How Program Trading Strategies Work
The program trading strategies take place behind the scenes. They trade without emotion and can be very profitable. These transactions, called program transactions, take place quietly, without worrying about the chaos of the trading floor. With the advent of electronic trading in the early 2000s, program trading strategies have become an essential part of investing for most traders and investors, especially large financial institutions.
Key points to remember
- Program trading refers to the use of computer generated algorithms to trade a basket of stocks at high volumes and sometimes with high frequency.
- The algorithms are programmed to run and are monitored by humans, although once executed, the programs generate the exchanges, not humans.
- Program trading strategies can execute thousands of trades per day (e.g. high frequency trading or HFT), while other strategies execute trades only every few months to rebalance portfolios over the long term.
- Although very popular, program trading has also been blamed for market failures such as flash crashes.
Program negotiation strategy
In general terms, program trading is high volume trading carried out by systems, usually automated, based on an underlying program or idea. However, there is more to programming than this simple definition implies. The New York Stock Exchange (NYSE) defines program trading as “a wide range of portfolio trading strategies involving the buying or selling of 15 or more stocks with a total market value of $ 1 million or more.”
The term “system trading” is frequently used interchangeably with program trading; however, this is not entirely correct. System trading refers to a methodology that can produce program trading if done in sufficient volume. Conversely, some program trading can be generated by a system trading methodology. Program trading, for our purposes here, refers only to the NYSE definition.
People plan the strategy …
Contrary to popular belief, the underlying portfolio strategy behind a buy or sell program is often not computer generated. The goals can be as disparate as balancing the portfolio between broad asset allocations and sector allocations. These can be intraday, short-term, or long-term strategies. The actual strategies and algorithms that drive program buying and selling are the property of each player and are some of Wall Street’s best-kept secrets.
… But computers do the job
Program swaps are almost always performed by computers, although there are times when this is not the case. For example, if Institution XYZ wants to sell a basket of 15 stocks totaling $ 2 million, they could simply split the sale among several different brokers. Conversely, a large single stock buy program can go straight to a market maker or a single broker who then breaks it down into smaller units. In practice, the NYSE is only interested in the regulation of transactions in computer-generated programs, and in particular, those generated by large movements in the term premium.
Program trading is everywhere
It is important to note that a large part of program trading involves the futures markets as well as the spot market. The most simplistic and well-known of these strategies is index arbitrage. Index arbitrage is frequently used by institutions that manage very large and diversified equity portfolios.
For example, an institution buys futures when the price is low, while simultaneously selling a basket of stocks in a covered trade to earn a few points of return compared to what an S&P stock portfolio would produce on its own.
The important point for the individual investor is that the futures market and the spot market are intimately linked. Movements in one market can trigger movements in the other. Each day, S&P futures have a fair value based on a formula that includes, for example, the days to expiration and the cost of carry for a corresponding basket of stocks.
70% to 80%
Percentage of the overall volume of transactions that are algorithmic transactions in the US and other developed markets.
There are certain premium levels that will generate program trades, although they vary slightly between companies due to different carry costs. Every day there are “Buy Execution Levels” and “Sell Execution Levels”. The best (and only public source) of information on daily fair value and premium execution levels can be found on HL Camp & Co.’s Program Trading Research site. Additionally, the NYSE publishes weekly on its website program trading activities of member companies for the previous week.
Rules, rules, rules
During the 1980s and 1990s, program trading was widely blamed for the excessive volatility in the stock market and was named guilty of some major crashes. As a result, the NYSE has imposed rules that define certain times when trading in computer-generated programs is restricted.
Since the new rules were established, there has been very little disruption directly attributable to the exchange of programs. Considering the amount of liquidity that the trading program brings to the stock and futures markets, its effect is probably more beneficial than not, even during large corrections.
Timing is the key
The buying and selling of programs tend to occur at certain times of the day, sometimes referred to as reversal periods. Over time, these will become evident to the keen observer by volume spikes and larger price swings. Why is this important? Say you own a Dow stock and want to sell it, wouldn’t it help you to do that on a buy program?
The bottom line
Program trades represent the majority of market activity on any given day and as such their impact on market movements is significant. Savvy investors need to watch trends and plan their buying and selling to make sure they aren’t caught on the wrong side of these high-volume, computer-controlled transactions.