Arbitrage: Exploitation of a riskless profit opportunity. By definition, arbitrage eliminates the opportunity for riskless profit as it takes advantage of it.

Bigger Fool Theory: "Buy a stock and you'll make money as long as some other fool is willing to buy the stock from you at a higher price in order to sell it to an even bigger fool at an even higher price." (Crash, Arbel & Kaff)

Index Arbitrage: A futures contract is designed to predict the price of a stock market index at some later date. Whether it is a bond or a bank account, a simple formula predicts the future value of any financial instrument:

F = S(1+r)^t

where F is the future value, S is the current value, r is the applicable interest rate, and t is the time to maturity. On a short term basis, t and r are fixed, leaving S and F as the only free variables. What this means is that, if you know the price of the S&P today, you can derive the price of a futures contract and vice versa. In practice, different factors influence the price of the futures market and the stock market. When one of these factors pushes the futures price and the index price out of alignment with each other, there is potential for a riskless gain. For instance, imagine the futures market is momentarily 20% undervalued relative to the stock market on the formula above. The arbitrageur could sell 10 shares of the S&P to buy futures contracts. When the relationship once again took hold, he would be able to sell those futures contracts back and buy 12 S&P contracts regardless of what the prices actually were. Computers, due to their speed, power, and ability to coordinate, are the ideal method of performing arbitrage transactions. The important aspect of index arbitrage for the 1987 crash is that, when futures are undervalued relative to index values as they were that day, arbitrage programs buy futures and sell stocks on the stock market.

Index Future: see Futures Contract

Institutional Investor: an investor that manages a fund for a large set of people, i.e. pension funds and mutual funds.

Futures Contract: a contract that obligates one party to buy a good from another party at a preordained price on a given future date.

Market Volatility: the rate of price fluctuations within a financial market.

Medium-Sized Shark: A group of small investors which have similar effects as that of an institutional investor by acting in concert.

Portfolio Insurance: A market strategy meant to reduce risk to a large fund at some cost to expected returns. In effect, it is like an athlete betting against his own team to insure at least one desireable result. The most common form of portfolio insurance involves trading a futures contract. If a money manager holds a set of stocks (which will provide some gain if the market rises) but is concerned about the market falling, she can sell an S&P 500 futures contract. Let's say the contract obligates her to provide the bearer with the value of a share of the S&P index for $10,000 in one month. If the market falls during that time, and the contract is worth $8,000 on that date, she has gained $2,000 to offset the losses in her portfolio due to the market move. If, on the other hand, the market rises to $13,000, she recieves only the $10,000 in the contract, resulting in a net loss of $3,000 which is presumably offset by gains in the underlying portfolio. The most important aspect of portfolio insurance for the 1987 crash is that pessimistic expectations led institutional investors to sell futures of the S&P in very large numbers in an attempt to hedge their portfolios, and that caused the futures market to decline more rapidly than the stock market.

Program Trade: A single, coordinated trade involving multiple transactions in sequence or at the same time.

Trading on Margin: Using borrowed money to invest in securities. This strategy raises an investor's exposure to risks, as well as his/her potential returns.

Stock Market Index: An instrument meant to mimic the movements of the stock market as a whole by being comprised of several of the most imporant stocks in the market weighted as they are in the market. The Dow Jones Industrial Average and S&P 500 are the most popular of these indices. When a passive investor buys or sells a stock market index, he is trading in every stock listed in that index.