"I don't hear as much these days about program trading as an market mover. I'm a little unsure of what program trading is anyway and thought maybe you could give me some basic info?"


Well, there is always one form of so-called 'program' trading going on, but it's not normally a big market mover. The thing you are NOT hearing about is index/futures arbitrage. In a bear market like we've been in for some time now, the index arbitrage possibilities pretty much aren't there. In our current situation, the nearby contracts of the S&P futures are trading at a DISCOUNT to the underlying futures contracts. This means that index arbitrage pretty much ISN'T happening. More on this a little further along.

Index futures/stock arbitrage gets attractive when the futures premiums get bid up by (mostly) speculators to a level well above 'fair value', making it profitable to buy stock and short the futures, thereby 'locking' in a profit on that spread, which is what any kind of pairs trading or arbitrage is all about. But, I'm getting ahead of myself on the basic info or explaining part!


Program trading has been associated with several trading strategies, including portfolio insurance, and index arbitrage.

In the broadest sense, program trading is simply the simultaneous trading of a portfolio of stocks, as opposed to buying or selling just one stock at a time. The New York Stock Exchange (NYSE) defines program trading as any trade involving fifteen or more stocks with an aggregate value in excess of $1 million.

The beginnings of program trading trace back to the 1970's, with the trades in the program being walked around to the NYSE stock specialists' posts at the New York Stock Exchange. Since then the techniques have become much more sophisticated and efficient, aided by of course the use of powerful computing power.

Professional investment managers and brokers can send orders to buy or sell groups of stocks directly from their computers to computers at the exchange. On most days, program trading represents about 10 percent of overall trading on the NYSE so we're not talking about an overall dominant influence, but in certain markets this activity can move prices significantly.

The actual decisions to buy and sell are made by people, not computers. Computers are in use to calculate algorithms that facilitate decisions, and in almost all cases computers help route trades to each individual stock in the program, but people make the trading decisions and implement them. I used to hear people in the UBS index arbitrage unit say, for example, to "trigger program 3". At that point most of what followed was automated but a person determined it was profitable to do a 'program' trade.

Program trading developed because of several market factors. 1.) Individual investors learned that trading a diversified portfolio of securities eliminated some of the risks of investing in individual stocks. 2.) Institutions (e.g., mutual funds) hold and trade a higher fraction of stocks than ever before. These professional investors execute their diversified trades directly in the stock market as program trades or in the futures and options markets, where investors or speculators can trade contracts that are tied to changes in market indexes, especially the S&P 500 (SPX). 3.) Technological advances have reduced trading costs.

Program trading has been associated with several trading strategies, including duration averaging, portfolio insurance, and index arbitrage. I'll speak mostly about program trading in general and about index arbitrage.

Program trades are mostly used to accommodate an investment objective that includes several stocks, or for arbitrage purposes (i.e., to profit from price discrepancies between the stock market and derivative markets such as the futures and options markets, but especially futures.

Program trading most often is a means of rebalancing large institutional portfolios, such as involving hedge funds, or pension and mutual funds. The fund manager may decide that they want to:

1.) 'Rebalance' their portfolio, moving from away from or toward more exposure to certain stock groups or sectors; e.g., into or out of tech stocks in general; more toward consumer related stocks, etc.

2.) Reduce their equity exposure; e.g., reduce the percentage of the total fund value that is invested in stocks by some percentage.

For a big fund, a 3% reduction in equities 'exposure' could be a few hundred thousand shares of 50 different stocks. When they decide to shift things around like this there may concern is to wind up at the end of the day getting into or out of the stocks involved about in line with how the market ended at the end of the day.

To best accomplish the fund manager(s) often will turn to a specialist type firm like my old firm, Cantor Fitzgerald, or Jeffries & Co.; or, a specialized group within one of the large institutional broker-dealers like Morgan Stanley or Goldman Sachs, etc, and they do this for a fee. The reason this buying/selling is farmed out is because the best results do not come about by just dumping the shares on the floor or out on the market in the case of the Nasdaq.

Sometimes literally hundreds of sales people will go out to their institutional clients that might be interested in buying a block(s) of certain stocks. They may negotiate a price, then 'cross' the trade and send to the exchange where it is reported just like any other trade. The quoted price then affects the trading in that stock. This has been the approach of the 'third market' firms like Cantor and Jeffries that purposefully were NOT member firms of the NYSE, in order that they are allowed to 'cross' trades off the floor of the Exchange or to line up a buyer with a seller at an agreed upon price.

'Portfolio trading' is MOST of what program trading is in terms of the total volume involved. The term 'program' is applied because it involved systematic activity and goals and is kept track of by a manager for that portfolio, or program, trade.

The more sexy part of program trading is index/derivatives arbitrage, most of which is stock/futures arbitrage. Currently, S&P September and December futures are trading well UNDER the actual index in an 'inverted' market situation, as traders bet that the market will fall and are not willing to bid up the futures to where the 'cash' index is trading.

The arbitrage possibilities pretty much exist ONLY when futures are trading at ABOVE fair 'fair value', as the current arbitrage would theoretically be to buy the futures and short the stocks and it's difficult to impossible to short all the stocks needed to complete the arbitrage.

However, I'll give a run down about where index arbitrage DOES work, which is when futures trade at or (especially) ABOVE S&P futures fair value.


'Fair value' is what the premium of futures over (above) the actual stock index 'should' be so that being long an S&P 500 futures contract is equal to owning the underlying basket of stocks; i.e., the 500 stocks in the S&P (SPX). Fair value is just what it implies, a value where futures are 'fairly' priced relative to the stocks themselves, which is the underlying 'commodity' for this type of commodity futures contract.

Futures trade above the cash index normally because owning the stocks pays dividends and to be 'fairly' priced, the futures should trade at a 'premium' to actual ownership of the stocks involved. This premium converges with cash the closer to expiration and also is reduced after some or many of the stocks involved have already paid their quarterly dividends.

Fair value (FV) is the spread or point difference that a futures contract would normally have relative to the underlying index. In a market where futures trade a value ABOVE the underlying index, a lot of traders and investors wonder what Fair Value is and what it means in terms of the type of program trading involved in stock index/futures arbitrage. The formula for Fair Value is simple:

FV = S [1 + (I - D)]

'S' is the S&P 500 Stock Index or SPX

'I' is the amount of interest paid to borrow the money to buy all of the stocks in the S&P 500 Index. The interest is calculated based on a percentage lending rate (R) from the current date (today) until the date that the S&P Futures Contract expires in March, June, September or December (futures month symbols: H, M, U, or Z).

'D' is the amount of Dividends paid from all of the companies owned by a holder of all stocks in the S&P 500 Index. The dividends are paid based on the record dates for each stock in the Index that are announced between the current date (today) and until the date that the S&P Futures Contract expires in March, June, September or December historically (month symbols: H, M, U, or Z). Dividend income is expressed as a percentage rate too.

That's basically all there is to fair value. Of course, calculating when each dividend is paid and so on requires accurate information and some computer power.


Assume that today (July 30, 2009) Fair Value of the front-month or nearest to expiration S&P September futures contract is 1.00 (100 points); i.e., SPX is at 986.75 and Sept. S&P futures should theoretically be trading at 987.75, rather than the sizable discount of 983 where it's trading currently).

The 'trigger' point or level for buy programs may be at 2.35, meaning that IF the premium of Sept. SPX futures ran up to 235 points above or over the actual index , it would become profitable for index arbitrage trading groups to buy stocks and sell or short futures which would be a 'buy program'.

The buy program works when the index arbitrage group can 'lock in' that spread difference of 235 points as they've calculated that after their transactions costs and by the time of the expiration of September index futures, the futures price will converge or become equal to the actual index. Worst case for the stock/futures arbitrage is that at the September futures expiration, the arbitrage trading group can sell the stocks they own and, at same time, buy back their short futures contracts, which closes out the program trade.

That's about it on index arbitrage and of course right now this type activity is NOT ANY factor to speak of in the current, still bearish leaning, market.

Simply put, we need a BULL MARKET and not just so the index arbitrage folks can wake up from their slumber and go to work. We need it for other reasons like to have a more active market again!