So you have to be very long term to filter out the noise. Much longer than most traders can handle because that strategy involves riding out large retracements. As an
alternative approach, one of the traders I know does very well in the stock index markets by trying to figure out how
the stock market can hurt the most traders. It seems to work for him.
How can he quantify that? He looks at market sentiment numbers, but basically it is a matter of gut feel.
Some critics have attributed the October 1987 crash to program trading. What are your own feelings? I think two different elements were involved. First, overly high prices left the stock market vulnerable to a
decline, which was triggered by rising interest rates and other fundamental causes. Second, that decline was
accentuated by heavy selling from pension funds who were involved in so-called portfolio insurance.
Are we talking about portfolio insurance as opposed to arbitrage-type program trading! [Portfolio insurance involves systematically selling stock index futures as stock prices decline (and covering those shorts when prices rise) in order to reduce portfolio risk. Program trading normally refers to buying and selling
stock index futures against an opposite position in a basket of stocks when the prices of the two are out of line.]
Right. The only way in which arbitrage could be said to have contributed to the problem, rather than helped
it, is that if it weren’t for program trading arbitrage, portfolio insurance may never have been developed.
So the arbitrageurs are only to be blamed for the market decline insofar as they made portfolio insurance possible? Yes. If you read the Brady report, you will see that the portfolio insurers came into the market with billions of
dollars worth of sales in a few hours. The market was unable to absorb it. Portfolio insurance was a terrible idea; it
was insurance in name only. In fact, it was nothing more than a massive stop-loss order. If it were not for portfolio
insurance selling, the market would still have gone down sharply, but nothing like the 500-point decline we witnessed.
