Every day on Wall Street computers buy and sell large blocks of stock with nothing more than a couple programming rules and an algorithm to provide direction. These trades, called program trades, take place behind the scenes, oblivious to the chaos of the trading floor. However, savvy investors would be foolish to ignore a system that produces an average of 30% of the daily trading volume on the New York Stock Exchange (NYSE).

In this article we'll first define program trading and the rules that govern it, and then we'll describe how wise investors can track program-trading patterns to make smarter investments.

Computers Do The Work
In general terms, program trading is large-volume trading made by systems, usually automated, based on an underlying program or idea. However, there is more to program trading than this simple definition implies.

The NYSE defines program trading as a "wide range of portfolio trading strategies involving the purchase or sale of 15 or more stocks having 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 accurate. System trading refers to a methodology that may produce program trading if done in sufficient volume. Conversely, certain program trades can be generated by a system-trading methodology. Program trading, for purposes here, refers only to the NYSE definition.

Program trades are almost always executed by computers, although there are instances when this isn't the case. For example, if Institution XYZ wants to sell a basket of 15 stocks totaling $2 million, it could simply split up the sale among several different brokers. Conversely, a big buy program on a single stock may go directly to a market maker or to a single broker who then splits it up into smaller units. As a practical matter, the NYSE is only interested in regulating the computer-generated program trades, and in particular those generated by large movements in the futures premium. (To read more on this subject, see How To Work Around A Market Maker's Tricks.)

People Plan The Strategy
Contrary to popular belief, the underlying portfolio strategy behind a program buy or sell is often not computer-generated. The goals may be as disparate as portfolio balancing to broad asset allocations to sector allocations. They may be intraday strategies, short-term or long-term strategies.

The actual strategies, and the algorithms that generate program buys and sells, are proprietary to each player and are among the most closely guarded secrets on Wall Street.

Program Trading Is Everywhere
Importantly, much of program trading involves the futures markets as well as the cash market. The most simplistic and widely know of these strategies is index arbitrage. Index arbitrage is frequently used by institutions with very large and diverse stock portfolios under management. (For further reading see Futures Fundamentals and Trading the Odds with Arbitrage.)

Example - Index arbitrage
An institution buys futures when the premium is low, while it simultaneously sells a basket of stocks in a hedged trade to garner a few points of return over what a portfolio of S&P stocks would produce on its own.

The important point for the individual investor is that the futures market and the cash market are intimately intertwined. Moves in one market can trigger moves in the other. Every day, the S&P futures have a fair value based on a formula that includes, for example, days to expiration and the cost of carry for a commensurate basket of stocks.

There are certain levels of premium that will generate program trades, although it varies slightly among firms due to different costs of carry. Every day there are "buy execution levels" and "sell execution levels". The best (and only public) source of information for daily fair value and premium execution levels can be found at HL Camp & Company's Program Trading Research site. Additionally, the NYSE publishes program trading activity by member firms every week for the previous week at its website. This is interesting reading, but not particularly useful for real-time decisions.

Rules Rules Rules
During the 1980s and '90s, program trading was largely blamed for excessive volatility in the stock market, and was named as a culprit in some major crashes. As a result, the NYSE has imposed rules that define certain times when computer-generated program trading is restricted.

The actual rules can be found at the NYSE website, but the common reference is "curbs in".

Since the new rules were established, there have been very few disruptions directly attributed to program trading. Given the amount of liquidity that program trading contributes to the stock and futures markets, its effect is probably more beneficial than not, even during sharp corrections.

Making Program Trades Work For You
It's important to remember that when one hears the expression "the market went up on heavy program buying" this does not mean that computers are indiscriminately buying every stock in the S&P 500. Programs weight certain stocks on the buy-side and while other programs weight the same stock on the sell-side. When a number of the big program-trading firms are weighting a particular stock in the same direction, let's say on the buy-side, you do not want to be on the opposite side of that trade. This is particularly true for Dow, OEX (S&P 100) and NDX (Nasdaq 100) stocks, which are widely held and actively traded by institutions. These are the most widely used stocks in program trading.

As mentioned earlier, the strategies and algorithms behind program buys and sells are secret. But for the individual trader or investor, the underlying objective of any individual firm is not overly important. What's key for the investor is knowing when these program buys or sells are converging consistently on an individual stock, or if programs are consistently heavier on the buy- or sell-side.

Example - Using program trades to your advantage
If one firm is consistently overweighting a stock, let\'s say General Electric (GE), in buy programs, the impact could be very short term and small. However, if five firms are overweighting GE in buy programs, the savvy trader would be buying GE too. Conversely, a savvy trader would not want to short GE if it is being heavily weighted in buy programs. (To learn more about this strategy, see our Short Selling Tutorial.)


Timing is Key

Program buying and selling has a tendency to happen at certain times of the day, sometimes called reversal times. Over time, these will become evident to the attentive observer by spikes in volume and wider price swings. Why is this important? Let's say you own a Dow stock and want to sell it, wouldn't it help you to do so during a buy program? (To learn more about timing, read Trading Is Timing.)

Conclusion
Program trades represent a large chunk of any given day's market activity and their impact on market movements is important. During the slower summer months program trades make up as much as 50% of market activity. Smart investors must watch for patterns and time their buying and selling to make sure they aren't caught on the wrong side of these large-volume computer-controlled trades.

Related Articles
  1. Personal Finance

    A Day in the Life of an Equity Research Analyst

    What does an equity research analyst do on an everyday basis?
  2. Mutual Funds & ETFs

    ETF Analysis: PowerShares S&P 500 Downside Hedged

    Find out about the PowerShares S&P 500 Downside Hedged ETF, and learn detailed information about characteristics, suitability and recommendations of it.
  3. Mutual Funds & ETFs

    ETF Analysis: ProShares Large Cap Core Plus

    Learn information about the ProShares Large Cap Core Plus ETF, and explore detailed analysis of its characteristics, suitability and recommendations.
  4. Mutual Funds & ETFs

    ETF Analysis: iShares Core Growth Allocation

    Find out about the iShares Core Growth Allocation Fund, and learn detailed information about its characteristics, suitability and recommendations.
  5. Mutual Funds & ETFs

    ETF Analysis: iShares MSCI USA Minimum Volatility

    Learn about the iShares MSCI USA Minimum Volatility exchange-traded fund, which invests in low-volatility equities traded on the U.S. stock market.
  6. Stock Analysis

    Should You Follow Millionaires into This Sector?

    Millionaire investors—and those who follow them—should take another look at the current economic situation before making any more investment decisions.
  7. Professionals

    What to do During a Market Correction

    The market has corrected...now what? Here's what you should consider rather than panicking.
  8. Stock Analysis

    Investors Need to Stop Shorting GoPro. Here's Why

    Discover why investors should stop shorting GoPro. GoPro has been one of the fastest-growing companies since 2005 with many betting against more growth.
  9. Chart Advisor

    Stocks to Short...When the Dust Settles

    Four short trades to consider, but not quite yet. Let the dust settle and wait for a pullback to resistance for a higher probability trade.
  10. Mutual Funds & ETFs

    ETF Analysis: Vanguard Mid-Cap Value

    Take an in-depth look at the Vanguard Mid-Cap Value ETF, one of the largest and most popular mid-cap funds in the U.S. equity space.
RELATED TERMS
  1. Equity

    The value of an asset less the value of all liabilities on that ...
  2. Derivative

    A security with a price that is dependent upon or derived from ...
  3. Inverse Transaction

    A transaction that can cancel out a forward contract that has ...
  4. Bear Closing

    Purchasing a security, currency, or commodity in order to close ...
  5. Best To Deliver

    The security that is delivered by the short position holder in ...
  6. Crowded Short

    A trade on the short side with an overwhelmingly large number ...
RELATED FAQS
  1. What is the difference between called-up share capital and paid-up share capital?

    The difference between called-up share capital and paid-up share capital is investors have already paid in full for paid-up ... Read Full Answer >>
  2. How do futures contracts roll over?

    Traders roll over futures contracts to switch from the front month contract that is close to expiration to another contract ... Read Full Answer >>
  3. Why would a corporation issue convertible bonds?

    A convertible bond represents a hybrid security that has bond and equity features; this type of bond allows the conversion ... Read Full Answer >>
  4. How does additional paid in capital affect retained earnings?

    Both additional paid-in capital and retained earnings are entries under the shareholders' equity section of a company's balance ... Read Full Answer >>
  5. What types of capital are not considered share capital?

    The money a business uses to fund operations or growth is called capital, and there are a number of capital sources available. ... Read Full Answer >>
  6. Why do companies enter into futures contracts?

    Different types of companies may enter into futures contracts for different purposes. The most common reason is to hedge ... Read Full Answer >>

You May Also Like

Trading Center
×

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!