What is Program Trading?
Program Trading, also known as system trading, is done by machines using the programs or algorithms by the set strategies to effectively, and efficiently trading in the market without the human intervention, and generally used by large investors, fund houses, and hedge funds for large volumes.
How Does it Work?
For executing a program trading, few algorithms are set, for example, selling stocks in a portfolio if the stock valuation crosses 10% of the overall portfolio value. Once the algorithms are set, the software used for contracting securities in the market places orders as mentioned in the program, if the required conditions meet. In this way, without external support, the applications keep running and executing orders on their own.
Types of Program Trading
Some prominent and popular types are mentioned below:
#1 – Principle Trades
A trader generally buys a group of stocks, mainly replicating the popular stock indexes such as the S&P 500, etc. As the retail customers buy it, the principle traders release the trades in the market and fulfill the customers’ orders. In this way, apart from earning a commission, a brokerage is also made.
#2 – Basis Trades
Another type of trading is known as basis trades. In this case, generally, a prominent investor takes a position in similar securities for milking the price inefficiencies. This strategy is also used in taking up contra trades where one security is bought, and a similar one is sold to reduce the exposure in the market.
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#3 – Contra Trades
The contra trades are also used in different markets too. Such as to cover the position of one security in the physical market, an option or futures could be sold if the required security is not available at the estimated price. Later on, using the leverage of futures and options, the original position is squared off with less turbulence due to the back of derivatives.
Examples of Program Trading
- In 2018, it was stated that approximately 55% of all the trading on a typical day has done by the help of an algorithm, and on some days, it went up till 90% too. For instance, let’s assume that a Hedge Fund wants to purchase a basket of securities at a predetermined price, and in one go, then it programs via algorithms. As the stated criteria meet, the securities are obtained, and similarly, these could be sold too. Umpteen strategies are plying the market in today’s world that could be executed by the program trading.
- One more example could be the automatic buying or selling of securities for maintaining the portfolio balance. The program could be taught to buy or sell the security once the individual security value goes up or down the 10% mark of the total portfolio.
Program Trading Strategy
Such trading happens in the large volume and requires a strategy to perform. First of all, a strategy or a pattern is observed or devised, and then programs are coded. Once the entire set up is ready, these programs wait for the required trigger point, and as soon as the market meets the coded criteria, trade happens. Humans do monitor the process of the programming and processing of trades.
- Program trading is unimaginably fast, and various trades could be places in just microseconds. In the situation of arbitrage, simultaneously buy and sell order needs to place, and even the slightest delay could eradicate the profit margin. So, in these situations, the algorithm trading is used.
- Large or institutional investors generally use this trading, and hedge funds, etc. and mostly place orders according to a set strategy. Sometimes multiple stocks are required to buy in one go. Thus program trading comes handy in these circumstances.
- The algorithm trading, because of its fast-paced order placing capabilities coupled with workings on predetermined strategies, helps the traders or arbitrageurs to exploit the opportunity of mispricing in the market.
- Again, as machines perform the program trading, it lacks human emotions and the hurdles it creates. Trading from the automated route does not involve indiscipline, fear, greed, and other emotions posing as a barrier to the desired strategy.
- In the decade leading to the 1990s, many market participants complained about extreme volatility, mostly caused by program trading. In a wakeup call, NYSE has imposed certain restrictions in times of massive volatility. Depending upon the price of a security, program trading is halted or subsided. It is widely known as Circuit Breakers. It could restrict the strategies or efficiency of the trading at times.
- Program Trading is quite expensive in terms of data feeds and the personnel to keep it running. All traders can’t avail of these options as the costs are quite steep.
- Irrespective of the speed, accuracy, and punctuality, it is still a machine and suffers technical and mechanical failures. The programs are not infallible and can make errors due to technical glitches.
It is widely used across markets and countries and provides an altogether different paradigm to the trading. Though being expensive, competitive, and heavily monitored, it is growing as the days passing by. Also, due to technological advancements and active participation in the securities markets, the days are not far when it will become a norm in the trading fraternity.
This article has been a guide to what is Program Trading and its definition. Here we discuss strategy and working of program trading along with types and examples. You may learn more about our articles below on accounting –