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The mechanical causes of the Oct. 19, 1987, crash, which wiped 22% off the value of the Dow Jones Industrial Average in a day, are now a frighteningly large part of the fabric of equity markets in the United States.
So is something else that didn't exist in 1987.
Something that, at the exact worst moment in the trajectory of a crash, will rip the heart of liquidity out of the market without blinking an eye.
In fact, the very nature of the crash will target the people who think they are the safest.
Here's how regulators fed the monster sleeping under passive investors' beds…
The Myth of Portfolio Insurance
Today there isn't just one form of "portfolio insurance," which regulators and academics tagged as the principal accelerator of the '87 crash.
There are thousands of equally suspect portfolio insurance strategies employed by tens of millions of investors that cover trillions of dollars' worth of stocks.
Back in 1987, portfolio insurance amounted to shorting S&P 500 futures against long stock portfolios. According to Paul Tudor Jones, whose hedge fund Tudor Investment Corp. made a small fortune on the '87 crash, about $60 billion in portfolio insurance had been put in place before the crash.
There are still money managers whose trading systems are set up to short-sell index futures if markets start falling. But there are much bigger and more systemic hedging and insurance schemes in effect today.
Risk parity is a portfolio management system that, instead of incorporating outside insurance or hedging devices, aims to rebalance the mix of diversified asset-class investments within a portfolio whenever risks become lopsided. For example, if equity prices were falling, they'd be sold, and the allocation to bonds (which would presumably be rising as traders buy them in a "flight to quality") would be increased.
Target volatility is another internal portfolio balancing strategy that sells assets whose volatility rises (increased price dispersion indicating greater risk) and reallocates capital to less volatile assets or cash.
If you think risk parity and target volatility are similar strategies, you're right. They're both based on volatility. The risk in risk parity is mostly measured by volatility.
Then there's volatility itself.
The VIX, the CBOE Volatility Index that measures how volatile the market is, has become a measure of fear. When the VIX rises, it indicates the risk of a market sell-off or worse.
Besides being an important stock and portfolio metric for Wall Street money managers and traders, volatility's been embraced by Main Street.
There are several tradable volatility instruments based upon the VIX that professional and "retail" traders and investors use to hedge their portfolios, but also to speculate on the actual level of the VIX itself.
What made portfolio insurance so incendiary in 1987 is the same thing that's going to turn all the new stock and portfolio insurance schemes into a fireball one day.
They're all rules-based, and rules don't care about what following them might do.
About the Author
Shah Gilani is the Event Trading Specialist for Money Map Press. In Zenith Trading Circle Shah reveals the worst companies in the markets - right from his coveted Bankruptcy Almanac - and how readers can trade them over and over again for huge gains.Shah is also the proud founding editor of The Money Zone, where after eight years of development and 11 years of backtesting he has found the edge over stocks, giving his members the opportunity to rake in potential double, triple, or even quadruple-digit profits weekly with just a few quick steps. He also writes our most talked-about publication, Wall Street Insights & Indictments, where he reveals how Wall Street's high-stakes game is really played.