Program Trading – Chapter 1
A substantial part of the trillions of dollars of global assets changing hands every day, is traded automatically, triggered by computer algorithms, a process known as �program trading.�
Program trading, which evolved rapidly during the 80�s with the advances in both computer technology and mathematical finance, evaluates market discrepancies and arbitrage opportunities and initiates trades automatically based upon computer analyses. Program Trading involves the simultaneous trading of a portfolio of stocks (in contrast to buying/selling one stock at a time). The NYSE defines program trading as any trade involving fifteen or more stocks with an aggregate value over $1 million.
Program trading grew out of several advances in mathematical finance, which in turn took advantage of the computing revolution. Important papers in mathematical finance proved that diversified portfolios consistently performed the best, and diversity in terms of correlated risks became quantified.
Program trading has been associated with several trading strategies, such as duration averaging, portfolio insurance, and index arbitrage. Duration averaging and portfolio insurance are both used to decide how much of an investor’s funds to invest in stocks versus other instruments such as bonds. Duration averaging is based on the venerable idea of buying low and selling high. Fund managers shift assets into stock portfolios when prices are low, and shift assets out of the stock portfolio when prices are high. This strategy can lead to losses if prices fall our of expected ranges and miss opportunities for profit if prices rise too much. Duration averaging reduces price volatility because duration averagers buy when prices fall and sell when prices rise, reducing the size of the move in either direction.
Portfolio insurance insures a minimum value for a portfolio in a falling market while still allowing participation in a rising market. This is done through use of derivative instruments such as, for example, �put” options on the S&P 500.
In dynamic hedging strategies, fund managers sell as prices fall and buy as prices rise, increasing market volatility because both create extra selling pressure when prices fall and extra buying pressure when prices rise.
Index arbitrage between the stock market and the futures and options markets is an important form of program trading. Financial products sold in the futures and options markets are mathematically related to the underlying products from which they are derived. When the price of one falls relative to its mathematically related others, index arbitragers can buy the cheaper product, sell the other one, and secure gains.
Fair Value, Sell Active, Sell Threshold, Buy Threshold, and Buy Active — these terms indicate when index arbitrage program trading activity could occur and can produce sudden, sharp market movements. Foreknowledge of the likelihood of an adverse program trade can help investors determine the wisdom of initiating long or short positions in stocks, index futures, Exchange Traded Funds (ETFs), and options.
Buy programs occur when the futures market is over-valued relative to the stock market and consists of the index futures being sold and the stocks in the index being bought. Sell programs, the opposite case, occur when the futures market is under-valued relative to the stock market and consists of the index futures being bought and the stocks in the index being sold. Over-valued and under-valued conditions arise because trading in the futures and equities markets occurs independently. The key to determining these over or under-valued conditions is the arithmetic difference between the futures and the spot index, known as the premium.
The five terms of fair value, sell active, sell threshold, buy threshold, and buy active refer to specific values of the arithmetic difference of an index futures contract price minus its spot price. If for example the S&P 500 futures contract price is 1000 and the S&P 500 spot index is 990, the difference is 10, and whether this difference has bearish or bullish implications depends on whether it falls in the range of sell programs, no programs, or buy programs.
This difference between the futures contract price and the spot index is called various names of premium, spread, and basis; the nomenclature adopted here will be premium (prem), in accordance with the CNBC ticker. Other data feeds use the symbol of $PREM.X, $PREM, or SP-PREM for the S&P 500 premium and ND-PREM for the NASDAQ 100 premium.
A sell program is the simultaneous short sell of all or most of the stocks in the index and the purchase of the index futures contract. The stocks comprising the index should therefore decline and, correspondingly, the index futures should rise, producing the effect of a stock market decline and futures market rise. Two significant values in the sell program range are the sell active and the sell threshold values.
A buy program is the simultaneous purchase of all or most of the stocks in the index and the sale of the index futures contract. The stocks comprising the index should therefore rise and, correspondingly, the index futures should decline, producing the effect of a stock market rise and futures market decline. Two significant values in the buy program range are the buy threshold and the buy active values.
