Most Popular
1. It’s a New Macro, the Gold Market Knows It, But Dead Men Walking Do Not (yet)- Gary_Tanashian
2.Stock Market Presidential Election Cycle Seasonal Trend Analysis - Nadeem_Walayat
3. Bitcoin S&P Pattern - Nadeem_Walayat
4.Nvidia Blow Off Top - Flying High like the Phoenix too Close to the Sun - Nadeem_Walayat
4.U.S. financial market’s “Weimar phase” impact to your fiat and digital assets - Raymond_Matison
5. How to Profit from the Global Warming ClImate Change Mega Death Trend - Part1 - Nadeem_Walayat
7.Bitcoin Gravy Train Trend Forecast 2024 - - Nadeem_Walayat
8.The Bond Trade and Interest Rates - Nadeem_Walayat
9.It’s Easy to Scream Stocks Bubble! - Stephen_McBride
10.Fed’s Next Intertest Rate Move might not align with popular consensus - Richard_Mills
Last 7 days
Stock Market Up 8 Out of First 9 months - 13th Dec 24
What Does a Strong Sept Mean for the Stock Market? - 13th Dec 24
Is Trump the Most Pro-Stock Market President Ever? - 13th Dec 24
Interest Rates, Unemployment and the SPX - 13th Dec 24
Fed Balance Sheet Continues To Decline - 13th Dec 24
Trump Stocks and Crypto Mania 2025 Incoming as Bitcoin Breaks Above $100k - 8th Dec 24
Gold Price Multiple Confirmations - Are You Ready? - 8th Dec 24
Gold Price Monster Upleg Lives - 8th Dec 24
Stock & Crypto Markets Going into December 2024 - 2nd Dec 24
US Presidential Election Year Stock Market Seasonal Trend - 29th Nov 24
Who controls the past controls the future: who controls the present controls the past - 29th Nov 24
Gold After Trump Wins - 29th Nov 24
The AI Stocks, Housing, Inflation and Bitcoin Crypto Mega-trends - 27th Nov 24
Gold Price Ahead of the Thanksgiving Weekend - 27th Nov 24
Bitcoin Gravy Train Trend Forecast to June 2025 - 24th Nov 24
Stocks, Bitcoin and Crypto Markets Breaking Bad on Donald Trump Pump - 21st Nov 24
Gold Price To Re-Test $2,700 - 21st Nov 24
Stock Market Sentiment Speaks: This Is My Strong Warning To You - 21st Nov 24
Financial Crisis 2025 - This is Going to Shock People! - 21st Nov 24
Dubai Deluge - AI Tech Stocks Earnings Correction Opportunities - 18th Nov 24
Why President Trump Has NO Real Power - Deep State Military Industrial Complex - 8th Nov 24
Social Grant Increases and Serge Belamant Amid South Africa's New Political Landscape - 8th Nov 24
Is Forex Worth It? - 8th Nov 24
Nvidia Numero Uno in Count Down to President Donald Pump Election Victory - 5th Nov 24
Trump or Harris - Who Wins US Presidential Election 2024 Forecast Prediction - 5th Nov 24
Stock Market Brief in Count Down to US Election Result 2024 - 3rd Nov 24
Gold Stocks’ Winter Rally 2024 - 3rd Nov 24
Why Countdown to U.S. Recession is Underway - 3rd Nov 24
Stock Market Trend Forecast to Jan 2025 - 2nd Nov 24
President Donald PUMP Forecast to Win US Presidential Election 2024 - 1st Nov 24

Market Oracle FREE Newsletter

How to Protect your Wealth by Investing in AI Tech Stocks

CRASH - If Some People Do It, Nothing Bad Happens, But If Everyone Does It, All Hell Breaks Loose

Stock-Markets / Stock Market Crash Aug 07, 2017 - 03:32 PM GMT

By: John_Mauldin

Stock-Markets BY JARED DILLIAN : In preparation for writing this article, I wanted to brush up on the Crash of 1987, so I let my fingers do the walking:

The Crash of ’87 doesn’t even make the list! Wow, short memories.

When I started trading index arbitrage in 2001, people were asking me if index arb caused the Crash of ’87.*

No, index arbitrage didn’t cause the Crash of ’87, nor was it a contributing factor.


The proximate cause of the Crash of ’87 (apart from the geopolitical concerns at the time) was portfolio insurance, a hedging technique marketed to real money accounts.

To understand portfolio insurance, you need advanced options knowledge, but basically it compelled you to sell futures on the way down (to hedge) and buy them on the way up (to get exposure).

Now, this is a key point to understand about certain strategies in finance:

Nothing bad happens if some people do it, but all hell breaks loose if everyone does it.

You don’t have to be a brain surgeon to realize that everyone selling at the same time could cause problems.

That is what happened.

The market declined, which caused portfolio insurance selling to kick in. That made futures cheap to fair value, which caused index arbitrage to kick in, selling a bunch of stock at the same time.

The Dow falling 22.61% in one day was a “25-standard deviation event.” That is an occurrence so rare that if the stock market had been open every single day since the Big Bang… it still shouldn’t happen. And yet it did.

Now you know why people care about tail risk.

Predicting a Crash

You can’t predict when a crash is going to happen… right?

After the Crash of ’87, a lot of people said they “predicted” it. And they did! They had the profits to prove it.

Paul Tudor Jones bet against the market in 1987 and had about the best year a hedge fund could possibly have. An account was written of it twenty years later in The New York Times.

So how did Paul Jones (and Robert Prechter, et al) deduce that the market was about to crash? It wasn’t as hard as you think—the price action was exceedingly squirrelly at the time, and financial pressures were building.

The Crash of ’87 wasn’t a lightning strike. Even people who didn’t predict a crash, per se, had a vague sense that something was terribly wrong.

Remember, lots of things in finance are in the category of “if some people do it, nothing bad happens, but if everyone does it, all hell breaks loose.”

That includes being short volatility.

Short VIX Carry Monkeys

I’ve covered this before in The 10th Man, but let’s briefly go over how crowded this trade is:

  • People are short VXX…
  • And short VIX futures…
  • And playing roll-down with the term structure.
  • People are selling variance outright…
  • And buying inverse vol ETFs…
  • And also selling upside VIX and VXX calls for income…
  • Along with massive overwriting and put selling programs.

All of these things are fine when some people do them—not when everyone does them.

If—make that when—all of these strategies unwind simultaneously, it has the potential to take down the entire financial system. I am not just being dramatic for effect. There has been open speculation about what a violent short vol unwind would look like.

Honestly, this is just a garden-variety crowded trade on Wall Street. A strategy works, people pile into the strategy, and it blows up. Problem is, this one happens to be much bigger than most.

Let me be clear as an azure sky of deepest summer: I am not predicting a crash.

I am saying that the conditions that could contribute to a crash are all present, and the likelihood has never been higher. That may seem like an irritating semantic difference, but I don’t make deterministic statements like the-market-will-crash.  I make probabilistic statements like: the underlying distribution has changed.

Get Thought-Provoking Contrarian Insights from Jared Dillian

Meet Jared Dillian, former Wall Street trader, fearless contrarian, and maybe the most original investment analyst and writer today. His weekly newsletter, The 10th Man, will not just make you a better investor—it’s also truly addictive. Get it free in your inbox every Thursday.

John Mauldin Archive

© 2005-2022 http://www.MarketOracle.co.uk - The Market Oracle is a FREE Daily Financial Markets Analysis & Forecasting online publication.


Post Comment

Only logged in users are allowed to post comments. Register/ Log in