Option Volatility and Black Monday

October 1987

Black Monday
October 1987 crash. Google Images

October 19, 1987

The market crash on October 19, 1987 was known as Black MondayThe the Dow Jones Industrial Average (DJIA) declined by (a record at the time) 508 points, or 22.61% to 1738.74. 

You truly had to be there to have any idea of what it was like on the trading floor of the Chicago Board Options Exchange (CBOE). As for me, I was in an upstairs office, trading from my desk. As the day progressed and the steady decline continued, market makers (and everyone else) it became obvious that everyone -- market makers, professional traders, and individual investors, became afraid to sell options.

Not just put options, but call options as well.(If you understand the concept of equivalent positions, then calls are puts and puts are calls)

As a result, option prices soared. With no market bottom in sight, and with put buyers arriving in the trading pits (via orders from brokers), there was no reasonable way for option sellers to hedge (reduce their portfolio risk when selling) those option positions. To compensate option sellers for the risk they accepted, option prices (premium) increased dramatically -- until mercifully, the closing bell rang.

 

October 20, 1987

The US Federal reserve came to the rescue by issuing the following statement before the market opened on the following morning: 

"The Federal Reserve, consistent with its responsibilities as the Nation’s central bank, affirmed today its readiness to serve as a source of liquidity to support the economic and financial system."

 

What is he Federal Reserve and what does it do? 
1. Conducts monetary policy.
2. Regulates banking institutions and protects the credit rights of consumers.
3. Maintains the stability of the financial system.
4. Provides financial services to the U.S. government.

But the market debacle was not yet over.

Despite the Fed announcement, the markets opened lower on Tuesday, October 20, 1987, and it seemed as if the end of the (financial) world was imminent (Honest - with markets falling and no buyers in sight, fear was rampant).

That is not an exaggeration. Before the market opened for trading, there was a lot of stock for sale -- and buyers were scarce. That delayed the opening of trading for many individual stocks.

Everyone wanted to own put options and the bid/ask markets reflected the panic.The bid/ask spreads became wide. Not wide by today's standards, but much wider, such that the chasm was indescribable. Many options had bid/ask spreads that were at least $10 wide. A typical option could easily have a $2 bid and a $12 ask. How is that possible? There were nowhere near enough people who were willing to be option sellers and it was nigh impossible to satisfy the demand for options -- calls or puts. As a result, option premium went through the roof (i.e., even higher than on Monday). 

It was not a fun time for anyone who had sold, and remained short, options. A great many of such traders were forced to repurchase the options sold -- simply because they did not have enough margin to cover the losses. However, not everyone suffered. Some people (not me) owned puts before the market crash and earned huge sums. 

At some point, calm was restored. Probably prompted by the Fed announcement, bargain hunters arrived on the scene to accumulate shares.

Panic selling eased and the crash mentality seemed to fade away quickly. At one point, the Dow Jones Industrial Average was 120 points lower, but when the closing bell rang, the average was higher by more than 100 points. The Fed saved the day -- or least that remains the consensus opinion.

NOTE: If you believe that traders who were short call options prospered, think again. When option premium surged, puts and calls increased in value. It may seem strange that calls can increase in value when the markets fall so far, but remember that the value of any option increases when the implied volatility increases. Implied volatility reached values so high that they have never been seen again. In fact, during the market debacle of 2008/2009, VIX (CBOE volatility Index) topped out near 90. During the Oct '87 crash, it reached 150.