Benefits-and-Drawbacks-of-Algorithmic-Trading

Program trading is a type of trading in

securities A security is a tradable financial asset. The term commonly refers to any form of financial instrument, but its legal definition varies by jurisdiction. In some countries and languages people commonly use the term "security" to refer to any for ...

, usually consisting of baskets of fifteen stocks or more that are executed by a computer program simultaneously based on predetermined conditions. Program trading is often used by hedge funds and other institutional investors pursuing index arbitrage or other arbitrage strategies. 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 A mutual fund is an investment fund that pools money from many investors to purchase Security (finance), securities. The term is typically used in the United States, Canada, and India, while similar structures across the globe include the SICAV in ...

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 Arbitrage (, ) is the practice of taking advantage of a difference in prices in two or more marketsstriking a combination of matching deals to capitalize on the difference, the profit being the difference between the market prices at which th ...

temporary price discrepancies between related financial instruments, such as between an index and its constituent parts. According to the

New York Stock Exchange The New York Stock Exchange (NYSE, nicknamed "The Big Board") is an American stock exchange in the Financial District, Manhattan, Financial District of Lower Manhattan in New York City. It is the List of stock exchanges, largest stock excha ...

, in 2006 program trading accounts for about 30% and as high as 46.4% of the trading volume on that exchange every day. 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%.

History

Several factors help to explain the explosion in program trading. Technological advances spawned the growth of

electronic communication network An electronic communication network (ECN) is a type of computerized forum or network that facilitates the trading of financial products outside traditional stock exchanges. An ECN is generally an electronic system accessed by an electronic trad ...

s. 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. As technology advanced and access to electronic exchanges became easier and faster, program trading developed into the much broader

algorithmic trading 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 ...

and high-frequency trading strategies employed by the investment banks and hedge funds.

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).

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 The future is the time after the past and present. Its arrival is considered inevitable due to the existence of time and the laws of physics. Due to the apparent nature of reality and the unavoidability of the future, everything that currently ex ...

based on that index). As of July 2012, it makes up less than 5% of the active Program Trading volume on the

NYSE The New York Stock Exchange (NYSE, nicknamed "The Big Board") is an American stock exchange in the Financial District, Manhattan, Financial District of Lower Manhattan in New York City. It is the List of stock exchanges, largest stock excha ...

daily.

Premium buy and sell execution levels

The "premium" (PREM) or "spread" is the difference between the

stock index In finance, a stock index, or stock market index, is an index that measures the performance of a stock market, or of a subset of a stock market. It helps investors compare current stock price levels with past prices to calculate market perform ...

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.

Regulations

United States

In the United States, program trading has been subject to regulation and oversight in response to concerns about its impact on market stability and volatility. The New York Stock Exchange (NYSE) introduced rules known as trading curbs or circuit breakers to address extreme volatility caused by program trading during the 1980s and 90s. Depending on the severity of price movements, these rules can lead to the halt of all program trading or restrict the trading of sell portfolios to upticks only. In addition to NYSE rules, regulatory bodies like the Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA) have established rules governing algorithmic trading strategies, including high-frequency trading (HFT). FINRA Rule 3110 (Supervision) outlines the regulatory requirements for member firms engaged in algorithmic strategies.

China

The China Securities Regulatory Commission (CSRC) has introduced a monitoring and reporting mechanism for program trading in Chinese stock markets in 2023. Stock exchanges in Shanghai, Shenzhen, and Beijing will implement rules on program trading and establish reporting systems to monitor unusual activities. These measures are set to take effect on October 9, 2023. The move comes in response to concerns about the role of computer-generated algorithms in stock trading, which have been blamed for exacerbating sell-offs in China's struggling stock markets.