Path: utzoo!mnetor!uunet!lll-winken!lll-lcc!mordor!sri-spam!ames!aurora!labrea!agate!ucbvax!hplabs!hplabsz!taylor
From: franka@mmintl.UUCP (Frank Adams)
Newsgroups: comp.society
Subject: Re: Computers and the Stock Exchange
Message-ID: <1532@hplabsz.HPL.HP.COM>
Date: 2 Feb 88 09:09:01 GMT
Sender: taylor@hplabsz.HPL.HP.COM
Organization: Multimate International, E. Hartford, CT.
Lines: 32
Approved: taylor@hplabs

I would like to take this opportunity to combat the myth that program
trading was responsible for the stock market crash.  It may have 
exacerbated the problem, but if so, it was not by very much.

The biggest cause of the crash, as far as I can tell, is the practice by
various big institutions of a technique misnamed "portfolio insurance".  
The idea of portfolio insurance is that if the stock market goes down a 
bit, you sell some of your stock, and invest the proceeds elsewhere.  The 
idea is that if you sell quickly enough, your losses are limited.

It should be obvious that if enough of the investment capital in the market
is playing this strategy, it will stop working.  All will try to sell at
once, and the market crashes.

This is what happened in October.

Program trading comes in as follows.  The people who engage in portfolio
insurance have adopted the practice of selling futures on stock market
indexes as the fastest way of getting rid of their stocks.  There is another
group of traders, who use computers to watch the relationship between the
futures market and the underlying stocks.  When these get out of line, they
sell one and buy the other.  (These people are known as arbitrageurs using
the original meaning of the word, which has nothing to do with takeovers.)
Now, when the institutions responded to falling prices by selling futures,
this made the futures price drop.  The program traders' response was to buy
futures, and sell the stocks.

Note what happens if the program traders don't exist.  The futures market
crashes even more heavily than it did.  Eventually (read, later that day),
the institutions stop selling futures at such a big loss, and sell the
stocks instead.  Thus the same crash happens, delayed only a few hours.

Frank Adams