Over the past few decades, there has been a radical shift in how traders conduct transactions in the capital markets. Capital market traders have moved in line with modern trends by installing electronic systems to conduct their trades. Using complicated algorithms and extremely fast supercomputers that provide all the required information such as economic, stock or company information as well as breaking news, most financial institutions buy and sell shares and currencies in a matter of microseconds, a practice known as high-frequency trading. Predictably, floor-traders are slowly becoming a dying breed.
Program trading, also known as portfolio trading or basket trading, refers to transactions that involve large amounts of many stocks. The New York Stock Exchange refers to program trading as a trading strategy that involves trading in stocks valued at least US$1 million. You can also think of it as transacting a whole portfolio at a go rather than one stock at a particular time.
Whilst program trading has only gained prominence recently, it’s not a new phenomenon in the financial markets. In fact, it was in existence as early as in the late 20th century when it was largely blamed for excessive volatility in the stock market, and listed as a major cause of most stock market crashes. Here are the reasons why money managers use program trading;
- Pension fund or asset managers at times wish to get exposure to several securities at the same time. Their performance is evaluated based on their ability to outperform a recognized market index such as S&P 500 Index. This means his performance is tracked by his benchmark or tracking error. To outperform the targeted index, the trader will compile a portfolio of stocks that he thinks may perform well.
- Traders are at times sacked for creating large trading positions (such as $400m) in the company’s books. For the company to move out of the position, i.e., to swap the $400m position for another one, it will sell the immediate position at once and purchase another one in one transaction, which is called basket trade.
Now, let’s have a look at the various types of program trades that traders usually employ;
Types of Program Trades
Program trades can be separated into various categories based on the services and costs offered to the consumers. These include;
1. Principal Trades
Also referred to as principal bid or risk bid, this is a type of transaction in which a trader purchases the whole portfolio from the secondary market (such as NASDAQ and NYSE) at a predetermined price. The broker will then hold the stocks for some time before selling them. The motive behind this type of trading is for the dealer to make profit for his portfolio through appreciation in prices. When a customer uses a brokerage to buy and sell stocks, the firm will use its own portfolio that it has to fulfil the client’s orders. The brokerage firm earns a profit (besides the commissions charged) from the bid-ask spread of a certain stock. To expand your knowledge on principal trades, please take some time to register for this course.
2. Agency Baskets (Agency Trading)
This is a popular, though more complicated method of fulfilling a customer’s orders than principal trades. It involves a client asking your broker to fulfil a certain position and find another party in the securities market who is willing to assume your position. Therefore, if you wish to purchase securities at a certain price, your broker will find another person who is willing to sell the stocks at the agreed price and so on. Once the broker finds the other party, the securities exchange will record the transaction in its ticker tape. You can then proceed to exchange the funds and stocks with the other party.
In this type of trade, the role of the broker is to find the best price (i.e. to help you obtain the lowest-cost deal possible if you are buying securities and vice versa). The dealer earns commissions for the job.
3. Basis Trades
This is a program trade in which a traders attempts to profit from incorrect pricing of similar stocks. In other words, the trader is of opinion that two similar stocks are incorrectly priced relative to each other and hence take short and long positions on them in order to benefit from the mispricing. Basis trading is called so because it normally seeks to earn profit from tiny basis point changes in the value spread of the two stocks.
A basis trade is also referred to as a program trade developed for a client who wants to alter his or her degree of market exposure by purchasing or selling a basket of stocks that closely monitors a future index such as DAX or the S&P 500 contract. In other words, if a customer has not invested in stocks, but is interested in investing, let’s say $400 million, into the securities market immediately, the basis trade is one way to achieve this. In much the same way, the customer can use a basis trade to reduce their level of market exposure if he or she is presently active in the market.
4. Exchange for Physical (EFP)
This type of program trade involves an investor with futures contracts exchanging them for securities. At times, brokers may not buy stocks immediately once they are paid for stocks sold. Instead, they pile up futures and buy stocks some time later. To reduce their exposure to futures, they may sell them for stocks at once via a program trading platform.
5. Agency Incentive
This type of program trade is similar to agency trades except in this case commission is hiked if trading performance is excellent. You can enroll in this program trading course to further learn more about this type of program trade.
Forces Influencing Program Trading
When a money manager places a risk bid (principal bid), he or she earns a profit from the price per share he bids minus the trading costs. In agency trade, the client bears these costs, though the performance of the money manager is evaluated based on such costs, which in turn influences whether the client will give him or her future business. There are three basic factors influencing program trading namely;
1. Market Impact
In a capital market, buying stocks in large sizes pushes up their prices, while selling them pushes the prices down
2. Adverse Selection
This refers to a situation where the other party to a transaction has more knowledge about the stocks that he or she is selling, and is covered more extensively in this program trading course.