Program trading
Encyclopedia
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. They are often used to arbitrage
temporary price discrepancies between related financial instruments.
More specifically, program trading in the US is described as a type of trading in securities, usually consisting of stocks traded on the New York Stock Exchange
with a combined value of at least $1 million, and their corresponding options
traded on the Chicago Board Options Exchange
and/or the American Stock Exchange
; and the Standard & Poor's
500 Index futures contract
traded on the Chicago Mercantile Exchange
. The trading of these items is 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; or, 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. These historical percentages show the dominance of Program Trading listed on the NYSE.
s. These electronic exchanges, like Instinet
and Archipelago Exchange, allow thousands of buy and sell orders to be matched very rapidly, without human intervention.
Second, the Securities and Exchange Commission mandated in 2001 that the major stock exchanges price stocks in dollars and cents instead of fractions. A stock previously priced at 7 1/8 is now listed at $7.13. Pricing stocks in penny increments instead of 1/16 increments results in 100 price points within a dollar instead of the previous eight price points. That means all the willing buyers and sellers are dispersed over many more prices, making it more difficult for them to meet on price.
Third, and perhaps most significant, the proliferation of hedge funds with all their sophisticated trading strategies is driving program-trading volume.
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.
, Credit Suisse First Boston
, UBS Securities, Barclays Capital
, SG America's Securities
, and Morgan Stanley
. 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. Barrons
shows a detailed breakdown of the NYSE-published program trading figures each week, identifying index and non-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.
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.
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:
Fair Value FV = S [1 + (I - D)]
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).
Security (finance)
A security is generally a fungible, negotiable financial instrument representing financial value. Securities are broadly categorized into:* debt securities ,* equity securities, e.g., common stocks; and,...
, usually consisting of baskets of fifteen stocks or more that are executed by a computer program simultaneously based on predetermined conditions. They are often used to arbitrage
Arbitrage
In economics and finance, arbitrage is the practice of taking advantage of a price difference between two or more markets: striking a combination of matching deals that capitalize upon the imbalance, the profit being the difference between the market prices...
temporary price discrepancies between related financial instruments.
More specifically, program trading in the US is described as a type of trading in securities, usually consisting of stocks traded on the New York Stock Exchange
New York Stock Exchange
The New York Stock Exchange is a stock exchange located at 11 Wall Street in Lower Manhattan, New York City, USA. It is by far the world's largest stock exchange by market capitalization of its listed companies at 13.39 trillion as of Dec 2010...
with a combined value of at least $1 million, and their corresponding options
Option (finance)
In finance, an option is a derivative financial instrument that specifies a contract between two parties for a future transaction on an asset at a reference price. The buyer of the option gains the right, but not the obligation, to engage in that transaction, while the seller incurs the...
traded on the Chicago Board Options Exchange
Chicago Board Options Exchange
The Chicago Board Options Exchange , located at 400 South LaSalle Street in Chicago, is the largest U.S. options exchange with annual trading volume that hovered around one billion contracts at the end of 2007...
and/or the American Stock Exchange
American Stock Exchange
NYSE Amex Equities, formerly known as the American Stock Exchange is an American stock exchange situated in New York. AMEX was a mutual organization, owned by its members. Until 1953, it was known as the New York Curb Exchange. On January 17, 2008, NYSE Euronext announced it would acquire the...
; and the Standard & Poor's
Standard & Poor's
Standard & Poor's is a United States-based financial services company. It is a division of The McGraw-Hill Companies that publishes financial research and analysis on stocks and bonds. It is well known for its stock-market indices, the US-based S&P 500, the Australian S&P/ASX 200, the Canadian...
500 Index futures contract
Futures contract
In finance, a futures contract is a standardized contract between two parties to exchange a specified asset of standardized quantity and quality for a price agreed today with delivery occurring at a specified future date, the delivery date. The contracts are traded on a futures exchange...
traded on the Chicago Mercantile Exchange
Chicago Mercantile Exchange
The Chicago Mercantile Exchange is an American financial and commodity derivative exchange based in Chicago. The CME was founded in 1898 as the Chicago Butter and Egg Board. Originally, the exchange was a non-profit organization...
. The trading of these items is based purely on their price in relation to each other on a predetermined basis; and not on any fundamental analysis
Fundamental analysis
Fundamental analysis of a business involves analyzing its financial statements and health, its management and competitive advantages, and its competitors and markets. When applied to futures and forex, it focuses on the overall state of the economy, interest rates, production, earnings, and...
reason such as an individual company's earnings, dividends, or growth prospects; or, on any overall economic reasons such as interest rate
Interest rate
An interest rate is the rate at which interest is paid by a borrower for the use of money that they borrow from a lender. For example, a small company borrows capital from a bank to buy new assets for their business, and in return the lender receives interest at a predetermined interest rate for...
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. These historical percentages show the dominance of Program Trading listed on the NYSE.
History
Three factors help to explain the explosion in program trading. First, technological advances spawned the growth of electronic communication networkElectronic communication network
An electronic communication network is the term used in financial circles for a type of computer system that facilitates trading of financial products outside of stock exchanges. The primary products that are traded on ECNs are stocks and currencies. The first ECN, Instinet, was created in 1969...
s. These electronic exchanges, like Instinet
Instinet
Instinet is an institutional, agency-only broker. As such, it executes trades for roughly 1,500 “buyside” clients such as 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.
Second, the Securities and Exchange Commission mandated in 2001 that the major stock exchanges price stocks in dollars and cents instead of fractions. A stock previously priced at 7 1/8 is now listed at $7.13. Pricing stocks in penny increments instead of 1/16 increments results in 100 price points within a dollar instead of the previous eight price points. That means all the willing buyers and sellers are dispersed over many more prices, making it more difficult for them to meet on price.
Third, and perhaps most significant, the proliferation of hedge funds with all their sophisticated trading strategies is driving 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
In electronic financial markets, algorithmic trading or automated trading, also known as algo trading, black-box trading or robo trading, is the use of electronic platforms for entering trading orders with an algorithm deciding on aspects of the order such as the timing, price, or quantity of the...
and high-frequency trading
High-frequency trading
High-frequency trading is the use of sophisticated technological tools to trade securities like stocks or options, and is typically characterized by several distinguishing features:...
strategies employed by the investment banks and hedge funds.
Program Trading Firms
Program Trading is a strategy normally used by large institutional traders such as Goldman SachsGoldman Sachs
The Goldman Sachs Group, Inc. is an American multinational bulge bracket investment banking and securities firm that engages in global investment banking, securities, investment management, and other financial services primarily with institutional clients...
, Credit Suisse First Boston
Credit Suisse First Boston
Credit Suisse First Boston was the former name of the banking firm Credit Suisse.-History:In 1978, Credit Suisse and First Boston Corporation formed a London-based 50-50 investment banking joint venture called the Financière Crédit Suisse-First Boston...
, UBS Securities, Barclays Capital
Barclays Capital
Barclays Capital is a global British investment bank. It is the investment banking division of Barclays plc which has a balance sheet of over £1.2 trillion . Barclays Capital provides financing and risk management services to large companies, institutions and government clients. It is a primary...
, SG America's Securities
Société Générale
Société Générale S.A. is a large European Bank and a major Financial Services company that has a substantial global presence. Its registered office is on Boulevard Haussmann in the 9th arrondissement of Paris, while its head office is in the Tours Société Générale in the business district of La...
, and Morgan Stanley
Morgan Stanley
Morgan Stanley is a global financial services firm headquartered in New York City serving a diversified group of corporations, governments, financial institutions, and individuals. Morgan Stanley also operates in 36 countries around the world, with over 600 offices and a workforce of over 60,000....
. 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. Barrons
Barron's Magazine
Barron's is an American weekly newspaper covering U.S. financial information, market developments, and relevant statistics. Each issue provides a wrap-up of the previous week's market activity, news reports, and an informative outlook on the week to come....
shows a detailed breakdown of the NYSE-published program trading figures each week, identifying index and non-index arbitrage.
Index Arbitrage
Index ArbitrageIndex arbitrage
Index arbitrage is a subset of statistical arbitrage focusing on index components.The idea is that an index is made up of several components that influence the index price in a different manner.For instance, there are leaders...
is another form of Program Trading. The major institutional traders using Index Arbitrage are Royal Bank of Canada
Royal Bank of Canada
The Royal Bank of Canada or RBC Financial Group is the largest financial institution in Canada, as measured by deposits, revenues, and market capitalization. The bank serves seventeen million clients and has 80,100 employees worldwide. The company corporate headquarters are located in Toronto,...
and the Deutsche Bank
Deutsche Bank
Deutsche Bank AG is a global financial service company with its headquarters in Frankfurt, Germany. It employs more than 100,000 people in over 70 countries, and has a large presence in Europe, the Americas, Asia Pacific and the emerging markets...
. 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.
Premium Buy and Sell Execution Levels
The "premium" (PREM) or "spread" is the difference between the most active S&P 500S&P 500
The S&P 500 is a free-float capitalization-weighted index published since 1957 of the prices of 500 large-cap common stocks actively traded in the United States. The stocks included in the S&P 500 are those of large publicly held companies that trade on either of the two largest American stock...
Stock Index
Stock market index
A stock market index is a method of measuring a section of the stock market. Many indices are cited by news or financial services firms and are used as benchmarks, to measure the performance of portfolios such as mutual funds....
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.
It is possible to compute the fair value of a futures contract. The calculation is based on the work of Professor Hans Stoll
Hans Stoll
Hans Reiner Stoll is the Anne Marie and Thomas B. Walker, Jr. Professor of Finance and Director of the Financial Markets Research Center at Vanderbilt University's Owen Graduate School of Management....
from Vanderbilt University
Vanderbilt University
Vanderbilt University is a private research university located in Nashville, Tennessee, United States. Founded in 1873, the university is named for shipping and rail magnate "Commodore" Cornelius Vanderbilt, who provided Vanderbilt its initial $1 million endowment despite having never been to the...
, one of the foremost authorities on the subject. The formula to calculate fair value is:
Fair Value FV = S [1 + (I - D)]
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).
See also
- Algorithmic tradingAlgorithmic tradingIn electronic financial markets, algorithmic trading or automated trading, also known as algo trading, black-box trading or robo trading, is the use of electronic platforms for entering trading orders with an algorithm deciding on aspects of the order such as the timing, price, or quantity of the...
also known as automated trading, algo trading, black-box trading or robo trading - High-frequency tradingHigh-frequency tradingHigh-frequency trading is the use of sophisticated technological tools to trade securities like stocks or options, and is typically characterized by several distinguishing features:...
- Alternative Trading SystemsAlternative Trading SystemsAlternative Trading Systems , are United States Securities and Exchange Commission approved non-exchange trading venues specifically designed to match buyers and sellers to find counterparties for transactions, instead of trading large blocks of shares on the normal exchange, a practice that can...
- Electronic trading platformElectronic trading platformIn finance, an Electronic trading platform is a computer system that can be used to place orders for financial products over a network with a financial intermediary. This includes products such as shares, bonds, currencies, commodities and derivatives with a financial intermediary, such as a...
- Outline of financeOutline of financeThe following outline is provided as an overview of and topical guide to finance:Finance – addresses the ways in which individuals, businesses and organizations raise, allocate and use monetary resources over time, taking into account the risks entailed in their projects.- Overview :The word...