Program trading is a type of trading in

securities A security is a tradable financial asset. The term commonly refers to any form of financial instrument, but its legal definition varies by jurisdiction. In some countries and languages people commonly use the term "security" to refer to any for ...

, usually consisting of baskets of fifteen stocks or more that are executed by a computer program simultaneously based on predetermined conditions. Program trading is often used by hedge funds and other institutional investors pursuing index arbitrage or other arbitrage strategies. There are essentially two reasons to use program trading, either because of the desire to trade many stocks simultaneously (for example, when a

mutual fund A mutual fund is a professionally managed investment fund that pools money from many investors to purchase securities. The term is typically used in the United States, Canada, and India, while similar structures across the globe include the SICAV i ...

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 In economics and finance, arbitrage (, ) is the practice of taking advantage of a difference in prices in two or more markets; striking a combination of matching deals to capitalise on the difference, the profit being the difference between the ...

temporary price discrepancies between related financial instruments, such as between an index and its constituent parts. 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. Barrons breaks down its weekly figures for program trading between index arbitrage and other types of program trading. As of July 2012, program trading made up about 25% of the volume on the NYSE; index arbitrage made up less than 1%.

History

Several factors help to explain the explosion in program trading. Technological advances spawned the growth of

electronic communication network An electronic communication network (ECN) is a type of computerized forum or network that facilitates the trading of financial products outside traditional stock exchanges. An ECN is generally an electronic system that widely disseminates orders ...

s. These electronic exchanges, like

Instinet Instinet is an institutional, agency-model broker that also serves as the independent equity trading arm of its parent, Nomura Group. It executes trades for asset management firms, hedge funds, insurance companies, mutual funds and pension funds. ...

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. As technology advanced and access to electronic exchanges became easier and faster, program trading developed into the much broader

algorithmic trading Algorithmic trading is a method of executing orders using automated pre-programmed trading instructions accounting for variables such as time, price, and volume. This type of trading attempts to leverage the speed and computational resources of ...

and

high-frequency trading High-frequency trading (HFT) is a type of algorithmic financial trading characterized by high speeds, high turnover rates, and high order-to-trade ratios that leverages high-frequency financial data and electronic trading tools. While there is no ...

strategies employed by the investment banks and hedge funds.

Program trading firms

Program Trading is a strategy normally used by large institutional traders. Barrons shows a detailed breakdown of the NYSE-published program trading figures each week, giving the figures for the largest program trading firms (such as

investment banks Investment banking pertains to certain activities of a financial services company or a corporate division that consist in advisory-based financial transactions on behalf of individuals, corporations, and governments. Traditionally associated wit ...

Index arbitrage

Index Arbitrage Index arbitrage is a subset of statistical arbitrage focusing on index components. An index (such as S&P 500) is made up of several components (in the case of the S&P 500, 500 large US stocks picked by S&P to represent the US market), and the va ...

is a particular type of Program Trading which attempts to profit from price discrepancies between the basket of stocks which make up a stock index and its derivatives (such as the

future The future is the time after the past and present. Its arrival is considered inevitable due to the existence of time and the laws of physics. Due to the apparent nature of reality and the unavoidability of the future, everything that currently ...

based on that index). As of July 2012, it makes up less than 5% of the active Program Trading volume on the

NYSE The New York Stock Exchange (NYSE, nicknamed "The Big Board") is an American stock exchange in the Financial District, Manhattan, Financial District of Lower Manhattan in New York City. It is by far the List of stock exchanges, world's largest s ...

daily.

Premium buy and sell execution levels

The "premium" (PREM) or "spread" is the difference between the

stock index In finance, a stock index, or stock market index, is an index that measures a stock market, or a subset of the stock market, that helps investors compare current stock price levels with past prices to calculate market performance. Two of the pri ...

fair value and the actual index level. As the derivative is based on the index, the two should normally have a very close relationship. If there is a sufficiently large difference the arbitraging program will attempt to buy the relatively cheap level (whether that is the basket of stocks which make up the index or the index future) and sell the relatively expensive product, making money from the price discrepancy. The fair value calculation takes into account the time to expiration of the future contract, the dividends received from holding all the stocks, and the interest cost of buying the stocks.

History

Program trading firms

Index arbitrage

Premium buy and sell execution levels

See also