Portfolio insurance and the 1987 crash: how hedging models fed the fall

What was portfolio insurance before the 1987 crash?

Portfolio insurance was a hedging technique that institutional investors used in the 1980s. Hayne Leland and Mark Rubinstein pioneered it in 1976. The idea promised a floor under a portfolio: when prices fall, the investor sells index futures, and the gains on those futures offset the paper losses on shares. The investor keeps the shares and avoids selling them one by one. By 1987 the Federal Reserve describes the product as very popular with US firms.

The appeal was clear. A pension fund could stay invested in a rising market and still hold a rule that limited losses in a falling one. Computer models set a target ratio between stocks and cash, and the ratio moved with the market. The product looked like insurance, and the name drew buyers who wanted a floor under their portfolio.

How did hedging models sell index futures as prices fell?

The model watched the market level. As prices fell, it lowered the target share of stocks in the portfolio and sold index futures to reach it. As prices rose, it bought futures back. The rule is mechanical: no manager decides on the day, and the model takes the same action whenever the same threshold is crossed. A fall of a few percent therefore creates a known amount of selling.

Take an illustration with round numbers. A fund targets 80% in stocks at the start of the week, and its model cuts the target to 70% after a 5% fall. The fund sells futures worth 10% of the portfolio, and that sale pushes futures lower, which lowers the target again. Each step of selling creates the next signal, and the loop runs until prices stop falling.

Why did sell signals build up ahead of Black Monday 1987?

Prices fell through the week of 14 October. Over the weekend the computer models continued to dictate very large sales, because the Friday close had set new lower targets. That left a large amount of model-driven selling waiting for the opening bell, on top of the ordinary sell orders from other investors.

On 19 October the models recommended further sales as stocks kept falling. Late-opening stocks were listed dramatically higher than their futures, which showed futures falling faster than the stocks they tracked. Index arbitrage then sold stocks against the cheaper futures, and the selling travelled from the futures market back into the stock market.

Why did hedging models meet a thin market on 19 October 1987?

A hedge works when a buyer stands on the other side. On 19 October 95 S&P 500 stocks and 11 of the 30 Dow stocks opened late, and of 2,257 NYSE-listed stocks 195 faced trading delays or halts. Orders waited in queues, and prices on screens lagged the real market. Models that assumed they could trade near the last price found that last prices had already moved.

Funding pressure added to the problem. The Brady Commission recorded margin calls about 10 times their average size and 3 times the previous highs, and 11 firms received margin calls above their adjusted net capital, sometimes by as much as 2 to 1. Firms that needed cash sold what they could sell, which meant futures and liquid stocks, and the hedging models then saw lower prices again.

How large was the portfolio insurance effect in the 1987 crash?

Researchers agree that portfolio insurance and index arbitrage played a role, and they disagree about its size. Hayne Leland, a pioneer of the strategy, argues that the price impact was probably relatively small. A Chicago Mercantile Exchange report found that mutual funds, broker-dealers, and individual shareholders drove more of the selloff, with influence 3 to 5 times greater than that of portfolio insurers.

Richard Roll found a surprising pattern: markets with more computerized trading experienced relatively less severe losses than markets with less of it. That result cuts against a simple story in which computers alone caused the fall. A balanced reading gives hedging models a real role in speed and a smaller role in the first trigger, which the page on what caused the 1987 stock market crash traces to valuation, the dollar, and fear.

Was portfolio insurance really insurance for investors?

Insurance transfers risk to a party that agrees to carry it. Portfolio insurance worked as a trading rule instead: it sold into a falling market, and it required a buyer at each step. A Chicago Mercantile Exchange committee wrote that sellers of dynamic hedging oversold these programs by marketing them as insurance. The name raised expectations that the technique could not meet when many users needed the same exit.

The lesson reaches beyond 1987. A hedge that depends on selling in a falling market works best when few others hold the same hedge. When many investors share one rule, the rule becomes a crowd, and its cost shows up as price. A review of any hedge asks who sits on the other side, how much that side can absorb, and what the plan is on the day liquidity thins. The EQOS Asia method page shows how a score turns such questions into numbers.

What changed after hedging models met the 1987 crash?

Regulators overhauled trade-clearing protocols to bring uniformity to all prominent market products, which addressed the mismatch between stocks, options, and futures. They also developed circuit breakers, rules that let exchanges halt trading after exceptionally large price declines, and the NYSE instituted a trading curbs rule in 1988.

Investors can test hedges against thin markets, gaps, and delays, and they can size positions so that a forced sale stays survivable. You can run such a test on the EQOS Asia simulator, which compares a soft landing, a correction, and a crash. This page is general information, not investment advice.

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About the author

Stéphane Jambu

President, EQOS Forecast Asia

Stéphane Jambu leads EQOS Forecast Asia and works as a consultant in e-commerce, search visibility, and AI. LinkedIn profile