Program trading

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Program trading is 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. [1] Program trading is often used by hedge funds and other institutional investors pursuing index arbitrage or other arbitrage strategies. [2] There are essentially two reasons to use program trading, either because of the desire to trade many stocks simultaneously (for example, when a mutual fund receives an influx of money it will use that money to increase its holdings in the multiple stocks which the fund is based on), or alternatively to arbitrage temporary price discrepancies between related financial instruments, such as between an index and its constituent parts. [3]

Contents

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. [4] Barrons breaks down its weekly figures for program trading between index arbitrage and other types of program trading. As of July 2012, program trading made up about 25% of the volume on the NYSE; index arbitrage made up less than 1%. [5]

History

Several factors help to explain the explosion in program trading. Technological advances spawned the growth of electronic communication networks. These electronic exchanges, like Instinet and Archipelago Exchange, allow thousands of buy and sell orders to be matched very rapidly, without human intervention.

In addition, the proliferation of hedge funds with all their sophisticated trading strategies have helped drive program-trading volume. [6]

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.[ citation needed ] [7]

Program trading firms

Program Trading is a strategy normally used by large institutional traders. Barrons shows a detailed breakdown of the NYSE-published program trading figures each week, giving the figures for the largest program trading firms (such as investment banks). [5]

Index arbitrage

Index Arbitrage is a particular type of Program Trading which attempts to profit from price discrepancies between the basket of stocks which make up a stock index and its derivatives (such as the future based on that index). As of July 2012, it makes up less than 5% of the active Program Trading volume on the NYSE daily. [5]

Premium buy and sell execution levels

The "premium" (PREM) or "spread" is the difference between the stock index future fair value and the actual index level. As the derivative is based on the index, the two should normally have a very close relationship. If there is a sufficiently large difference the arbitraging program will attempt to buy the relatively cheap level (whether that is the basket of stocks which make up the index or the index future) and sell the relatively expensive product, making money from the price discrepancy. The fair value calculation takes into account the time to expiration of the future contract, the dividends received from holding all the stocks, and the interest cost of buying the stocks. [8]

See also

Related Research Articles

In economics and finance, arbitrage is the practice of taking advantage of a difference in prices in two or more markets; striking a combination of matching deals to capitalize on the difference, the profit being the difference between the market prices at which the unit is traded. When used by academics, an arbitrage is a transaction that involves no negative cash flow at any probabilistic or temporal state and a positive cash flow in at least one state; in simple terms, it is the possibility of a risk-free profit after transaction costs. For example, an arbitrage opportunity is present when there is the possibility to instantaneously buy something for a low price and sell it for a higher price.

Commodity market Physical or virtual transactions of buying and selling involving raw or primary commodities

A commodity market is a market that trades in the primary economic sector rather than manufactured products, such as cocoa, fruit and sugar. Hard commodities are mined, such as gold and oil. Futures contracts are the oldest way of investing in commodities. Commodity markets can include physical trading and derivatives trading using spot prices, forwards, futures, and options on futures. Farmers have used a simple form of derivative trading in the commodity market for centuries for price risk management.

Stock market Place where stocks are traded

A stock market, equity market, or share market is the aggregation of buyers and sellers of stocks, which represent ownership claims on businesses; these may include securities listed on a public stock exchange, as well as stock that is only traded privately, such as shares of private companies which are sold to investors through equity crowdfunding platforms. Investment is usually made with an investment strategy in mind.

Day trading Buying and selling financial instruments within the same trading day

Day trading is a form of speculation in securities in which a trader buys and sells a financial instrument within the same trading day, so that all positions are closed before the market closes for the trading day to avoid unmanageable risks and negative price gaps between one day's close and the next day's price at the open. Traders who trade in this capacity are generally classified as speculators. Day trading contrasts with the long-term trades underlying buy-and-hold and value investing strategies. It is made easier using day trading software. Day trading is similar to swing trading, in which positions are held for a few days.

Futures contract Standard forward contract

In finance, a futures contract is a standardized legal agreement to buy or sell something at a predetermined price at a specified time in the future, between parties not known to each other. The asset transacted is usually a commodity or financial instrument. The predetermined price the parties agree to buy and sell the asset for is known as the forward price. The specified time in the future—which is when delivery and payment occur—is known as the delivery date. Because it is a function of an underlying asset, a futures contract is a derivative product.

In finance, an equity derivative is a class of derivatives whose value is at least partly derived from one or more underlying equity securities. Options and futures are by far the most common equity derivatives, however there are many other types of equity derivatives that are actively traded.

Hedge (finance) An investment position intended to offset potential losses or gains that may be incurred by a companion investment

A hedge is an investment position intended to offset potential losses or gains that may be incurred by a companion investment. A hedge can be constructed from many types of financial instruments, including stocks, exchange-traded funds, insurance, forward contracts, swaps, options, gambles, many types of over-the-counter and derivative products, and futures contracts.

An exchange-traded fund (ETF) is a type of investment fund and exchange-traded product, i.e. they are traded on stock exchanges. ETFs are similar in many ways to mutual funds, except that ETFs are bought and sold from other owners throughout the day on stock exchanges whereas mutual funds are bought and sold from the issuer based on their price at day's end. An ETF holds assets such as stocks, bonds, currencies, futures contracts, and/or commodities such as gold bars, and generally operates with an arbitrage mechanism designed to keep it trading close to its net asset value, although deviations can occasionally occur. Most ETFs are index funds: that is, they hold the same securities in the same proportions as a certain stock market index or bond market index. The most popular ETFs in the U.S. replicate the S&P 500 Index, the total market index, the NASDAQ-100 index, the price of gold, the "growth" stocks in the Russell 1000 Index, or the index of the largest technology companies. With the exception of non-transparent actively managed ETFs, in most cases, the list of stocks that each ETF owns, as well as their weightings, is posted daily on the website of the issuer. The largest ETFs have annual fees of 0.03% of the amount invested, or even lower, although specialty ETFs can have annual fees well in excess of 1% of the amount invested. These fees are paid to the ETF issuer out of dividends received from the underlying holdings or from selling assets.

Proprietary trading occurs when a trader trades stocks, bonds, currencies, commodities, their derivatives, or other financial instruments with the firm's own money, aka the nostro account, contrary to depositors' money, in order to make a profit for itself. Proprietary trading can create potential conflicts of interest such as insider trading and front running.

Algorithmic trading is a method of executing orders using automated pre-programmed trading instructions accounting for variables such as time, price, and volume. This type of trading attempts to leverage the speed and computational resources of computers relative to human traders. In the twenty-first century, algorithmic trading has been gaining traction with both retail and institutional traders. It is widely used by investment banks, pension funds, mutual funds, and hedge funds that may need to spread out the execution of a larger order or perform trades too fast for human traders to react to. A study in 2019 showed that around 92% of trading in the Forex market was performed by trading algorithms rather than humans.

Stock trader Person or company involved in trading equity securities

A stock trader or equity trader or share trader is a person or company involved in trading equity securities and attempting to profit from the purchase and sale of those securities. Stock traders may be an investor, agent, hedger, arbitrageur, speculator, or stockbroker. Such equity trading in large publicly traded companies may be through a stock exchange. Stock shares in smaller public companies may be bought and sold in over-the-counter (OTC) markets or in some instances in equity crowdfunding platforms.

A trading curb is a financial regulatory instrument that is in place to prevent stock market crashes from occurring, and is implemented by the relevant stock exchange organization. Since their inception, circuit breakers have been modified to prevent both speculative gains and dramatic losses within a small time frame. When triggered, circuit breakers either stop trading for a small amount of time or close trading early in order to allow accurate information to flow among market makers and for institutional traders to assess their positions and make rational decisions.

Index arbitrage is a subset of statistical arbitrage focusing on index components.

An electronic trading platform is a piece of computer software that allows users to place orders for financial products over a network with a financial intermediary. These products include products such as stocks, bonds, currencies, commodities, and derivatives. The first widespread electronic trading platform was Nasdaq. The availability of such trading platforms to the public has encouraged a surge in retail investing.

Portfolio insurance is a hedging strategy developed to limit the losses an investor might face from a declining index of stocks without having to sell the stocks themselves. The technique was pioneered by Hayne Leland and Mark Rubinstein in 1976. Since its inception, the portfolio insurance strategy has been dubiously marketed as a product. However, this is a misnomer as it is not a policy and there is no insurer of last resort.

High-frequency trading (HFT) is a type of algorithmic financial trading characterized by high speeds, high turnover rates, and high order-to-trade ratios that leverages high-frequency financial data and electronic trading tools. While there is no single definition of HFT, among its key attributes are highly sophisticated algorithms, co-location, and very short-term investment horizons. HFT can be viewed as a primary form of algorithmic trading in finance. Specifically, it is the use of sophisticated technological tools and computer algorithms to rapidly trade securities. HFT uses proprietary trading strategies carried out by computers to move in and out of positions in seconds or fractions of a second.

The United States of America v. Jerome O'Hara and George Perez is a federal court case for the ongoing trial of Jerome O'Hara and George Perez, two computer programmers who previously worked for Bernard L. Madoff Investment Securities LLC (BLMIS) until the arrest of the company's chairman, Bernard Madoff, on December 11, 2008.

Systematic trading is a way of defining trade goals, risk controls and rules that can make investment and trading decisions in a methodical way.

In finance, a dividend future is an exchange-traded derivative contract that allows investors to take positions on future dividend payments. Dividend futures can be on a single company, a basket of companies, or on an Equity index. They settle on the amount of dividend paid by the company, the basket of companies, or the index during the period of the contract.

Interactive Brokers American financial services firm

Interactive Brokers LLC (IB) is an American multinational brokerage firm. It operates the largest electronic trading platform in the U.S. by number of daily average revenue trades. The company brokers stocks, options, futures, EFPs, futures options, forex, bonds, and funds.

References

  1. "NYSE, New York Stock Exchange > About Us > News & Events > News Releases > Press Release 08-27-2009". www.nyse.com. Archived from the original on July 16, 2011.
  2. Lemke and Lins, Soft Dollars and Other Trading Activities, §2:35 (Thomson West, 2013-2104 ed.).
  3. Furbush, Dean (2002). "Program Trading". In David R. Henderson (ed.). Concise Encyclopedia of Economics (1st ed.). Library of Economics and Liberty. OCLC   317650570 , 50016270 , 163149563
  4. "NYSE Weekly Historic Stats 2004–2006 using new method" (PDF). NYSE.
  5. 1 2 3 "Market Data Center | Barron's".
  6. Opalesque (August 9, 2005). "Background article: Program trading".
  7. New York, Fed - Algorithmic trading note (2015). "Senior Supervisors Group - Algorithmic Trading Note - 2015" (PDF). New York Fed.
  8. "How Program Trading Strategies Work".