In the late 1980s, the stock markets of the world were consumed by another speculative bubble. This was a time when valuations and sustainability were considered quite irrelevant and everyone got in because it seemed to be a way where everyone could profit from this great boom that would never end.

Euphoria set in as news programs ran stories every night on the success of the stock market, more fuel was thrown on the fire by the stock broking community and touring gurus who played to packed houses their stories of how everyone could make it big by joining in with the miracle of Wall Street, and sharing their own secrets for doing so.

People bought stocks on margin, believing prices could only ever go up, business optimism was high (though showing signs of strain) and novice investors considered 30% returns per year to be the norm from their managed funds.

All major stock markets of the world enjoyed bull markets for the majority of the period between August 1982 and October 1987. The world's 19 largest markets averaged a gain of 296% during this period and the Dow Jones Industrials gained over 200%.

All good things must come to an end, and on October 19, 1987 there was a sudden market break (a euphemism for crash). Although the market had already been falling for a week or two, there were few that believed this was anything other than a brief retracement as the market went on its way to still greater heights.

Between the close of trading on Tuesday, October 13, 1987 through to the close of trading on Monday, October 19, approximately one trillion dollars was wiped off the value of equities on the American market alone. In those four days, the Dow Jones fell from over 2,500 to just above 1,700. On Monday, October 19, 1987 alone the Dow fell 22.6 percent, a feat never before seen in history, and only seen since during the extraordinary volatility of the late 1990s. What happened on Wall Street was repeated all over the world as the lead indicators of Australia and Singapore showing losses of nearly 50 percent.

Many blame much of the violence of the fall (particularly those in New York) on index arbitrageurs. While it is ridiculous to suggest that index arbitrage or "dynamic portfolio insurance" in some way caused the decline in the stock market, the breathtaking speed at which it occurred is often thought to have been brought about by the massive sell orders automatically brought onto the market by program traders.

Index arbitrage, which I talk about in the futures FAQ, involves taking contrary positions in different markets over the same stock, index or commodity. You enter into an arbitrage situation when you notice that a difference exists between the pricing of a cash entity and its futures equivalent by selling the one that is more expensive and buying the one that is cheaper, knowing that when the futures contract comes of age the difference will have reduced and you take a profit.

In the 1980s, the idea of "dynamic portfolio insurance" became popular. This was the practice where futures traders would hedge against falls in the stock market by having their computers short sell index futures whenever stocks began to fall, closing these positions when stocks rallied. In this they could profit from the futures transaction (by buying back their short sold futures contract at a lower price), offsetting falls in stocks. As stocks rose the portfolio insurers would have no open positions either long or short, enabling stocks to profit on the long side with no offsetting loss in short futures positions.

Sellers of portfolio insurance sold "hedging plans" to portfolio managers throughout 1987, and the prospect of having a sophisticated risk strategy in place employing computers and sophisticated futures positions seemed too good to pass up. Before the crash more than $60 billion worth of stock portfolios had been signed up for dynamic portfolio insurance.

When the market fell on October 16, the hedgers computers gave a signal to sell futures short. As stocks fell further the hedgers' computers said to sell even more short. At this, index arbitrageurs came in and bought the oversold futures positions, short selling stocks in compensation. This made stocks even cheaper and so the hedgers tried to sell even more futures contracts short. As the herd began to wake up to what was happening they too began to dump their stocks onto the market. Retail investors sold their managed funds, meaning that fund managers were also forced to sell in order to provide money for redemptions. Thus the decline was multiplied into an avalanche. With so many people selling stock and so few willing to buy, stock prices fell by more than 500 points before stabilising on October 19.

The crash itself was not caused by portfolio insurers or arbitrageurs per se, but simply by too many people wanting to sell their stocks at the same time. If futures had not been around then dynamic portfolio insurers would have sold actual stocks instead, the other way to achieve "portfolio insurance".

Another technical factor frequently cited was the failure of the market infrastructure to keep pace with transaction volume. Congestion in the stock market meant that index arbitrageurs could not be certain that they could sell their stock while buying in the futures market, leading to exaggerated falls in futures prices, leading to more downward pressure on stock prices.

These technical factors of course may have led to a sharper fall, but they themselves had no role in causing the decline in the first place. The Brady Commission and a multitude of academic and industry led studies of the crash to try to find a cause. Interest in the crash was sparked by the very similar patterns in price movements in 1929 and 1987, leading to speculation that a great depression was again to follow as it did in the 30s.

Since then a variety of factors have been cited as the underlying fundamental causes of the crash. Currency worries, the US trade balance, trade deficits, inflation and interest rates and worries over taxation reform have all been blamed to an extent for creating the climate of uncertainty that preceded the crash. However the crash itself did not coincide with changes in any of these fundamental factors, all of which had been brewing for some years. Furthermore, many of these factors were centred on the United States alone or only a few countries, and indeed may have favoured the US' trading partners, therefore the effects of the crash should not have been felt consistently worldwide.

It seems likely that no one factor really had any say in things more than this being the bursting of a speculative bubble. Interest rates rose to the point where implied valuations built into stock prices were stratospheric. When you can get 17% from bank accounts it makes very little sense to put money in the stock market, especially when the market is sitting on the back of such a sustained bullish phase. It was quite obvious to everyone with any sense at all in 1987 that the stock market was in a speculative frenzy, much as it was obvious more recently when tech stocks got out of hand. The only reason why people all stayed in so long was because they felt that although it was clearly madness, there was no point selling when there seems to be no end to this prosperity and the stock market has done nothing but make people wealthy for a decade, besides which, everyone thinks they are smarter than the crowd and would be clever enough to sell when real trouble comes.

Apparently, people aren't actually that clever.