DEFINITION of Program Trading
Program trading uses computer algorithms to buy and/or sell a basket of securities. Orders are placed directly into the market and executed according to predetermined instructions. For example, a trading algorithm might buy a portfolio of 50 stocks over the first hour of the day. Institutional investors, such as hedge fund managers or mutual fund traders, use program trading to execute large-volume trades. Executing orders in this way helps reduce risk by placing orders simultaneously and can take advantage of market inefficiencies.
BREAKING DOWN Program Trading
Program trading is defined by the New York Stock Exchange (NYSE) as the purchase or sale of a group of 15 or more stocks that have a total market value of $1 million or more and are part of a coordinated trading strategy. This type of trading may also be referred to as portfolio trading or basket trading. (For further reading, see: The Power of Program Trades.)
Purpose of Program Trading
Principal Trading: A brokerage firm may use program trading to buy a portfolio of stocks under their own account that they believe will increase in value. To generate additional revenue, they might then onsell these stocks to their customers to receive a commission. The success of this strategy largely depends on how successful the brokerage firm’s analysts are at selecting winning stocks.
Agency Trading: Investment management firms that trade exclusively for clients may use program trading to buy stocks that are in the firm’s model portfolio. Shares then get allocated to customer accounts after being purchased. Fund managers may also use program trading for rebalancing purposes. For instance, a fund might use program trading to buy and sell stocks to rebalance a portfolio back to its target allocations.
Basis Trading: Program trading can be used to exploit the mispricing of similar securities. Investment managers use program trading to buy stocks they believe are undervalued and short stocks that are overpriced. For example, a manager could short a group of semiconductor stocks that he or she thinks are overvalued and purchase a basket of hardware stocks that appear undervalued. Profits result when the prices of the two groups of securities converge.
Regulation of Program Trading
Many market participants blamed program trading for causing extreme volatility that contributed to significant market crashes in the 1980s and 90s. This resulted in the NYSE introducing rules that prevent program trades executing during certain times to minimize volatility. Depending on the severity of the price action, all program trading may be halted, or sell portfolios may be restricted to only trading on upticks. Program trading restrictions are known as “trading curbs” or “circuit breakers.” (To learn more, see: The Perils of Program Trading.)