i'll take that as an on to the next. :)
"program trading" does not refer to a computer program. a "program" is intended in that phrase to mean a "group" or a "project". perhaps those aren't the best synonyms, but the idea is that if one is going to buy or sell the s&p 500, for instance, one has a lot of work to do to execute all those trades. these days, computers are in everything, so "program trading" has taken on the notion that it means computer program. however that is not the original meaning of the term.
to do a perfect arbitrage trade (i.e. no risk trade which takes advantage of a price differential) one in theory would have to make a futures transaction and have 500 different stock transactions. let's go back to my example of the december s&p selling for 2000.00 and the cash at 1370.23. we would short (i.e. sell) the futures contract and proceed to go buying up the 500 stocks. (ignore for a minute that there exists now a stock "spy" on the amex). let's figure out how much money we would make (or lose).
well, since we have a lot of work to do to execute all these 500 trades, it takes time. the 1370.23 price on the s&p is the "last" or last sale price. the specialists on nyse and the market makers on nasdaq sell to us at "ask" not "last". also, by the time we get around to all 500 stocks, the market may have moved against us. also, we have commissions. also, we have to pay for our stock within three business days and don't get our money for the futures contract until mid december, so we have the carrying cost of the money we have invested (either in terms of borrowings or in terms of missed earnings on our cash). also, we have to put up margin dollars at the chicago mercantile exchange for them to be sure that we will honor the futures committment we have made. to the good side, we collect whatever dividends the stocks we have in our possession during the holding period pay.
a calculation we often see on cnbc is "fair value". fair value considers some of the issues i have above but not all. it considers the cash index, the time value of money until the expiration of the contract, and the dividends. it does not consider the transaction/friction/slippage costs i listed above. at some times we are quoted where "buy programs" or "sell programs" will kick in. these levels are estimates which include all the factors which will provide sufficient margin to cover all the costs and transaction risk and allow for sufficient return on capital to make the trade worthwhile.
i have seen defrocked many times say what idiots people are if they think that a small amount above or below fair value will cause the index to open up or down. if there is not sufficient spread to overcome the issues above, the small spread represents no effect on the market from his point of view.
now there are modifications to the above. the advent of the amex basket spy has certainly impacted program trading. i believe that the oex was historically popular because it only had 100 stocks in the portfolio that had to be hedged rather than 500. also, firms can make their own models and decide that a subset of the index can be hedged with safety. in other words if a certain 50 stocks fluctuate 99.7% as accurately as the entire 500, they might only do the 50 to reduce on their transaction costs and market risk. however, in their own proprietary model, they may require a slightly different level to fire off their program since their transaction costs etc. are different. |
