Over the last year, ``program trading'' has become a powerful market force -- greatly exacerbating price changes. And the record 86.61 point plunge last Thursday was no exception. What is program trading?
It's a quick-reflex, computer-assisted trading game for the well endowed. The minimum position is about $10 million. Multiply that by a few dozen brokerages and major institutional investors employing similar strategies, and the results can be dramatic. As much as 40 percent of the record volume last Thursday and Friday may have been tied to program trading.
In a typical computer-assisted arbitrage trade, money is invested in two markets simultaneously: stocks and a futures or options index.
Computers calculate a theoretical value for the futures or options index, based on the prices of the stocks in the index. When stock prices and index values get out of whack, computers alert traders.
For instance, the computer may notice that speculators are bidding up the price of options on the Major Market Index. That is, value being placed on the options doesn't match up with the price of the 20 stocks making up that particular index.
Before the spread disappears, a program trader may buy a group of stocks that mimic the index, then sell short the overpriced options. This locks in the spread, giving an almost risk-free profit, yielding as much as a 12 percent annualized return. If stock prices tumble, then the shorted options increase in value, more than countering the stock losses.
Some say program trading makes the market more efficient, quickly correcting misvalued securities. It's a good hedging tool for portfolio managers. Others complain that the big price swings have nothing to do with fundamental changes in a company. And they put the small investor at a disadvantage.
Program trading can make for an especially volatile market on ``triple-witching Fridays.'' Four-times-a-year stock options, index options, and index futures all expire on the same Friday.
But last week, the Securities and Exchange Commission asked the New York Stock Exchange to agree to new procedures that may reduce the number of last-minute market orders in the 30 Dow industrials on Sept. 19. It's billed as an experiment; there are no plans yet to use it again in December.