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Information > Financial Terms > This page Program Trading Arbitrage
between the market for stock index futures and the stock market itself.
Arbitrage traders attempt to profit by buying in one market and
selling in another. Program
traders try to buy a stock index futures contract, such as the S&P
500 stock index, when it is cheap relative to the prices of the underlying
stocks, and sell it when it is high.
If the price of the futures contract becomes overvalued, program
traders sell the futures and buy the stocks. Using
computers, program traders constantly track prices on the futures market
and prices on the stock exchange.
The computers also keep abreast of interest and dividend rates.
Then if prices in the futures market get substantially out of line
with what traders think they should be based on mathematical equations,
the computers issue buy or sell orders.
Computer information is vital to quickly identify buying and selling
opportunities in the market. By
selling futures and buying the stocks at the same time, program traders
create a fully hedged position. They
also capture a spread, since the futures usually sell at a premium over
the value of the stock (because the interest rate is usually higher than
the dividend rate). When the
futures contract expires, the spread goes to zero because the value of
the expiring contract must equal the price of the stocks.
The traders then "unwind" the programs - selling the stocks and
letting the futures expire. When
this occurs, they pocket the risk-free profits from the original spread,
sometimes far beyond what is available on Treasury bills.
In 1985, the spreads were so large that program traders could earn
annualized returns that were 400 to 600 basis points above the prevailing
three-month Treasury bill rate. Since
that time, because more and more firms have set up program trading operations,
the returns from program trading are reported to have declined. At
the end of every quarter, program traders must unwind their positions
because the index futures and options expire.
The last hour of trading on the stock exchange during the last
day of each quarter has come to be known as the "triple witching hour,"
the hour at which futures, options, and index options contracts all expire
at the same time. Some of
these days have been marked by extreme volatility in the market, as program
traders have dumped large volumes of stock on the market.
This has led to concerns in some quarters as to how this volatility
should be managed. In
1989, many major players in program trading withdrew from all forms of
program trading and criticized rival brokerage firms about their role
in this controversial trading strategy.
This computer-aided strategy for buying and selling baskets of
stocks and offsetting amounts of stock-index futures has been criticized
for disrupting the market and adversely affecting its integrity.
Some maintain that brokerage firms complete with their customers
when they employ this technique. |