January 26, 2010

What You Should Know About Program Trading

Jan 19-22: What You Should Know About Program Trading

A word on last week’s panels in KC (see Dick Johnson’s write-up at his superb blog) and NYC about modern trading: Had a great time in KC and felt we effectively explained how different time horizons and purposes, combined with lots of passive market-making, affect stock prices today. In NYC, it was a bit frustrating. We started in the middle and never got out of the maze. Sometimes the magic works, sometimes it doesn’t.

Speaking of the maze, you hear the term “program trading” often. Did you know that every other purpose for owning your stock may be overwhelmed by programs? It’s important to know their effect on your stock, and what’s behind them.

The NYSE defines programs as system-driven orders in 15 or more securities totaling more than $1 million. Every Friday, there’s a blurb in the Wall Street Journal on it, and Friday January 22, it was 27.6% of volume on the Big Board, up quite a bit from the week before.

We view program trading a bit differently because markets have radically evolved since the NYSE defined program trading that way. To us, managed, multi-day, multi-stock order-execution is program trading. Stripping out the jargon, we cluster execution by its behavior, and if it’s being managed to fit volume, and it’s happening over multiple days in more than one issue, it’s program-driven. We miss some, but not much. By our measure, program trading on the Big Board averages over 50% of volume, and a bit more than that on the Nasdaq.

This river of liquidity is the lifeblood of the equity markets. It balances out mutual fund inflows and redemptions, it rebalances ETFs and asset-allocation models and pension and sovereign-wealth funds, and it tweaks portfolios according to market risk. Just a few years ago, it had the flavor of investment value. That is, data on financial performance played a big role in its behavior. Today, those things take a back seat to market risk, an eyelid-drooping term that means “what can screw up my portfolio performance today?”

The markets have changed a lot. Shares for meeting the needs of these constantly swirling programmed waters are harder to locate. There are many intermediaries, and pockets of liquidity tucked into corners, and everything is affected by everything else. Morgan Keegan executes a sell order for a conservative investor in bank stocks, and over in tech equities, the trades trigger rebalancing in leveraged ETFs.

While any little thing can affect trading now (that’s a separate discussion), and high-speed, low-cost execution cloaks some massive inefficiencies in our markets when it comes to re-locating liquidity of any size at all, everything depends on the river. If we don’t have good, healthy program trading, the risk climbs for everybody, and prices move inversely to risk.

During expirations last week, we had a massive, program-led dislocation in the markets stemming from a steep rise in the cost of portfolio insurance, reflected in the pricing of various hedges. So money sold equities to reduce risk, and bought derivatives as insurance. Result: markets crumbled by hundreds of points. This is the truth. We can see it in the data. Anything else is peripheral to risk-management right now.

And here’s what keeps Ben Bernanke up at night, we surmise: half the volume in the equity markets is dependent on program trading. Most of that volume is driven by a handful of very large banks. Liquidity is now being withdrawn from the banking system. Mortgage-backed securities auctions, which have a big impact on other asset classes including equities in programs and which are led by the same banks, are ratcheting down.

If program trading starts falling, risks rise in the markets. This is a delicate balancing act for monetarists. And of course, if something other than supply and demand or buying and selling is setting prices, then the market isn’t really free.

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