program trading

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Program trading is a generic term used to describe a type of trading in securities, usually consisting of baskets of fifteen stocks or more. ^[1]

Kent State University's Masters of Financial Engineering Program is one of the select Master programs nationally that specifically cover Program Trading in its core coursework. ^[2]

While this definition provides a very simplistic answer, program trading is far more complicated.

Program Trading Definition

Program trading is a generic term used to describe a type of trading in securities, usually consisting of stocks traded on the New York Stock Exchange, 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, program trading accounts for about 30% and as high as 46.4% of the trading volume on that exchange every day.^[3] These historical percentages show the dominance of Program Trading listed on the NYSE.

Program Trading Firms

Program Trading is a strategy normally used by large institutional traders such as Goldman Sachs (the largest program trading firm), 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. ^[4] Barrons shows a detailed breakdown of the NYSE-published program trading figures each week, identifying index and non-index arbitrage.^[5]

Program Trading and Index Arbitrage

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.^[6]

Program Trading is based on the Premium Buy and Sell Execution Levels.

The "premium" (PREM) or "spread" is the difference between the most active S&P 500 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.^[7]

It is possible 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 calculation fair value is: ^[8]

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).

References