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program trading

program trading

program trading, a form of securities trading, also known as index arbitrage. Program traders exploit the price discrepancies between indexes of stocks and futures contracts by using sophisticated computer models to hedge positions. Program trading (also called computer-assisted trading) arose with the advent of computer and telecommunication technologies, whereby trade in different markets could be monitored simultaneously and manipulated accordingly. Because the size of the transactions often caused massive jolts in the stock market, many concluded that program trading was largely responsible for the 500-point drop in the Dow Jones Industrial Average on Oct. 19, 1987. During the economic recession that followed, the New York Stock Exchange put new restrictions on computerized trading, and many companies refused to do business with any brokerage house that engaged in program trading. With the unprececented growth of the stock market in the later 1990s, program trading saw a resurgence in some trading houses.

Program trading is casually defined as the use of computers in stock markets to engage in arbitrage and portfolio insurance strategies. However, the New York Stock Exchange (NYSE) defines the term as "a wide range of portfolio trading strategies involving the purchase or sale of 15 or more stocks having a total market value of $1 million or more" without any direct reference to the use of computers. The word "program" can be interpreted in its earlier, more general meaning of a defined and pre-arranged sequence of steps, rather than specifically a computer program. Some program trading strategies are subject to regulatory restrictions. For instance, NYSE Rule 80A requires index arbitrage trades to be marked when submitted.

In recent times, there has been a subset of program trading called algorithmic trading. This is when a computer program takes a large order, breaks it up into small pieces (typically 100-300 shares per piece), and gradually submits these pieces to the market. The goal is to complete the order without other market participants realizing that a large trade is in progress, because they would change their behaviour (and thus the price) to the detriment of the program trader if they recognized a large trade.

Through the 1970s and early 1980s, computers were becoming more important on Wall Street. They allowed instantaneous execution of orders to buy or sell large batches of stocks and futures; and the novelty of program trading is the most popular explanation for the 1987 crash. Many blamed program trading strategies for blindly selling stocks as markets fell, exacerbating the decline.

Program trading is extremely popular in hedge funds, where traders automate sophisticated strategies that would be difficult to put into practice without computer assistance. Computers also allow traders to test their strategies against historical data in an attempt to predict and optimize them for future conditions.

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