Case Study

Program trading is the sophisticated trading of a large portfolio of securities in combination with an offsetting position in a futures contract. The ability to pursue this strategy for earning a risk free return depends on integrating computer programs with trades involving one of the many new products in the securities marketsstock index futures. High-powered computer programs determine the point at which the value of a portfolio of securities that is identical to the securities constituting a stock index is out of line with the value of a futures contract on that same stock index. Thus, the value of all the stocks included in the S&P 100 Index may be determined to be either overvalued or undervalued relative to the price at which a futures contract on the index is selling. Program traders take one position in the securities constituting the index and, at the same time, take an offsetting position in a futures contract on the index. Because the two positions must be of equal value on the date that the futures contract expires, the program trader profits by the difference in values when the position was established. The greater the initial divergence of values and the shorter the wait until the values converge, the more profitable the trade. The profitability of the trade must be compared with the rate of return that can be earned on other risk free investments to determine if the arbitrage operation is profitable enough to be worthwhile. Because most positions in program trading are closed out near the settlement date of the futures contract when the value of the securities is at or close to the value of the futures contract, considerable trading, volatility, and turmoil in the markets can occur on the expiration dates. Big price changes involving the stock included in the averages and indexes frequently take place, especially late in the day on the settlement date. Although there has been considerable criticism of program trading as the stimulus to volatility in the security markets, some analysts claim that program trading has a favorable effect in that it makes for more efficient markets. Program trading can be used profitably only when values in the market are out of line. Because program trading involves such huge sums and such sophisticated trading practices, it is generally undertaken only by a limited number of traders with access to large pools of capital: establishing a position at one time in 100 or more stocks is not small potatoes. Offsetting the need for investing huge sums, however, is the fact that program traders establish what is essentially a riskless investment position. It is left to the remainder of the investment community to absorb the added risk of a more volatile market.