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Jaren Johnson
FIN 2100 Intro to Investments (5:30 p.m.)
Professor A. Marlon Andrus
12/02/10
Program Trading
Many people are familiar with mutual funds, 401k retirement plans, common stock,
bonds, futures, options, and a variety of other investment vehicles. When these vehicles are
driven by sound information and proven strategies, many people find them to be a rewarding
means of investing their money. However, during the financial crisis of 1987, commonly
referred to as Black Monday, many people saw their investments inexplicably plummet into
oblivion along with the stock market. Even though experts could never identify a definitive
explanation for the crash, many were quick to declare a culprit which most people are not
familiar with program trading. Despite being largely unknown and obscure, program trading is
a very real, influential, and highly controversial aspect of the investment world.
Program trading has been tracked since the early 1970s though examples of it have
been noted prior to that. The NYSE defines a program trade as a wide range of portfolio
trading strategies involving the purchase or sale of fifteen or more stocks (NYSE, Glossary).
The aggregate of stocks is often referred to as a program or a basket. The aggregate in a
basket of stocks is worth a minimum of one million dollars. Program trading is often associated
with a computer driven trade without any human interaction; although, the reality is that program
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trading is as simple as buying or selling baskets of stocks. Despite the simplistic definition, the
world of program trading is very complex, competitive, and at times hotly debated.
In order to understand program trading, it is important to establish that success in the
investment world requires the accumulation/interpretation of sound information. Valid
information paves the way for strategy, provides a degree of comfort and stability, and increases
the potential for success to the investment vehicle and methodology of choice. Once information
is accumulated, it can then be used in a fundamental or a technical/analytical approach. These
separate philosophies create a natural conflict in strategy, methodology, and anticipated time
frames for a return on investment
In a fundamental approach, concrete information is accrued which is used to paint a
picture of the health of a company and its projected value over time. In a purely analytical
approach, information is used to support and establish desirable if/then conditions. These
conditions can then be used to create a mathematical equation known as an algorithm. When
certain conditions are met, the algorithmic mechanism will recommend either a buy or sell
execution. For large institutions, this execution will likely be in the form of a program trade.
According to Dean Furbush (financial economist for the SEC during the Black Monday
financial crisis; former Chief Economist and Executive Vice President of NASDAQ) there are 3
interrelated conditions providing for the development of program trading. First, investors are
seeking to eliminate risk by diversifying in a portfolio of securities verses individual stocks.
Second, institutions hold and trade a greater fraction of equity than ever before. Third, modern
technology has reduced the cost of trading. It is important to interject that Dr. Furbush refers to
the aforementioned as conditions. Conditions provide the parameters for analytical analysis
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and algorithmic program trades. Recognizing this sheds light into the various strategies suited to
program trading, as discussed by Mr. Furbush.
The strategy known as Duration averaging is as simple as selling when a stocks value
is high, and buying when the value is low. An algorithm will be created specifying a particular
range (low to high) for the stocks to fluctuate within. As the stocks hit desirable numbers within
that range, a buy or sell mechanism is triggered. The strategy known as portfolio insurance is
the equivalent of buying a put on a particular index. This is done to offset a decline in the
value of stocks held in that index.
Because of cost, it is cheaper to implement certain strategies in the futures and options
markets vs. the stock market this creates a fundamental imbalance, which sets the stage for
index arbitrage. Index arbitrage is based upon maintaining equilibrium between the prices
existing in the futures market verses the stock market. According to Mr. Furbush, good or bad
news will generally move prices much quicker in the futures market. The time required for the
stock market to catch up disrupts the fair-value relation of the markets. In a simple example, if
the futures market jumped, due to good news, the stock market would take some time to catch
up. A program order would be executed, based upon the algorithmic mechanisms in place, to
buy the stock at a lower price, before it catches up to the futures market. The futures market is
derived from other markets, which means that fluctuations which cause a discrepancy in the fair-
value relation can bind up the underlying market. Index arbitrage allows the fair-value relation
of the markets to come into equilibrium, which ensures that the markets maintain liquidity.
The controversies of program trading are several, although most are based on a lack of
understanding. For example, many people can readily appreciate and quickly grasp the
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efficiency of a program order when they buy into or cash out of a mutual fund; but, when it
comes to index arbitrage and creating liquidity, it takes some time and a few helpful analogies to
put the pieces together. Other angles of concern are based upon fears of market manipulation,
and the age-old conflict between analytical trading verses long-term investing. Program trading
has the potential, as previously mentioned, to create fundamental imbalances in the market (valid
corporate information, vs. analytical trading). This may, or may not, affect the fundamental
investor long-term, but it still demands that one should be aware of program trading especially
if plans are made to sell securities that happen to be on the same day that large institutions are
weighting stocks.
Algorithm-powered program trading is backed by large institutions with deep pockets
and specialized computers. I feel that it is very dangerous for a small investor to abandon the
fundamental approach. Anyone involved in short-term investments (in particular, if index stocks
are involved) would be very wise to catch up on program trading. My conclusion is that program
trading plays an important role in the stock market. I agree with those who feel that the liquidity
created by program trading offsets many of the negative factors. However, the potential for
abuse is very high (SLPs, investment banks, hedge funds, etc). Many restrictions are already in
place; though, these restrictions may need to be revisited.