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Program trading

Simply put, program trading is computerized buying and selling of securities. Instructions to buy or sell at pre-set prices are programmed into computers, which then execute the orders on cue.

One method of program trading _ referred to as portfolio insurance _ is intended to minimize the impact of price fluctuations and protect against losses from falling prices. Computerized sell orders kick in when stock prices fall to a specified level.

The other method of program trading _ called index arbitrage _ is intended to profit from price fluctuations. Index arbitrage works on the basis of price discrepancies between the futures markets and the stock market. Traders take advantage of the difference between the price of a stock index (which represents a basket of stocks) and the corresponding index futures contract (which is an obligation to buy or sell at a set price on a specified date).

When the price of a stock index and its correlating futures contract differ, a trader will sell the more expensive of the two and buy the cheaper vehicle.

The price differences are minute _ as little as 1/32 of a dollar (3.1 cents) _ so huge volumes of stocks and contracts are traded to realize substantial profits. For some brokerage firms, index arbitrage is a significant source of income.

Program trading, specifically index arbitrage, has been the subject of much controversy. The practice was put under the microscope after the "Black Monday" stock market crash of Oct. 19, 1987, when the Dow lost more than 500 points, and again after the Dow took a 190-point nosedive on Oct. 13, 1989.

Both times, program trading was blamed by some for exacerbating, if not causing, the free falls and related volatility in the markets.

And both times, retail investors, who are crucial to the liquidity of the markets, were scared away for extended periods of time. Their aversion was fueled, in part, by the perception that program trading gave big institutions unfair advantages over the little guys.

Some brokerage firms with large retail clientele (as opposed to institutional brokerages unconcerned with individual investors) put moratoriums on their index arbitrage activities to reassure their retail customers that their interests came first.

In addition, stock and futures exchanges implemented "circuit breakers," which restrict index arbitrage program trading when the market is falling or rising rapidly. The circuit breakers kick in when the market has fallen or risen a certain number of points. They are intended to be temporary to give investors time to react and to control volatility.

Source: Times research