Holy Volatility Batman!

My gosh! What causes these market prices to skyrocket and plummet in just minutes? Part of the answer is program trading. Program trading is the buying and selling of many stocks at once as opposed to just one stock at a time. The NYSE says that program trading is any trade involving 15 or more stocks with a combined value of $1,000,000 or more. Program trading started in the 70ââ,¬â"¢s with traders going to specialists at the NYSE and executing trades on a group of stocks as quickly as possible. Nowadays, the techniques have gotten much more sophisticated using computers. On most days program trading represents about 10% of the volume on the NYSE. Today, we will discuss program trading and its role in the market. Finally we will mention how to potentially profit.

Types of Program Trading

There are several types of program trades. They are index arbitrage, portfolio insurance, and duration averaging. Index arbitrage involves the relations between stock futures and stocks themselves. Because futures markets involve more leverage, and more speculation, the futures markets tend to move much faster than the stock markets themselves. This includes the S&P futures and the S&P 500. Because the S&P futures tends to move faster, they often rise too high as compared to their actual intrinsic value(that is the dollar value of the futures if exercised immediately) and arbitrage opportunities arise. That is, arbitrageurs, sell the overvalued futures and buy the underlying index at the same time and make a zero-risk transaction instantly. Some people think that index arbitrage increases the volatility of the market significantly. But, the average index arbitrage moves the stocks in the underlying index by less than 5 cents.

Another type of program trading is portfolio insurance. Portfolio insurance on a portfolio of technology stocks for example typically consists of buying puts on the QQQQ's. If the portfolio drops in value, the value of the put increases, thus protecting the value of the portfolio. If the portfolio goes up in value, the holder of the put only loses what he paid for it.

The last form of program trading we will discuss is duration averaging. Duration averaging is used to determine how much money a portfolio manager will allocate to stocks as opposed to another asset such as bonds or cash. Fund managers attempt to buy low and sell high. In other words, when prices fall, fund managers buy and when prices rise, they sell.

The Effects of Program Trading  

As mentioned earlier, index arbitrage transfers the information from the futures market to the cash market and the net effect is quite small. So for all the doomsayers out there who think that program trading caused the 1987 crash, they are mostly wrong. Also, when it comes to duration averaging, fund managers buy as the market goes down and sell as the market goes up. That means that the effect is a REDUCTION in volatility for the market.

Profiting from Program Trading

One way to profit from program trading is to keep an eye of the futures markets as you day trade futures or perhaps even stocks. The movement in the futures markets should clue you into what will soon happen in the cash market. In other words, you can use this information to decide when to enter and exit trades.

Another way to profit from program trading is to use many forms of technical analysis. If so many trades are made mechanically, then pay attention to volume and price changes. Remember that technical analysis is not simply a bunch of a lines on a graph. It is real information that actually has meaning and can help you recognize when institutions are net sellers or net buyers of a security.

Yet another way to profit from program trading is to consult experts. Here are a couple of non-affiliated sites that may be of help: programtrading.com, and indexarb.com. Both sites aim to profit from program trading. Be disciplined- and trade well! 

Price Headley is the founder and chief analyst of BigTrends.com.