Ever taken a breakout trade only to see your quick profits erode into a loss? Ever been "sure" that you were on the right side of the markets, only to see price reverse sharply, shake you out and then resume its original course? You may have been the victim of program trading.
Program trading is defined as the purchase or sale of a basket of at least 15 stocks with a total value of $1 million or more and developed as result of 3 primary factors:
- Individual investors are learning the value of a diversified portfolio. After the "Bubble Burst" of 2000, many people realize that the old warning not to put all your eggs in one basket has some practical application in trading.
- Institutional activity is at record levels because the "Big Boys" now hold a higher percentage of equity than ever before. They execute their trades directly to the exchanges, trading trillions in the blink of an eye across all three types of exchanges: Futures, equities and options.
- Reduced costs associated with advances in technology have resulted in the "Big Boys" being able to cover the costs of these transactions by executing certain "arbitrage" type trades. While there are several types of strategies associated with program trading, most of them try to accomplish one of two goals: An investment objective or an arbitrage objective.
Program Trading: Goal No. 1: An Investment Objective
Let’s first talk briefly about program trading that pursues an investment objective. There are quite a few of us with long-term investments based on U.S. equities. 401k, Keogh, SEP plans and just about everything from life insurance to annuities can be fixed to our markets in some fashion.
Let’s paint an "investment objective program trade" picture for you. With just the sheer number of 401k participants alone, I want you to picture a dump truck, or miles of dump trucks, lining up to dump their loads of cash into the markets every 2 weeks. That is one purpose of program trading, as a vehicle for these massive transactions to take place and reduce the customer costs associated with these transactions.
Program Trading: Goal No. 2: An Arbitrage Objective
Now, let’s focus on the second goal that program trading pursues: Arbitrage. That sure sounds like a big word, but it is actually a very simple concept to understand. Arbitrage is defined as the simultaneous purchase of a security in one market and the sale of it or a derivative product in another market to profit from price differentials between the two markets.
A derivative product is any instrument that derives its cash flows, and, therefore, its value, by reference to an underlying asset, reference rate or index. The value of the derivative and its underlying is mathematically related. Arbitrage trading is an equalizer between the underlying cash issues and the related derivative products to keep the mathematical relationship at a constant value.
An Arbitrage Example
Let’s paint an arbitrage picture for you to show you how this works. The relationship between the S&P 500 cash markets (the actual value of the 500 equities) and the S&P 500 futures markets (derivative contracts based on the 500 issues in the index) is trading in equilibrium.
Suddenly, the futures move higher based on some fundamental or technical reasons while the cash markets continue to lag. Arbitrage traders step in and sell the overvalued futures and purchase the undervalued cash markets quickly, bringing the two correlated markets back into equilibrium. Simply put, when one of the two mathematically correlated markets gets ahead or behind the other, arbitragers step in quickly to restore the direct mathematical relationship between the two by simultaneously buying the undervalued product and selling the other one to lock in a quick gain.
That is the goal of the arbitrage trader: To profit whenever buying or selling by other traders causes price to move too high or too low relative to the underlying stock prices. Remember that over the past 30 years or so program trading has developed as a result of the way we "the investing public" hold equities. Unlike active traders, most investors hold equities through a derivative product, such as mutual funds, in conjunction with various retirement and wealth-building plans.
The "Big Boys" use program trading to facilitate these huge transactions for our mutual funds (investment objective) while keeping the relationship between the cash markets and derivative products in perfect mathematical equilibrium (arbitrage objective) having the net effect of lowering costs and increasing liquidity for all.
The next time you take a short-term trade and it stops on a dime and goes against you, remember that it may not have anything to do with the fundamental or technical aspects of that index or stock. In fact, can you think of a better time for the "Big Boys" to make these huge trades than when the markets are out of balance and a quick profit can be made?
Remember: They are publicly traded companies with shareholder responsibilities and a mandate to profit. Unfortunately, it can often be at the expense of short-term active traders like you and me.