Program Trades Dominate NYSE 18 Years After Crash: Taking Stock
Oct. 19 (Bloomberg) -- Computer-guided trading, cited for accentuating the U.S. stock market's ``Black Monday'' crash 18 years ago today, now accounts for more than half of the shares changing hands on the New York Stock Exchange.
So-called program trading -- defined by the NYSE as the purchase or sale of a basket of at least 15 stocks valued at a minimum of $1 million -- has grown because of automation in the securities industry, the emergence of exchange-traded funds and the growth of derivatives.
Rather than making the market vulnerable to another plunge, programs help expedite routine transactions, traders said. They may play a larger role once the Big Board lifts restrictions on electronic trades next year.
``This is not your father's program trading,'' said Daniel Mathisson, head of electronic trading at Credit Suisse First Boston in New York. ``We are now seeing that grouping stock trades has become the norm.''
Programs account for 57 percent of the NYSE's trading this year, according to exchange data. The peak of 71 percent was set in the week ended Sept. 16, when the calculation of the Standard & Poor's 500 Index was altered and options and futures contracts on stocks and stock indexes expired.
The exchange started tracking the trading in July 1988, when the proportion was about 10 percent. Nine months earlier, on Oct. 19, 1987, the market had its steepest one-day drop ever as the Dow Jones Industrial Average plummeted 23 percent.
Then-NYSE President John Phelan pointed to programs that exaggerated price swings in explaining the plunge. Some members of Congress called for trading restrictions, or even a ban.
``Program trading was caught red-handed as the chief villain behind the meteoric velocity of the decline,'' said Representative Edward Markey, a Democrat from Massachusetts who headed the House Subcommittee on Telecommunications and Finance, according to an Oct. 21, 1987, Washington Post report.
As it turned out, a strategy known as portfolio insurance had more to do with the market's drop than the computer-guided trading, according to Mark Rubinstein, a finance professor at the University of California at Berkeley's Haas School of Business who has written about the crash.
The strategy called for investors to sell S&P 500 futures to offset losses in stocks. On Oct. 19, the contracts' declines made them cheaper than the underlying shares. Arbitragers, who accounted for about a third of program trades at the time, then bought futures and sold stocks, driving share prices even lower.
``Program trading was the messenger and you want to blame the message,'' Rubinstein said in an interview.
Since the crash, the use of programs has changed. Index arbitrage now accounts for only about 10 percent of trading, according to the NYSE.
Money-management firms are increasingly asking brokerage firms to buy or sell baskets of shares based on a statistical profile, showing membership in the S&P 500 and industry groups as well as volatility. This ``principal trading'' accounted for 41 percent of program trades last week, up from 27 percent five years ago, according to the NYSE.
Most programs were executed by brokerage firms on behalf of clients. ``Agency trading'' amounted to 55 percent of the total, down from 70 percent a year ago, NYSE data shows.
Automation has fostered the adoption of computer-guided trading by making it easier and faster for firms to complete purchases or sales.
Hank Camp, who runs a Palm Beach, Florida-based research firm called HL Camp & Co. that specializes in index arbitrage, said he once called NYSE floor brokers to execute orders. Now, ``I can hit a button and clear a 30-stock trade in a second,'' said the 57-year-old.
The emergence of exchange-traded funds, or ETFs, has contributed to growing use of programs. Created in 1993, the funds enable investors to buy or sell a single security that represents an index. Their value reached $251.5 billion in August, according to the Investment Company Institute.
Barclays Global Investors, the biggest manager of ETFs, uses program trading in part to match up the amount of money invested with funds garnered from stock sales. This ensures the firm doesn't buy too many shares in any industry at once, said Michael Sobel, head of equity trading.
Program trading ``allows you to do cash and sector balancing,'' said Sobel, whose San Francisco-based firm oversees $1.6 trillion. ``But if you had to boil it down as to why we use it, it's because it increases efficiency'' and reduces costs.
Ties to Options
Trading tied to futures and options contracts on stocks and stock indexes has spurred the increase as well. These contracts are known as derivatives because they derive their value largely from the underlying assets.
In the options market, the number of contracts on equities, ETFs and indexes changing hands in the first nine months of this year surged 46 percent from all of 2000, according to Chicago- based Options Clearing Corp.
Options on ETFs accounted for more than 12 percent of the trading. The contracts are settled through the purchase or sale of fund shares, sparking orders for baskets of underlying stock.
The NYSE's plan to combine electronic and floor-based trading next year into a ``hybrid market'' may make program trades even more popular.
Currently, a broker can only send an order for no more than 1,099 shares for automatic execution every 30 seconds. The NYSE will lift that restriction, allowing a greater number of shares to be handled by computers.
The prospect of another increase suggests to some traders that the NYSE's program-trading criteria are outdated. Adjusted for inflation, the $1 million minimum would equal $1.62 million today. The S&P 500 has risen fivefold since the 1987 crash.
``Some of the basket sizes that we deal with nowadays are pretty ridiculous,'' said Tony Huck, managing director of trading at Investment Technology Group Inc. in New York. ``The definition doesn't represent what a program means today.''
Ray Pellecchia, an NYSE spokesman, declined to comment.
Whatever happens, program trading has become a mainstream part of the exchange -- a role it didn't have back in 1987.
``If a broker in the olden days had 20 order tickers that had been called in, he now pushes one button and it counts as a program,'' said CSFB's Mathisson. ``That's partly just the change in logistics about how orders are handled.''
To contact the reporter on this story: Edgar Ortega in New York at
Last Updated: October 19, 2005 00:18 EDT