What is Black Monday?

Key Takeaways

• The black Monday crash was not triggered by a single news event but resulted from a combination of factors,

• Protective measures like trading curbs and circuit breakers have been implemented since Black Monday.

• A well-devised, long-term investment strategy provides the confidence for investors to remain steadfast amid market volatility.

Causes of Black Monday

The significant drop in the stock market didn't happen because of one big news story. No major news came out the weekend before the crash. But a bunch of things came together, making investors really panicky.

1. A Strong Bull Market that needed a Correction

One of the main reasons behind the Black Monday crash was a robust bull market that hadn't seen a significant price correction since 1982. During this time, stock prices had tripled in value.

2. Impact of Program Trading

The 1987 stock market crash highlighted the role of financial and technological innovation in heightened market volatility. In automatic trading, also known as program trading, human decision-making is removed, and buy or sell orders are automatically generated based on the price levels of benchmark indexes or specific stocks. Before the crash, the models in use tended to create vital positive feedback, resulting in more buy orders during rising prices and more sell orders when prices started to fall.

3. Portfolio Insurance

Portfolio insurance, a program trading tactic, appears to be a major player in the events of Black Monday. This strategy aims to protect a stock portfolio from market risk by engaging in short-selling stock index futures. By doing so, it restricts potential losses if stock prices drop, all without the need to sell off the actual stocks. As computer programs initiated the liquidation of stocks upon reaching specific loss thresholds, it resulted in a downward push on prices. This initiated a chain reaction as declining markets triggered more stop-loss orders, and bidding activities ceased.

4. Triple Witching

On October 16, the Friday preceding the crash, witnessed the occurrence of triple witching, a phenomenon involving the simultaneous expiration of stock options, stock index futures, and stock index options contracts. This led to exceptionally high volatility during the final hour of Friday trading, marked by significant sell-offs in the after-hours markets.

5. Mass Panic

Crises, like the tense situation between Kuwait and Iran that posed a risk to oil supplies, heightened investor anxiety. The media has been criticised for amplifying these events. Although various theories attempt to explain the crash, there is a general consensus that widespread panic played a crucial role in exacerbating the crash.

Can It Happen Again?

Following Black Monday, various protective measures, such as trading curbs and circuit breakers, have been implemented in the market to prevent panic-driven selling. Despite these safeguards, the use of high-frequency trading (HFT) algorithms, powered by supercomputers capable of executing massive volumes in mere milliseconds, has contributed to increased volatility.

The 2010 Flash Crash stands as an example of HFT malfunction, causing a rapid 10% decline in the stock market within minutes. In response, tighter price bands were implemented, yet the stock market has still encountered moments of significant volatility since 2010.

During the global crisis in 2020, markets experienced similar losses in March, coinciding with unemployment rates reaching levels not seen since the Great Depression. However, the markets rebounded during the summer of that year.

Lessons to Learn from Black Monday and Other Stock Market Crashes

A market crash, regardless of its duration, is a temporary event. Some of the most significant market upswings have taken place promptly after a sudden crash. The sharp market downturns in August 2015 and January 2016, both amounting to approximately 10% declines, saw a complete recovery, with the market rallying to new or nearly new highs in the subsequent months.

1. Stick to Your Plan

A well-devised, long-term investment strategy aligned with personal investment goals should instill confidence for investors to remain resolute when others are succumbing to panic. Investors without a strategy tend to be guided by their emotions in decision-making.

2. Seize Buying Opportunities

Recognizing that market crashes are temporary, these moments should be viewed as a chance to acquire stocks or funds. Market crashes are unavoidable, and astute investors have a list ready for stocks or funds that become more appealing at lower prices, making purchases when others are selling.

3. Ignore the Noise

In the grand scheme, market crashes like Black Monday are minor blips in the performance of a well-organized portfolio. Short-term market events are unpredictable and soon fade from memory. Long-term investors benefit more by disregarding the media and herd noise, focusing instead on their enduring objectives.

Conclusion

The critical lesson from Black Monday is that improbable events can occur frequently. Incidents like terrorist attacks, wars, earthquakes, tsunamis, pandemics, infestations of murder hornets, ships getting stuck in canals, and unexpected stock market crashes are part of the regular occurrence. While each event may seem improbable individually, the frequency of such unexpected happenings suggests that they are likely to happen.