Program Trading

Source: Encyclopedia of Banking & Finance (9h Edition) by Charles J Woelfel
(We recommend this as work of authority and you can order it here)

Arbitrage between the market for stock index futures and the stock market itself.  Arbitrage traders attempt to profit by buying in one market and selling in another.  Program traders try to buy a stock index futures contract, such as the S&P 500 stock index, when it is cheap relative to the prices of the underlying stocks, and sell it when it is high.  If the price of the futures contract becomes overvalued, program traders sell the futures and buy the stocks.

Using computers, program traders constantly track prices on the futures market and prices on the stock exchange.  The computers also keep abreast of interest and dividend rates.  Then if prices in the futures market get substantially out of line with what traders think they should be based on mathematical equations, the computers issue buy or sell orders.  Computer information is vital to quickly identify buying and selling opportunities in the market.

By selling futures and buying the stocks at the same time, program traders create a fully hedged position.  They also capture a spread, since the futures usually sell at a premium over the value of the stock (because the interest rate is usually higher than the dividend rate).  When the futures contract expires, the spread goes to zero because the value of the expiring contract must equal the price of the stocks.  The traders then “unwind” the programs – selling the stocks and letting the futures expire.  When this occurs, they pocket the risk-free profits from the original spread, sometimes far beyond what is available on Treasury bills.  In 1985, the spreads were so large that program traders could earn annualized returns that were 400 to 600 basis points above the prevailing three-month Treasury bill rate.  Since that time, because more and more firms have set up program trading operations, the returns from program trading are reported to have declined.

At the end of every quarter, program traders must unwind their positions because the index futures and options expire.  The last hour of trading on the stock exchange during the last day of each quarter has come to be known as the “triple witching hour,” the hour at which futures, options, and index options contracts all expire at the same time.  Some of these days have been marked by extreme volatility in the market, as program traders have dumped large volumes of stock on the market.  This has led to concerns in some quarters as to how this volatility should be managed.

In 1989, many major players in program trading withdrew from all forms of program trading and criticized rival brokerage firms about their role in this controversial trading strategy.  This computer-aided strategy for buying and selling baskets of stocks and offsetting amounts of stock-index futures has been criticized for disrupting the market and adversely affecting its integrity.  Some maintain that brokerage firms complete with their customers when they employ this technique.  

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