Black Monday 1987

Topics: Stock market, Futures contract, Option Pages: 5 (1614 words) Published: September 17, 2012
The Stock Market Crash of 1987: Black Monday
The “S&P 500”, or “Standard and Poor’s 500 Index”, is an index of 500 stocks that is designed to be a leading indicator of U.S. equities and is meant to reflect the risk and return characteristics of all stocks in the United States market. This, along with the Dow Jones Industrial Average, is one of the most commonly used benchmarks to determine how well the market is doing, and it is even considered by many experts to be the definition of the U.S. market. On October 19, 1987, a day known as Black Monday, the S&P 500 fell about 20 percent in what was one of the largest stock market crashes in United States History. The causes of the crash are derivative securities, computer trading, illiquidity, and the U.S. trade and budget deficits. While most economists generally consider these to be the causes of the 1987 stock market crash, they are frequently debated, and there is evidence to both sides of the argument for each cause.

Securities are something that you can own and trade on a secondary market. They allow you to own a certain asset without ever actually taking possession of the asset. There are three types of securities, which are equity securities, debt securities, and derivative securities. Equity securities mainly involve stocks and the stock market. This involves buying and selling shares of a corporation on a stock trading market such as the NASDAQ, NYSE, and many foreign markets. Debt securities are loans that you give to companies or even the government in the form of bonds. When a company needs to raise money for any particular reason they issue bonds at a certain price with an interest rate that allows the buyers to gain an almost guaranteed profit on their investment. Many investors prefer to invest in bonds instead of stocks because they are safer and much less of a risk to take. However, with risk comes reward and the stock market can provide a large reward if played correctly.

The last type of securities are derivative securities. These are unlike the other two types of securities because rather than buying or selling actual stocks or bonds, investors buy or sell only the rights to buy or sell stocks at a particular price. Investors do this because they believe that it is a better way to maximize their profits. It can maximize profits because the investors buy a futures contract at a small fee that allows them to purchase the stock for a certain price at a certain date. At the date that was agreed upon, if the price that the particular stock is selling for is higher than the price that they paid the fee to gain the rights to, they will exercise their futures contract option and purchase the stock at the lower negotiated price and immediately resell it for a quick profit. T his is considered less of a risk than buying actual stocks because instead of purchasing a number of shares and hoping for the price to go up to gain a profit, you are only paying a small fee to potentially earn the same profit. The only reason investors would agree to sell the call option to another investor is because they get to keep the fee paid by the buyer if the price of the stock goes down, prompting the buyer not to exercise his option. The risk that the buyers of the call option are taking is that they will waste their money by paying the fee and not exercising their option, but they see this as less of a risk than buying actual shares of stock.

The reason that these derivative securities caused the stock market to crash in October of 1987 is because the derivatives market and the stock market were not acting in sync. People holding stocks that figured they would go down decided to sell futures contracts to protect themselves from losing too much money on dropping stock prices. This caused a lot of problems for the stock market that ultimately contributed to the crash. “’Markets continued to decline on Friday, as ongoing anxiety was augmented by some technical factors....
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