The Real Cause of the Crash of '87

 | Oct 21, 2017 | 9:10 AM EDT
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The Crash of 1987, now 30 years old, continues to be misunderstood by the financial media. I know. I was there, in the pit, making options markets in Waste Management (WM) , Martin Marietta (MLM) , MCA (Universal) and what is today Barrick (ABX) .

The financial media still think the cause of the crash was a then-novelty known as portfolio insurance.

Portfolio insurance is a hedging tactic where a fund manager sells short S&P 500 futures relative in the size of that short sale as per how much downside insurance he/she needs to protect their long stock portfolio.

The S&P 500 futures selling certainly exacerbated the selling on crash day, but that was a reactive move and thus only a catalyst.

The portfolio insurance market on crash day was as costly as buying car insurance after you crashed your car! In other words, it was quite expensive and continued to be such, especially as the market ran out of buying power near the end of that awful day. 

What I know to be the real cause of the Crash of '87 revolved around this fact: Almost every market maker and fund manager who always hedged longs did not roll their stock options hedges (puts) from the October expiry into the November expiry! I was there, making those put markets on Friday, Oct. 16. And what I began to sense was that either these pros had best start rolling, or down might go Frazier!

What is not reported or probably understood by those who think they know market history is that Oct. 16 was the October expiration day where all the hedges anyone was long (put options) expired (well, actually options expire at 1 p.m. ET the following Saturday -- but you can't buy them on Saturdays!). And nobody rolled those options hedges into the November expiry! Go figure.

Thus the vast majority of options professionals as well as fund managers came into the market on Monday, Oct. 19 un-hedged!

They would stoke a fire for the ages. For many, that lack of prudence would be a funeral pyre.

Since last year's election, the market has basically gone straight up. Put yourself into the shoes and minds of those who, from August 1982 to August 1987, played in a big bullish market that went straight up. One might have felt invincible. Certainly those who consistently shorted naked puts and made nice money doing so for five years felt invincible.

That feeling died a wicked and quick death on Oct. 19, 1987.

Those who played the options trading game felt invincible when, on any downside options expiration Friday for five years, they bought that dip. The reason for that cockiness was that the odds greatly favored that they would be able to flip to close those new longs come the next Monday. It was a 95% or so lock to take that risk.

That lock-flip tactic lasted five years. It was like printing money to play that game. Well, that ended, as the lock got changed, on Oct. 19, 1987.

Far too many pros and fund managers had to feel on that Friday, Oct. 16, that they were smart to buy that day. And that they did not need to roll their expiring October options hedges into November. Instead, they "knew" they could easily roll for a much cheaper debit into any put options hedges on that following Monday (which became crash day).

Pros call this bass-ackwards horrible mess "long and wrong."

Panics start from far too many being long and wrong, especially when no downside hedges are in place.

Will it all set up again is the big question for today or any day in the future.

Take note that I know of fractals and the math of self-similarity. As such, we will "crash" again, but doing so in a self-similar fashion. When? Beats me as I never fight the tape!

Also know that I was one of the very few who was massively short on Oct. 19, 1987. I had begun to buy puts in August when my hand-calculated VIX of sorts (the VIX would be "invented" in 1993, six years after the crash), blended with my own option volatility calculations, was being offered for sale by the options markets at less than 10 number. That for me was the "go short" bell ringing, that setting up in August 1987.

By mid-September I had accumulated over 900 net long puts, most of them (700+) in Waste Management. My WM options graph, the total net of all my options long and short and stock held short (the P&L-type graph showing delta, gamma, theta, et al) looked like a V. The maximum risk in dollars of that entire combination of the WM position was less than $35,000.

The week before crash week is not much of a consideration by those who today opine on the Crash of '87. That is ignorant primarily because it was the precursor and catalyst to the crash. That week preceding the crash saw the market lose almost 10%. Thus, that week broke a five-year trend of up, up and, ah, up.

I would nicely close over 200 long puts that week. Most times a 10% move down in the underlying (stock, index or ETF) equates to 100% gain in your long puts. And like most of my fellow market makers, that feeling of being short the market and right for a change was a good one. Duh.

Yet those gains by the shorts added to that "invincible" feeling.

Buying call options and shorting put options on any expiration Friday, if it was the hard-down expiration move on that day, was the trade tactic du jour for those previous five years. Thus, in order to sell what was presumed to be lock-flip of an up Monday to come had caused far too many pros and fund managers not to roll their long-side hedges come that Oct. 16 expiry.

Long and wrong is a lethal combo. Book it.

And now you can toss in the portfolio insurance mess!

I would eventually close out almost all of those long 700 puts by 2:30 p.m. ET on crash day. The average price of that nice long 700 lot was about 50 cents. I would sell them for an average price of over $11.

And I got long over 200 calls on that crash day's close. Being long calls and long synthetic calls (long stock and at-the-money puts) as well as long 10 S&P 500 futures (hedged!) was my new position on the close of crash day.

All of that newly formed portfolio would be sold the next day by noon when the Dow, et al, would explode up about 15%. That explosion up was thanks to the Fed cutting interest rates a whopping 2% at 8 a.m. on Tuesday, Oct. 20. I still tip my hat to the "G Man," Alan Greenspan, then Fed chairman. 

I have been a contributor to this site for over seven years. I do what I do here because I still have the passion that only trading can create, although my trading days have been retired.

I teach what I know as well as instruct my own growing-up rug rats so they might know what I learned over my 42 Wall Street years.

Please feel free to ask any questions regarding the above. I will answer all inquiries.

And for those who will be attending the Oct. 28 "Symposium for Active Investors," to be held at the Harvard Club of NYC, know that I will answer all your questions on what I know about the Crash of 1987 as well as how any self-similarity might be forming today. 

Join Jim Cramer, Skip Raschke CNBC's Jon Najarian and Other Experts Oct. 28 in New York

Jim Cramer will host Skip Raschke, CNBC's Jon Najarian, TD Ameritrade's JJ Kinahan, famed analytics expert Marc Chaikin and other market mavens on Oct. 28 in New York City to share successful strategies for active investors.

You can join them as they discuss how smart investors can make the most of options trading, futures contracts, fundamental and quantitative analysis and great ETFs to buy right now. Participants will also get a chance to meet Jim and other panelists and take photos.

When: Saturday, Oct. 28, 8 a.m.-3 p.m. ET

Where: The Harvard Club of New York, 35 W. 44th St., New York, N.Y.

Cost: $250 per person.

Click here for the full conference agenda or to reserve your seat now. 

Originally published Oct. 19.

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