Is Your Business Prepared For The Next Economic Downturn?

While the Wall Street Journal's warning of potential market turmoil on October 12, 1987 was prescient, it's important to remember that markets are dynamic, ever-evolving entities. While the use of portfolio insurance may very well be a legitimate cause for concern, it's important to not overlook other potential components that could lead to market turbulence. It's essential to stay informed of current market trends and to be mindful of potential risks, as well as opportunities.

Portfolio insurance was an investment strategy developed in the mid-1980s that used stock index futures and options to reduce risk in a portfolio. Many investors used the strategy in the late 1980s in an effort to protect their investments from market volatility. While the strategy may have sounded like a smart approach, it instead exacerbated the decline of the Dow Jones Industrial Average on Black Monday. The strategy was based on the idea of buying stock index futures and options to protect a portfolio from falling prices, but the strategy backfired because it required the sale of additional stocks as prices declined. This resulted in a massive sell-off of stocks, which caused the Dow to plummet by 22.6%. As a result, many investors lost a significant portion of their portfolios, and the effects of Black Monday are still felt today.

Institutional investors sought out portfolio insurance from Wall Street brokers to help protect against losses during market declines. The brokers used computer algorithms to automatically sell S&P 500 futures contracts short whenever the market went down. As the decline continued, the algorithms would sell more contracts, allowing the investors to protect their portfolios from further losses. This type of portfolio insurance was a great way for institutional investors to safeguard their investments during volatile times.

When trading options, it is important to remember that for every buyer, there is a seller, and for every seller, there is a buyer. Risk management protocols ensure that dealers must buy or sell up to 100 shares of a stock or index for each option, and this means that those with deep pockets can easily manipulate the market. It is important to understand the implications of this, and to be aware of the potential for market turmoil due to the actions of hedge funds and other financial entities.