Large Bets and Stock Market Crashes

Stock market crashes have rattled market participants, frustrated policymakers and puzzled economists. But contrary to conventional thinking, these crashes are neither random nor unpredictable.

“Useful early warning systems are feasible,” says Albert "Pete" Kyle, the Smith School's Charles E. Smith Chair Professor of Finance.

Kyle, with Smith Assistant Professor of finance Anna Obizhaeva, has developed a formula that can predict the magnitude of price declines based on the size of bets relative to other market conditions.

The framework, “market microstructure invariance,” sheds light on past crashes, and could help prevent future crashes if traders and policymakers take heed.

Lack of foresight by traders and policymakers, says Kyle, enabled a trio of historic market crashes spurred by large bets:

• Wall Street Crash of 1929: Margin calls resulted in massive selling of stocks and reductions in loans to finance margin purchases.
• Black Monday, 1987:Portfolio insurers sold large quantities of stock index future contracts.
• SocGen, 2008: The Societe Generale bank liquidated billions of Euros in stock index future positions accumulated by rogue trader Jerome Kerviel.

Conventional thinking that prices react to changes in fundamental information, not to price pressure from trades by individual investors, contributed to the 1987 event, says Kyle, who investigated the crash for the Presidential Task Force on Market Mechanisms, which became better known as the Brady Commission, led by eventual U.S. Treasury secretary Nicholas Brady.

“Ironically, policymakers deliberated whether portfolio insurers dumping billions of dollars in stocks would make the market crash, but ultimately allowed it to happen by going along with conventional Wall Street wisdom,”  he said. “Our methodology would have foretold the crash.”

The same holds true for the SocGen event, as European regulators could have estimated a “quite dramatic” 10 percent price drop, which rippled to the Federal Reserve cutting interest rates “by an enormous amount,” Kyle said.

Evidence of the peril of large bets extends to “mini-crash” episodes. Three days after the 1987 crash, the futures market opened with a 20 percent decline because of a large sell order by business investor George Soros, who subsequently sued his broker for the excessive bet. Later, the 2010 “Flash Crash” was triggered by about $4 billion in sales of futures contracts by a single entity that was identified by federal investigators as a "large fundamental investor."

Quantitatively, financial markets have exploded worldwide. The volume and velocity of securities now traded in one day dwarf what was once traded in a full year. This makes it crucial for market players to follow reasonable trading algorithms and better understand how market depth is related to the volume and volatility of the markets in which they participate, says Kyle. “Very large and sophisticated players, like Warren Buffett, probably have this savvy, but most others likely do not.”