A large trade
executed automatically by a computer on behalf of institutional investors
. Program trades are usually open orders
in which the computer is programmed to wait until a certain price
prevails before buying
a large quantity of securities
. Because of the large number involved, program trading may lead to increased market volatility
; because of this, program trading has been blamed for the 1987 Stock Market Crash, selling automatically as prices were reached, making the problem worse. Exchanges now limit the times when program trades may occur to prevent a recurrence. Program trading is also called basket trading. See also: Algorithmic trading
An arbitrage operation in which traders take a long or short position in a portfolio of stock and the opposite position in one or more futures contracts on the same portfolio. Program trading is undertaken in order to take advantage of a difference in market values between two essentially identical portfolios of securities. Both sides of the trade are closed out on or near the day the futures contract expires when the values of the positions should be equal. Because of the size of the trades and the complexity of the technique, program trading is practiced almost exclusively by large institutions. Program trading has been blamed for many of the occasionally occurring big movements in the market. Compare basis trading
Case Study Program trading is the sophisticated trading of a large portfolio of securities in combination with an offsetting position in a futures contract. The ability to pursue this strategy for earning a risk free return depends on integrating computer programs with trades involving one of the many new products in the securities markets—stock index futures. High-powered computer programs determine the point at which the value of a portfolio of securities that is identical to the securities constituting a stock index is out of line with the value of a futures contract on that same stock index. Thus, the value of all the stocks included in the S&P 100 Index may be determined to be either overvalued or undervalued relative to the price at which a futures contract on the index is selling. Program traders take one position in the securities constituting the index and, at the same time, take an offsetting position in a futures contract on the index. Because the two positions must be of equal value on the date that the futures contract expires, the program trader profits by the difference in values when the position was established. The greater the initial divergence of values and the shorter the wait until the values converge, the more profitable the trade. The profitability of the trade must be compared with the rate of return that can be earned on other risk free investments to determine if the arbitrage operation is profitable enough to be worthwhile. Because most positions in program trading are closed out near the settlement date of the futures contract when the value of the securities is at or close to the value of the futures contract, considerable trading, volatility, and turmoil in the markets can occur on the expiration dates. Big price changes involving the stock included in the averages and indexes frequently take place, especially late in the day on the settlement date. Although there has been considerable criticism of program trading as the stimulus to volatility in the security markets, some analysts claim that program trading has a favorable effect in that it makes for more efficient markets. Program trading can be used profitably only when values in the market are out of line. Because program trading involves such huge sums and such sophisticated trading practices, it is generally undertaken only by a limited number of traders with access to large pools of capital: establishing a position at one time in 100 or more stocks is not small potatoes. Offsetting the need for investing huge sums, however, is the fact that program traders establish what is essentially a riskless investment position. It is left to the remainder of the investment community to absorb the added risk of a more volatile market.
Program trading is the purchase or sale of a basket, or group, of 15 or more stocks with the combined value of $1 million or more.
In some cases, programmed trades are triggered automatically when prices hit predetermined levels.
In other cases, institutional investors, arbitrageurs, and other large investors use program trading to take advantage of the spread between a basket of stocks replicating an index and a futures contract on the same index.
Large-scale program trading can cause abrupt price changes in a stock or group of stocks and may even have a dramatic effect on the overall market. The New York Stock Exchange (NYSE) and other exchanges have instituted a series of circuit breakers, which halt trading for a period of time when prices fall by specific percentages in a single day, to help prevent such disruption.