Most investors have at least heard of the famous “Black Monday” crash on October 19th, 1987.  It comes up in movies from time to time and there’s no shortage of blog articles where it gets mentioned.  But something that I have noticed is that a lot of people don’t know what happened in the volatility markets that day.

The VIX Index officially launched on January 19th, 1993 so we don’t have any live implied volatility metric to see what happened on Black Monday.  The CBOE  (Chicago Board Option Exchange)  has reconstructed VIX values going back to 1990, but not far enough back to include the crash.

But recall from yesterday’s blog post about “VIX vs VXO”  we do have the “old VIX” calculation method which is called VXO, and those reconstructed values do go back to 1986:

You see that huge black bar on the left that goes up to 150?  That’s Black Monday and as you can see it dwarfed even the financial crisis in 2008.  Let’s zoom in on just October 1987:

So in 1 day the VXO spiked 312.95%

So why do I bring this up?  Well for one I just think it’s incredibly interesting and it’s something that all investors should be aware of.  We are so used to getting excited when the VIX spikes 30%  (which is pretty normal by the way)  but how many people out there know that had it existed the old VIX would have spiked over 300%?

Hopefully it goes without saying why being aware of the historical worst case scenario is valuable for all of our future investing decisions.  So I think there are two important questions to ask:

1)  Can something like this happen again?

2)  What can we do to protect ourselves?

So can it happen again?  Short answer, yes.  I think it’s wise to assume that anything that has already happened in the past could happen again so really this is just a discussion about the likelihood or probability of it happening again.  In general there are two camps, the yes it could and the no it couldn’t.  Let me highlight the two main arguments in this debate:

Argument #1)  Trading curbs or “circuit breakers.”  Since Black Monday, measures have been introduced to help slow down the rate of decline during crashes.  There are three levels that if breached a circuit breaker will kick in:

7% decline  –  Markets are halted for 15 minutes
13% decline  –  Markets are halted for 15 minutes
20% decline  –  Markets close for the remainder of the day

So many argue that these circuit breakers would help reduce major declines from becoming all out crashes because traders will have time to properly analyze what’s happening rather than just a mass rush for the exit.

On the other side of the argument though, it is possible that these circuit breakers could have the opposite effect and actually promote further frantic selling.  There may be increased selling pressure as markets approach halt thresholds, or further mass selling as soon as markets are set to open again.

Ask yourself:  If markets crashed 7% and were halted, would you buy the open or try to be fast on the trigger and sell?  What if they cross level 2 and 13% down?  Buy the dip, or sell as fast as you can?

Of course the cause of the crash and percieved magnitude would need to be taken into account, but the bottom line is we don’t know.  It’s possible that circuit breakers slow things down, and it’s also possible that it would create air pockets of selling from 7% – 13% – 20% and those thresholds may be breached extremely quickly.

Argument #2:  High frequency trading.  It’s not an exact science and there’s different definitions, but high frequency trading likely makes up 50% or more of equity volume and algorithms are fast becoming by far the biggest player in the global equity markets.

I’ve heard people argue that it actually makes markets safer today than they were in the past.  Perhaps it improves liquidity or adds a faster counter balance between buying and selling.

To me those aren’t particularly convincing but I don’t find it hard at all to imagine a situation where the algorithms started flocking together during a crash and amplify the selling.

Hockey games  (I’m Canadian)  in stadiums that seat 20,000+ have plenty of doors for everyone to exit the stadium safely.  But if everyone tries to leave together that doesn’t work.  Equity markets have enough volume for everyone to get their trades done, but what if all the algorithms try to do it at the same time?

So since we really don’t know for sure whether markets are more or less safe than they were in the past, and there’s good arguments on both sides of the debate, why don’t we just assume that what’s happened in the past could happen again and invest accordingly?

Question 2)   What can we do to protect ourselves?

to be continued…  Happy Thanksgiving everyone!


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