 1445.5date.high 1469.0date.low 1220.0date.close 1252.5
1400.01350.01300.01250.01200.01150.01100.01050.01000.0950.0
4/20/06
900.0850.0800.0750.0700.011/3/05
12/3/05
1/3/06
2/3/06
Daily trading range of NYMEX front month silver futures prices from October 1, 2005 to April 21, 2006.
FIGURE 9.7
A sudden break in silver futures prices.
3/3/06
4/3/06
TRADING CATALYSTS
10/3/05
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The most important lesson is that trading is a game. Many tradingstrategies have an objective of inducing positive feedback trading. Thismeans that market participants may try to force weaker hands out ofthe game by pushing prices enough in one direction to set off stops.Similarly, knowing how other market participants are likely to react tolarge changes in market prices may assist other traders in anticipatingfuture short-run price changes. The widespread knowledge that somemarket participants during the October 1987 crash used portfolioinsurance strategies encouraged other traders to short the market inadvance of likely mechanical sales from portfolio insurers.Special risks may arise in trading during these time periods. Forinstance, liquidity may dry up, making it difficult to trade. Rapidlychanging prices may entail considerable trade execution or slippagerisk. Exchanges may impose restrictions that effectively change therules of the game mid-stream and benefit one side of a trade resultingin sharp price changes. In addition, a crisis in one market may degenerate into a general liquidity crisis in which losses may arise on bothlegs of “hedged” positions.The examples considered in this chapter demonstrate that internal market catalysts often exert a more powerful effect on marketprices and volatility than external market catalysts. Moreover, theinfluence of internal market catalysts on market prices often lastslonger than external market catalysts. However, the game-like natureof trading is more apparent with internal market catalysts.
ReferencesBrancaccio, David. Marketplace. October 30, 1997 (http://marketplace.publicradio.org/shows/1997/10/30_mpp.html).Chancellor, Edward. Devil Take the Hindmost: A History of FinancialSpeculation. New York: Farrar, Straus and Giroux, 1999.
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Coll, Steve. “Stock Market Takes Biggest Nose Dive Yet; Dow Falls108 Points in Frenzied Trading.” The Washington Post, October 16,1987.Coy, Peter. “Panic Sweeps Stock Market; Plunge Rivals 1929 Crash.”The Associated Press, October 19, 1987.The Financial Times. September 27, 2002.Garber, Peter M. Famous First Bubbles: The Fundamentals of EarlyManias. Cambridge, MA: MIT Press, 2000.Harvard Business School. “Long-Term Capital Management, L.P.(D).” 1999.Hiatt, Fred. “Japanese Stocks, Yen Sink; Nikkei’s 28,002 CloseLowest in 17 Months.” The Washington Post, April 3, 1990.Keynes, John Maynard. The General Theory of Employment, Interestand Money. New York: Harcourt, Brace & World, 1936, p. 154.Kindleberger, Charles P. Manias, Panics and Crashes, A History ofFinancial Crises. John Wiley, 2001.Maidenhead, H.J. “Silver Prices Decline on New York CommodityExchange on Sept 12 After…” New York Times Abstracts, September13, 1979.McNair, George. The Globe and Mail. January 26, 1980.McNair, George. “Silver Price Drop Is Felt in Markets.” The Globeand Mail, March 28, 1980.Mittelstaedt, Martin. “Stock Prices Plunge in Panic Selling UAL Buyout Problems Trigger Drop.” The Globe and Mail, October 14, 1989.Norris, Floyd. “Shadow on a Market.” The New York Times, August18, 1991.Norris, Floyd. “The Crash of 1987—Men and Machines WreakHavoc on Wall Street.” Barron’s, October 26, 1987.Partridge, John. “Silver Dive Halts Trading, Rattles Markets, AnalystsBlame Speculators, Profit Taking for 14 Per Cent Drop Biggest since1983.” The Globe and Mail, April 21, 2006.
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Perold, Andre F. “Long-Term Capital Management, L.P. (D).” Harvard Business School Publishing, 1999.Platts Commodity News. “TOCOM Front-Month Silver Plunges by16% Friday on Panic Sell-Off.” April 21, 2006.Report of the Presidential Task Force on Market Mechanisms. January 1988, U.S. Government Printing Office, pp. 29-42.Santoni, G.J. “The October Crash: Some Evidence on the CascadeTheory.” Federal Reserve Bank of St. Louis.Schleifer, Andrei. Inefficient Markets. New York: Oxford UniversityPress, 2000.Soros, George. “Brady Commission Should’ve Stressed Market Stability.” The Wall Street Journal, January 14, 1988.Stewart, James B., and Daniel Hertzberg. “Terrible Tuesday: Howthe Stock Market Almost Disintegrated a Day After the Crash—Credit Dried Up for Brokers and Especially Specialists Until FedCame to Rescue—Most Perilous Day in 50 Years.” The Wall StreetJournal, November 20, 1987.The Toronto Star. “Tokyo Stock Plunge Drags Down Asian Markets.”February 26, 1990.The Wall Street Journal. “Bill Rates Drop; Dealers Say Mart Went‘Nuts’ on Hunt Woes.” March 28, 1980.The Wall Street Journal. “Silver Price Falls $10 to $34 an Ounce inRecord 1-Day Drop.” January 23, 1980.The Wall Street Journal. “Gold, Silver Speculators Return to Market;Cause Is Uncertain.” November 29, 1979.The Wall Street Journal. “COMEX Names Committee to ProbeRecent Spurt in Silver Prices.” October 5, 1979.U.S. Commodity Futures Trading Commission. “Report of the Commodity Futures Trading Commission on Recent Developments in theSilver Futures Markets.” Committee on Agriculture, Nutrition, andForestry of the United States Senate, U.S. Government PrintingOffice, May 1980, pp. 83-86.
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Vartan, Vartanig G. “Dow Jones Industrial Average Declines 2.14Points to Close at 759.58 on March 27.” New York Times Abstracts,March 28, 1980.Vise, David A. “Dow Regains 102 Points in Another Wild Day; OtherIndexes Slide, Blue Chips Rally on Record Volume.” The WashingtonPost, October 21, 1987.
Endnotes1
John Maynard Keynes. The General Theory of Employment, Interest andMoney. New York: Harcourt, Brace & World, 1936, p. 154.
2
H.J. Maidenhead. “Silver Prices Decline on New York Commodity Exchange onSept 12 After…” New York Times Abstracts, September 13, 1979.
3
Silver futures were also traded on the Chicago Board of Trade. The Commodities Exchange later merged with the New York Mercantile Exchange. “COMEXNames Committee to Probe Recent Spurt in Silver Prices.” The Wall StreetJournal, October 5, 1979. The article notes that: “The Hunt family,…who havebeen big silver buyers in the past, also is thought to be in the market.”
4
The Wall Street Journal. “Gold, Silver Speculators Return to Market; Cause isUncertain.” November 29, 1979.
5
As the name suggests, position limits refer to the maximum number of futures oroption contracts that a speculator can have at any one point in time. Position limits are set by an exchange or other regulatory authority. The principal ideabehind position limits is to limit the influence of an individual speculator on market prices. There are no position limits for hedgers.
6
The Wall Street Journal. “Silver Price Falls $10 to $34 an Ounce in Record1-Day Drop.” January 23, 1980.
7
George McNair. The Globe and Mail, January 26, 1980. It should be pointed outthat the highest futures price of gold was reached on Monday, January 21, 1980when COMEX gold futures hit $875 per troy ounce—that is, the price of goldfutures peaked one trading day after the price of silver peaked.
8
It also would conceivably provide the liquid wherewithal to possibly buy moresilver.
9
U.S. Commodity Futures Trading Commission. “Report of the CommodityFutures Trading Commission on Recent Developments in the Silver FuturesMarkets.” Committee on Agriculture, Nutrition, and Forestry of the UnitedStates Senate, U.S. Government Printing Office, May 1980, pp. 83-86.
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10
U.S Commodity Futures Trading Commission. “Report of the CommodityFutures Trading Commission on Recent Developments in the Silver FuturesMarkets.” Committee on Agriculture, Nutrition, and Forestry of the UnitedStates Senate, U.S. Government Printing Office, May 1980, pp. 83-86.
11
George McNair. “Silver Price Drop Is Felt in Markets.” The Globe and Mail,March 28, 1980.
12
Vartanig G. Vartan. “Dow Jones Industrial Average Declines 2.14 Points to Closeat 759.58 on March 27.” March 28, 1980.
13
The Wall Street Journal. “Bill Rates Drop; Dealers Say Mart Went ‘Nuts’ onHunt Woes.” March 28, 1980.
14
Floyd Norris. “Shadow on a Market.” The New York Times, August 18, 1991.
15
To understand how Salomon Brothers profited from the short squeeze, it isimportant to know some institutional details of the Treasury market. The Treasury market is enormous and the dollar value of trading easily dwarfs the stockmarket. Treasury securities are even traded before they are issued in the whenissued market—a kind of informal forward market that exists between theannouncement of a Treasury auction and the actual issuance of the securities.
16
As a side note, at the time, legendary trader John Meriwether ran the bond arbitrage group at Salomon, which accounted for virtually all of the firm’s profits. Hewas also vice chairman and head of Salomon’s fixed income department at thetime but unaware of, and uninvolved in, the Treasury bid-rigging scandal. Meriwether left Salomon and later formed his own hedge fund, Long-Term CapitalManagement, taking a number of talented Salomon coworkers with him.
17
Andrei Schleifer. Inefficient Markets. New York: Oxford University Press, 2000.
18
Peter Garber contends that most commonly considered bubbles were actuallyconsistent with rational expectations and a generally efficient market.Peter M. Garber. Famous First Bubbles: The Fundamentals of Early Manias.Cambridge, MA: MIT Press, 2000.In contrast, Charles Kindleberger and Edward Chancellor make the case for theexistence of manias and bubbles in their separate books. Edward Chancellor.Devil Take the Hindmost: A History of Financial Speculation. New York: Farrar,Straus and Giroux, 1999. Charles P. Kindleberger. Manias, Panics and Crashes, AHistory of Financial Crises. John Wiley, 2001.
19
The Toronto Star. “Tokyo Stock Plunge Drags Down Asian Markets.” February26, 1990.
20
Fred Hiatt. “Japanese Stocks, Yen Sink; Nikkei’s 28,002 Close Lowest in 17Months.” The Washington Post, April 3, 1990.
21
As noted earlier, the Federal Reserve Board chose not to increase marginrequirements during this time period, which would have reduced the ability ofindividual investors to lever their stock holdings.
22
The Financial Times. September 27, 2002.
23
Market participants may disagree over whether the Federal Reserve has beensuccessful in this regard.
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24
Andre F. Perold. “Long-Term Capital Management, L.P. (D).” Harvard BusinessSchool Publishing, 1999. This case consists of a letter from John Meriwether toLTCM investors during the crisis. Liquidity provision strategies are strategiesdesigned to profit from investing in less liquid securities.
25
Steve Coll. “Stock Market Takes Biggest Nose Dive Yet; Dow Falls 108 Points inFrenzied Trading.” The Washington Post, October 16, 1987. The article notes:“…Investors and analysts attributed today’s heavy retreat to snowballing fearsthat the stock market’s huge five-year rally may be ending. They also worried thatthe sharp selloff may roll into other financial markets around the world or undermine the growth of the U.S. economy.”
26
The short-term peak of the Dow Jones Industrial Average occurred on August25, 1987 when the Dow closed at 2722.42.
27
Peter Coy. “Panic Sweeps Stock Market; Plunge Rivals 1929 Crash.” AssociatedPress, October 19, 1987.
28
Floyd Norris. “The Crash of 1987—Men and Machines Wreak Havoc on WallStreet.” Barron’s, October 26, 1987. The article notes that at one point on Tuesday, October 20, 1987, Japanese stock index futures traded in Singapore at a discount to cash that was so large that it implied a 75% decline in Japanese stockprices.
29
That is, create a security whose payoffs match those of a put option.
30
Report of the Presidential Task Force on Market Mechanisms, January 1988,U.S. Government Printing Office, pp. 29-42.
31
Report of the Presidential Task Force on Market Mechanisms, January 1988,U.S. Government Printing Office, pp. 29-42.
32
The Washington Post reported that 95 NYSE stocks had delayed openings and183 stocks had trading due to order imbalances. David A. Vise, “Dow Regains102 Points in Another Wild Day; Other Indexes Slide, Blue Chips Rally onRecord Volume,” The Washington Post, October 21, 1987.
33
James B. Stewart and Daniel Hartzberg. “Terrible Tuesday: How the Stock Market Almost Disintegrated a Day After the Crash—Credit Dried Up for BrokersAND Especially Specialists Until Fed Came to Rescue—Most Perilous Day in50 Years.” The Wall Street Journal, November 20, 1987.
34
David A. Vise. “Dow Regains 102 Points in Another Wild Day; Other IndexesSlide, Blue Chips Rally on Record Volume.” The Washington Post, October 21,1987.
35
For example, G.J. Santoni. “The October Crash: Some Evidence on the CascadeTheory.” Federal Reserve Bank of St. Louis.
36
George Soros. “Brady Commission Should’ve Stressed Market Stability.” TheWall Street Journal, January 14, 1988. Soros argues:…The concept of rational expectations doesn’t apply when those expectations relate to events that are themselves contingent on the participants’ decisions. The events cease to be uniquely determined andparticipants are confronted with genuine uncertainty. They are forced totake a view and the bias they bring to bear plays a role in the outcome.
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37
Some futures contracts are restricted in terms of the maximum price move up ordown they can make during a trading day. A limit move essentially closes tradingfor the day as market participants are unwilling to sell at a below market price inthe case of a lock-limit up move or buy at an above market price in the case of alock-limit down move.
38
Martin Mittelstaedt. “Stock Prices Plunge in Panic Selling UAL Buyout Problems Trigger Drop.” The Globe and Mail, October 14, 1989. The article notes:…long-term U.S. Treasury bond[s]…rallied nearly $17 for each $1,000face amount and the yield declined to 7.88 per cent from 8.03 per cent.Meanwhile, junk bonds…dropped precipitously. The prices of someissues fell more than $20.
39
David Brancaccio. Marketplace. October 30, 1997 (http://marketplace.publicradio.org/shows/1997/10/30_mpp.html).
40
John Partridge. “Silver Dive Halts Trading, Rattles Markets, Analysts BlameSpeculators, Profit Taking for 14 Per Cent Drop Biggest since 1983.” The Globeand Mail, April 21, 2006.
41
Platts Commodity News. “TOCOM Front-Month Silver Plunges by 16% Fridayon Panic Sell-Off.” April 21, 2006.
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10THE ACCIDENTALCATALYST
“We learn little from victory, much from defeat.”—Japanese proverb
The Large Cost of Small ErrorsAt 9:27 A.M., on December 8, 2005, a trader at Mizuho SecuritiesCompany—a prominent Japanese brokerage firm—inadvertentlyoffered to sell 610,000 shares of J-Com, a newly issued stock, at oneyen each rather than offering one share of J-Com at 610,000 yen.Given that the exchange rate was approximately 120.27 yen to thedollar, this was the equivalent of offering to sell a $5,072 stock at lessthan a penny a share. Although the trader quickly recognized hiserror and attempted to cancel the order several times, it was too late.
305
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A malfunction in the Tokyo Stock Exchange trading system, coupledwith inadequate exchange oversight over unusual orders, preventedthe trader from canceling the erroneous order.1At the time the order was placed, another broker was bidding¥672,000 for J-Com stock. That bid was hit as were all other bidsabove ¥572,000. Within three minutes, the large sell order caused theprice of J-Com stock to plunge by ¥100,000—the maximum dailydecline allowed under exchange rules—as the unfilled balance of theorder automatically became an order to sell at the lower limit of¥572,000 per share. Note that no one was able to buy J-Com at ¥1 pershare. However, the balance of the large sell order was still in the system. Rumors quickly spread that the trade was an error and by 9:40A.M., the price of J-Com rose to ¥772,000—the maximum amount thestock was allowed to rise—as traders jockeyed to buy shares.2 Theprice impact of the error was exacerbated by the fact that the stockwas newly listed on the Tokyo Stock Exchange and there were only3,000 shares available for trading.3 Trading in J-Com stock was suspended until December 14, 2005.Over 700,000 shares of J-Com stock were traded on December 8,2005 and a special settlement price of ¥912,000 was established forJ-Com stock traded on December 8, 2005 with settlement occurringon December 13, 2005.4 Individuals or organizations that boughtJ-Com stock on that day were paid the difference between their purchase price and the special settlement price.5The price of J-Com continued its upward spiral after tradingresumed on December 14, 2005 and the stock peaked in late December 2005