‘Scary’ World of Program Trading

Eric Seff is torn on the subject of the controversial computerized trading practices that exacerbated the stock market’s violent wrenching on Sept. 11 and 12.

“It’s the closest thing to making money without working I’ve ever found,” said Seff, the investment manager for Chase Manhattan’s investment subsidiary, Chase Investors Management.

But, in a more philosophical mood, Seff said he finds program trading “really scary.”

It is not, he said, just that smaller investors are being scared out of the market by the well-endowed players of the game, in which computer programs advise on buy-and-sell decisions based on price disparities between different markets.

But should the stock market ever return on its own to the higher levels of volatility it has known in the past, he fears that the added presence of program trading could trigger a disastrous nose dive, if not an out-and-out collapse.

“What if we’re on our way back to average or above-average volatility and on top of that you add the aggravation of these programs?” Seff asked. “I think the prospects for a true collapse are slim, but I find this a really scary thought.”

After taking the blame for Wall Street’s worst week ever--a week that saw the Dow Jones industrial average tumble a record 86 points in a single day, Sept. 11--program trading is back in the spotlight.

Regulators have redoubled their review of the trading strategy. Some major corporations whose stocks get whipsawed by the churning are voicing concern--albeit privately--that the volatility from program trading is reducing investor interest in their stocks.

And even some of the firms that have found a gold mine in program trading are advocating a careful review of its effects on volatility.

“Whatever (the regulators) have got to do to calm this down, I would support,” said Robert N. Gordon, president of Twenty-First Securities, a New York investment boutique that specializes in program trading. “If that means no more program trading, OK, so long as they leave us with the (stock index, options and futures) tools that have been proven to take the volatility out of the market.” Jack Barbanel, director of futures trading at Gruntal & Co., also calls for “some sort of solution, and fast,” because of concern that program trading already has caused the marketplace a loss of credibility with the public.

“Already there’s enough nervousness in the market about the economy,” Barbanel said, “and then you couple that with (Wall Street’s) insider-trading scandal and this program trading business and how could you think the public isn’t somewhat insecure?”

Adding to the public nervousness, he asserts, was the “finger-pointing that went on among many of the leading program traders” after the 86-point drop in the Dow.

Concerns Over Deficit

“The next day, program traders were saying the market dropped because of concerns over the deficit and other economic factors and that it had nothing to do with program trades,” Barbanel said. “Now it seems very curious that everybody woke up on (that) Thursday deciding that there suddenly was a change in sentiment over the economy. Usually there is some hint when sentiment is changing and there was absolutely none. Of course program trading was behind it.”

Barbanel and a small but growing cadre of financial specialists advocate a range of remedies--from a formal disclosure to investors that the advent of high-speed computers and sophisticated computer programs have changed the character of the market, to a change in the expiration dates of the financial instruments central to the program trades.

A more vocal group advocates a hands-off approach. Program trading, they say, has already survived as a profitable trading technique far longer than anyone anticipated and could run out of steam on its own any time.

For all the emotion it has set off, program trading is very much an unemotional trading strategy.

No subjective considerations like consumer confidence, corporate earnings trends or anticipated economic strengths and weaknesses are factored into the selection of stocks to buy or sell. Only the numbers matter.

In one of the most popular types of program trades, traders can earn millions of dollars with very little risk simply by tracking two numbers: the price of a stock index futures contract and the level of the underlying stock index.

The former is an agreement to buy or sell the cash value of the stock index at a specified price on a certain date.

Different Forms of Products

These are simply different forms of identical products traded in separate markets. One reflects stocks’ current prices while the other represents investors’ expectations of what those stocks will be worth a few months later.

The two numbers often converge. But when they get out of kilter, traders can profit by simultaneously selling the more expensive of the two and buying the cheaper one.

T. Brett Haire Jr., First Boston’s managing director, calls this disparity “the barometric pressure of market sensitivity.” And the larger it is, the more money the trader makes for himself or his client.

Say the value of the stocks in the Standard & Poor’s 500--the stock index most widely used in program trading--is 232 and the futures contract on that stock index is priced at 231, as was the case last week.

A computer programed by the trader would pick up that discrepancy and alert the trader to an opportunity for a program trade.

If the chief trader chooses to make a trade, he would call his traders on the floors of the exchanges, instructing one trader to buy the undervalued S&P; futures contract and simultaneously sell a predetermined group, or “program,” of stocks that matches or mimics the action of the S&P; index.

Thus, it is a modern-day twist on classical arbitrage and in fact is sometimes called index arbitrage.

Since the price of the futures contract always matches up with the price of the actual commodity--in this case, an index of stocks--on the day the contract expires, the trader is not concerned about which direction these two financial instruments move. He knows that, either way, he has locked in a profit of $500 per contract.

‘Not an Emotional Event’

That is because the value of futures contracts is determined by multiplying the value of the contract by $500. So this investor paid $115,500 for the futures contract and received $116,000 for the stock, thus pocketing $500.

“It’s not an emotional event,” Haire of First Boston observed. “It’s a simple recognition that 232 is larger than 231; the good old-fashioned, John Wayne American way.”

Through such trades, one client of Twenty-First Securities made the equivalent of a 20% annualized yield on Sept. 11, a rate of return that was commonplace in 1982 and 1983, when program trading first made its entrance but that has become far less typical as more players have caught on to the game.

The client had asked only that the firm get him a return slightly higher than the 5.3% going rate on Treasury bills.

It is the prospect of such high returns in an environment of low interest rates that has generated such investor interest in program trading--over the past year especially--and brought greater liquidity to the stock market.

Traders say the volume of program trading has doubled over the past two years and now funnels as much as $15 billion into the stock market. It is now estimated to account for 15% to 20% of all stock market activity on active trading days.

Nonetheless, it is still a game for the monied elite. That is because an investor must actually buy stocks comprising the index that will be involved in the program trade, or at least replicate the value of the index by buying several representative stocks.

Rather than buying shares in all 500 stocks in the S&P; 500, for example, a trader would create a synthetic stock index that matches the action of the index, but with only 40 or 50 of the stocks.

Even so, huge sums of money are involved to buy or sell such large blocks of stock, which is why traders estimate that there are only 60 to 100 Wall Street brokerages and institutional investors participating in program trading.

“To play the game the right way,” said Barbanel of Gruntal, “you need $15 million to $20 million at least.”

Even if the traders of these pools of capital, which are often as large as a billion dollars, place orders in a fashion aimed at avoiding the creation of havoc on the floor of the exchange, such huge trades can trigger (and in the past year often have triggered) abrupt and unpredictable swings in the stock market.

Program trading was at work, for example, on Jan. 8 when the Dow Jones industrial average fell 39 points; on March 11, when the Dow soared 43 points, and on Sept. 11 when the Dow fell 86 points.

But whether the trading strategy is making the stock market appreciably more volatile is a matter for heated debate.

The reversals, while sharp and unpredictable, are only momentary, supporters argue. They cite a recent study of 30 years of stock price movements conducted by Salomon Bros., the leading Wall Street firm that is usually credited with originating program trading as it is practiced today.

Volatility Has Declined

(The name program trading originally meant buying and selling entire portfolios, or programs, of stocks at one time. After the introduction of financial indexes and futures in 1982, the strategy evolved into its present form.)

Solly, as the firm is called, found that instead of rising, the stock market’s volatility has in fact declined in recent years, largely because the so-called derivative financial instruments that are the tools for program trading have stabilized it.

Detractors argue that statistical averages in this case miss the point.

“It’s like the guy who has one foot in ice water and the other in boiling water,” said Samson Wang, chief investment officer for Beacon Capital Management. “Measure the average and his temperature is normal. But, boy, does he feel the pain.”

Because the dramatic price reversals are often short-lived and most stock market players are long-term investors, the price swings “shouldn’t be anything that scares you,” said Robert J. Birnbaum, president of the New York Stock Exchange.

But it is the perception of increased volatility ignited by such swings that is “making people nervous and scared and questioning whether they want to play any more,” Wang said.

Program trading even has some big institutional investors agitated, Wang asserted, because they generally base their trading decisions on trends in corporate earnings and economic conditions. When program traders close out their huge positions, he says, “there is enormous volume, making trends harder to determine.”

Criticizing program trading because it brings greater technical sophistication to the marketplace “is as illogical as insisting that you can’t shift to word processors from typewriters because that would cause the demise of the typewriter business,” argued John Kelley, director of First Boston’s equities futures department.

Different Dynamics Brought to Market

“Yes, program trading has brought different dynamics to the stock market, but they’re not inherently bad because they’re different.”

No one has found an effective way to measure whether program trading has actually provoked a stampede of individual investors out of the stock market. But investment advisers say that they have lost clients and that many of those who remain in the market are edgy and feeling suddenly alienated.

“Program trading is disturbing, alarming, confusing, bewildering and frightening to the average investor,” argued Hugh Johnson, chief investment officer at First Albany, a brokerage based in Albany, N.Y. “Regardless of whether the market really is more volatile, the perception is that it is and yet these are emotions the program traders are just dismissing.”

Investor perception is one of the New York Stock Exchange’s concerns.

“As it is today, there is no opportunity to disclose to all investors what’s happening, and that can lead to perceptions that may or may not be true,” exchange President Birnbaum said.

His reference is to the aspect of program trading that is most mysterious and frightening to investors--the “triple witching hour.”

This is the point at which the products used in program trading--futures contracts on stock indexes, options on stock indexes and options on individual stocks--expire.

Greater Rate of Return

Triple witching hour is 4 p.m. Eastern time on the third Friday of the last month of each quarter. But program traders do not have to wait until then to unwind their program positions by buying or selling stocks. In fact, the quicker they can profitably close them out, the greater their rate of return.

But those who have not unwound their program positions before the expiration leave instructions that trades be made precisely at the close of the stock market on those days, often setting off frantic last-minute trading both in these instruments and in the stocks underlying them.

If they do not buy or sell their contracts before the expiration, they are required to settle the terms of the contract with cash.

This “snowballing effect” is somewhat troubling to Chase Manhattan’s Seff because it shows why this strategy, low-risk though it is, is not risk-free, as is often asserted.

When the market drops dramatically and an investor owns stocks, the value of his shares declines on paper but he isn’t actually out anything unless for some unrelated reason he has to sell just then.

But when an investor plays the market by selling his stocks and buying an equal amount of futures, he does risk losing money, or at least not getting the rate of return that made the program trade worthwhile.

Pays a Relatively Small Fee

When he sells the stock to buy the future, he pays a relatively small fee for the future--typically $3,000 per contract--and puts the rest of the money from the stock sale into an interest-bearing money-market instrument, whose expiration often is the same as that of the futures contract.

But because of the nature of futures contracts, if the market drops precipitously and this investor is holding a future, he has to fork over an amount of money representing that day’s decline. The larger his holdings and the steeper the decline, the more he is required to give up.

“So if the market falls a lot, you’re sending the money you thought you were going to get on the money market to your broker instead,” Seff said. “So there’s the risk.”