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Program trading

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This is an old revision of this page, as edited by Merlinme (talk | contribs) at 16:52, 2 August 2012 (→History: I can see no reason why penny pricing increases the need for program trading; the reason given makes absolutely no sense, and no citation is given.). The present address (URL) is a permanent link to this revision, which may differ significantly from the current revision.

Program trading is a generic term used to describe a type of trading in securities, usually consisting of baskets of fifteen stocks or more that are executed by a computer program simultaneously based on predetermined conditions.[1] There are essentially two reasons to use program trading, either because of the desire to trade a large number of stocks at the same time (for example, when a mutual fund receives an influx of money it will use that money to increase its holdings in the multiple stocks which the fund is based on), or alternatively to arbitrage temporary price discrepancies between related financial instruments, such as between an index and its constituent parts.[2]

Index arbitraging in the US might use program trading to trade stocks on the New York Stock Exchange along with their corresponding options traded on options markets such as the Chicago Board Options Exchange and the American Stock Exchange, along with and the Standard & Poor's 500 Index futures contract traded on the Chicago Mercantile Exchange. If trading these items for arbitrage purposes, they will be bought and sold based purely on their price in relation to each other on a predetermined basis; and not on any fundamental analysis reason such as an individual company's earnings, dividends, or growth prospects; and not directly on any overall economic reasons such as interest rate movements, currency fluctuations, or governmental or political actions.

According to the New York Stock Exchange, in 2006 program trading accounts for about 30% and as high as 46.4% of the trading volume on that exchange every day.[3]

History

Several factors help to explain the explosion in program trading. Technological advances spawned the growth of electronic communication networks. These electronic exchanges, like Instinet and Archipelago Exchange, allow thousands of buy and sell orders to be matched very rapidly, without human intervention.

In addition, the proliferation of hedge funds with all their sophisticated trading strategies have helped drive program-trading volume.[4]

As technology advanced and access to electronic exchanges became easier and faster, program trading developed into the much broader algorithmic trading and high-frequency trading strategies employed by the investment banks and hedge funds.[citation needed]

Program Trading Firms

Program Trading is a strategy normally used by large institutional traders such as Goldman Sachs, Morgan Stanley, Credit Suisse First Boston, UBS Securities, Barclays Capital, ISI and SG America's Securities. During the second quarter of 2009, Goldman Sachs recorded record trading profits, with much of those gains ascribed to program trading, according to heavy press coverage.[5] Barrons shows a detailed breakdown of the NYSE-published program trading figures each week, identifying index and non-index arbitrage.[6]

Index Arbitrage

Index Arbitrage is another form of Program Trading. The major institutional traders using Index Arbitrage are Royal Bank of Canada and the Deutsche Bank. Index Arbitrage ranges from 2% - 10% of the active Program Trading volume daily. On some occasions the Royal Bank of Canada and Deutsche Bank will push Index Arbitrage to move as high as 20% but that is rare, as the market size of the non-Index Arbitrage Program Trading firms, primarily Goldman Sachs and Morgan Stanley, tend to dominate.[7]

Premium Buy and Sell Execution Levels

The "premium" (PREM) or "spread" is the difference between the most active S&P 500 Stock Index Futures Contract fair value minus the actual S&P 500 Stock Index (cash). The decision to execute a program is based on this difference, which usually ranges between $5.00 to $-5.00, and slowly decays or rises as the S&P 500 Futures Contract approaches expiration. When the PREM difference rises to a certain execution level, "buy" programs kick in. Large institutional traders then buy the stocks in the S&P 500 Stock Index on the New York Stock Exchange and sell the S&P 500 Stock Index Futures Contract against those positions on the Chicago Mercantile Exchange. When the PREM difference drops to a certain execution level, "sell" programs kick in and those large institutional traders do the exact opposite.[8]

It is possible to compute the fair value of a futures contract. The calculation is based on the work of Professor Hans Stoll from Vanderbilt University, one of the foremost authorities on the subject. The formula to calculate fair value is:[9]

Fair Value FV = S [1 + (I - D) x t]

The equation represents the value of the S&P 500 Index (S), plus the risk-free interest rate, or the margin rate to borrow to pay for the purchased shares (I), minus the dividend received from the stocks (D), the difference between the latter two terms being multipled by the time to contract expiration (t) expressed as a fraction of a year.

See also

References

  1. ^ http://www.nyse.com/press/1251367637915.html
  2. ^ "Program Trading". Library of Economics and Liberty.
  3. ^ "NYSE Weekly Historic Stats 2004-2006 using new method" (PDF). NYSE.
  4. ^ Opalesque (9 August 2005). "Background article: Program trading".
  5. ^ http://www.ft.com/cms/s/0/e51f695a-8220-11de-9c5e-00144feabdc0.html
  6. ^ http://online.barrons.com/public/page/9_0210-nysepgtd.html
  7. ^ http://online.barrons.com/public/page/9_0210-nysepgtd.html
  8. ^ http://www.investopedia.com/articles/trading/07/program_trading.asp
  9. ^ http://invest-faq.com/articles/deriv-futures-fair-value.html
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