What Happened in 1987, Could It Happen Again?
A play-by-play recounting of the different phases of option selling prior to the 1987 crash.
The market grinded higher for years with few pullbacks and funds were created (as always) to take advantage of this type of market action: lower and lower stock volatility over time (they became the best performers and therefore, had huge amounts of capital).
These funds would buy stock and sell calls simultaneously (called a buy-write) to earn the time premium of at-the-money. I remember that they actually calculated a rate of return on the strategy by dividing the time premium (income) by the stock price (the investment cost).
An offshoot of these funds called "dividend capture funds" did the same thing, but sold in-the-money options (against long stock) on companies that had a fairly high dividend. These were supposed to earn "bond-like" returns with bond-like risk. Both strategies have the same risk profile as "short puts" and these funds kept selling them, driving the implied volatility of options lower and lower.
This was the first phase of option selling.
The market makers and broker-dealers took the other side of this strategy, hedged themselves and just traded the volatility. Then as market volatility kept declining, they too began to sell out-of-the-money puts against the strategy to add a "kicker" to the minimal amount of money they were making (since the volatility of the market was so low). This was not overly dangerous but it left the market vulnerable.
This was the second phase of option selling.
Then the market-makers and broker dealers became greedier and began selling lots of out-of-the-money puts against their positions. In other words, they were selling twice as much out-of-the-money puts than prudence would dictate. They thought it was free money.
This lasted for quite some time and became more extreme.
This was the third phase of option selling.
In the beginning in 1986 there was actually a fourth phase of option selling, the now infamous "portfolio insurance".
I worked at Morgan Stanley (MS) and portfolio insurance was the brain child of some "mathematicians" in the fixed-income department. Looking back it is evident that the models they used to structure portfolio insurance did not correctly interpret the distribution of returns of stocks: unlike bonds, they have much "fatter tails."
Above all, Wall Street is a marketing machine made to come up with new products, financial engineering, to sell to their clients. And this was a doozy. MS (subsequently other broker dealers caught on quickly and offered the product too) approached "long-only" funds to offer "insurance" cheaply, so cheaply in fact that they could not resist.
Essentially the pitch offered the fund's manager a deductible (say 2% downside) and the fund's performance was insured by the broker-dealer for a fee (the premium).
This looks and smells like the BD was offering the fund manager a "synthetic" put, good enough. But reading through the fine print, it really wasn't. It was really just a "best efforts" basis and the ultimate liability was still on the fund. Whether these managers realized this or not I do not know; if they did, the BD did a great job of convincing them that this would be no problem.
Essentially, what the broker-dealer was offering was to sell S&P 500 futures against the fund's amount of capital as the market dropped so that the fund would be short futures in the exact amount of their capital once the market reached the deductible level.
If the market began to rise, the broker-dealer would then buy the futures back so the fund could participate on the upside. In essence, the broker-dealer had to correctly estimate the volatility of the market: if the market was more volatile than expected, it would cost the fund more than anticipated to insure the portfolio.
Here is the heart of the matter. When a fund buys a real put, the price goes up so that supply matches demand. The market can always bear the demand for puts because the gamma (leverage) goes down as the price goes up. As the price of options goes up and the gamma goes down, the leverage in the system inherently decreases.
With portfolio insurance, the broker-dealer never raised the price; the BDs offered insurance at the same price regardless of demand. As a result, fund managers bought gobs of the insurance at low prices and loaded up the market for a potential disaster: the amount of potential futures trading necessary to insure portfolios dwarfed the liquidity of the market. In geek terms, the gamma in the market rose to incredible levels.
We had huge funds shorting puts, market makers shorting puts and broker-dealers through portfolio insurance shorting "synthetic" puts in size. An out of the money SPX put that should have traded at $1 was trading at $.06!
When the market began to trade lower (because yields were rising and the dollar was falling), the market began to experience heavy selling to hedge the abundance of out-of-the-money puts that, all of a sudden, had much larger deltas.
By Monday morning there was too much selling of futures for the market to bear and it crashed. The 1987 crash had nothing to do with valuation-it was purely structural in nature.
Every market is different. There is no doubt that leverage like 1987 could come from somewhere else. In 1998, it came from huge leverage in a few hedge funds that were inextricably tied to the broker-dealer system. In the future it may come from the huge OTC derivative market that exists.
I check the rearview mirror at least once a day now.
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