The debate over computer-assisted trading: who is right?

• Author: Essinger, James

The debate over computer-assisted trading: who is right?

Of the many types of computer-assisted securities trading, program trading may be the most misunderstood. Here, a researcher explains what the technique is, how technology supports the trading method, and what it has done to the U.S. and international securities markets.

While there are many types of computer-assisted trading, no type has excited such interest and controversy as what has become known as "program trading." A United States Presidential Commission has looked into it. Numerous official reports, including one by the U.S. Securities and Exchange Commission (SEC), have been produced about it. And--especially during the months following the crash of October 1987--it has been the subject of media attention.

For a period of time following the crash, certain forms of computer-assisted trading were prohibited from using the New York Stock Exchange's (NYSE) order delivery systems; although this ban has now been removed, the NYSE has imposed permanent restrictions on computer-assisted trading activity.

Setting the record straight

The scale of the controversy is perhaps all the more surprising in that there are remarkable inconsistencies between what different people mean by the term "program trading." Reports in the U.S. and U.K. general media indicate that some journalists believe that program trading denotes any computer system which appears to carry out an actual trading decision on behalf of the trader. This interpretation of the term is wholly erroneous; no such systems exist.

Another widely used--but incorrect--definition of the term denotes a computer system which interfaces with a decision support system. Such a package gives the trader not only the information he might need to decide whether or not to trade, but also specific guidelines that could be interpreted as a computerized "suggestion." The most clear example of such a system is one featuring limit-marking. Limit-marking is the use of preprogrammed parameters, relating to stock prices, which cause a computer to "alert" the trader (such as by a red light flashing on the screen) when a certain parameter has been reached. This would be the signal to the trader to trade on that particular stock or other financial instrument. Limit-marking technology is already a common feature of the U.S. financial trading arena, and it is rapidly becoming popular in London and Tokyo. It is not, however, reasonable to call such a utilization of computers in financial trading a program trade.

The only accurate definition of program trading occurs when a trader aims to trade a large group, or basket, of different stocks together. The trader buying the basket of stocks will usually have a good idea of what stocks are in the basket, but will by no means know all the details of the basket's contents.

This is the true meaning of the term "program trading." It originated in the 1970s, when trades of entire portfolios came to be seen as being traded in programs. The role of computers in this type of trade is primarily to act as a system of logging the trades that have been completed. Computers are useful because a typical program trade may contain several hundred stocks, and to trade this manually would be labor-intensive and time-consuming.

Program trading imposters

There are two financial trading strategies that make use of computers and which have often been called, erroneously, program trading. These are index arbitrage and portfolio insurance.

Index arbitrage is a trading strategy by which a trader aims to make a profit by exploiting small differences, at a given time, between prices of stocks and derivative investments on the same index or exchange or--more often--on different indices or exchanges. Index arbitrage nowadays usually takes place between traditional stocks or securities and futures contracts in these stocks. The computer would identify opportunities for making profit through arbitrage, and would alert the trader to these possibilities. However, the decision to make the trade would still be made by the human trader.

Portfolio insurance involves a trader using a variety of trading strategies in order to forestall heavy loss in a portfolio he is managing, if the price of a particular stock or basket of stocks falls. One version of portfolio insurance is the stop-loss trade, whereby a certain proportion of a particular stock is sold as the price of the stock falls past certain trigger points. For example, if an investor holds 50,000 shares in Corporation X and each share is worth, say, $10, the investor clearly stands to suffer a heavy loss if the price of the stock falls to $5. This being the case, a stop-loss trading strategy might involve selling, say, 10,000 shares each time the price of the stock fell by $1. It is easy to see that such a strategy could be linked...