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New 'Program' Trading Alters Face of Market

September 16, 1986|JAMES FLANIGAN

OK, just what is program trading, the computerized tidal wave involving indexes on common stocks and futures contracts on the prices of those indexes that is so violently churning the stock market, most recently last week when the Dow Jones industrial average fell more than 120 points in two days? And what does program trading's sudden and awesome rise mean?

It is a phenomenon comprising two parts greed and one part fear in which major Wall Street investment houses and large institutional investors are changing the stock exchange into a commodities market. Like the markets for cotton or grains, the new stock market provides participants a useful way to hedge against losses, as well as opportunities to make big money with lightning speed.

Small investors need not apply, however. For program trading means, emphatically, that investing has entered a new era in which the individual investor can play only for the long term--buying a stock and waiting two years at least for it to go up. Anything less is speculation, an investment expert once said, and these days the speculating small investor is badly overmatched by institutions trading stocks in response to computer programs attuned to minute price differentials.

Accentuates Market Movement

Still, program trading only accentuates the market's movement; it does not cause it. "Natural buyers moved the market up 600 points from last October to the peak," says Eugene Brody, director of options management at Oppenheimer Capital Corp., "and it was natural sellers who sent it down last week."

Fine, you say, but what is program trading? It is the application to the stock market of risk-transfer techniques developed in Chicago in the 1850s. Farmers faced a problem as their grain shipments piled up in wagons on Chicago streets and prices fell. Having borne the risk of producing the crop, the farmers found it intolerable that they should bear the additional risk of a price decline at the market gate.

So they protected themselves by contracting to deliver grain for a specific price on a specific date. They transferred the risk to the grain buyer, in other words, who then sold the contract to others. This early trade in contracts led to the futures markets that we see today.

That such an idea should come to the stock market was inevitable with the growth of pension funds to nearly $1 trillion in assets. The investment managers for those pensions need to earn a return but dare not suffer a loss of principal. They therefore needed to transfer risk. And so futures contracts on stock market indexes, such as the widely used contract on the Standard & Poor's 500 stock index, arose four years ago.

Portfolio Insurance

The way it works, a pension investor can hold the actual stocks covered by the S&P 500--all the major U.S. companies--and sell a futures contract at a price below which the fund manager doesn't wish the portfolio to fall. Then, if the stocks in the S&P 500 index decline, the fund manager will still be able to collect the old higher price for the futures contract and thus offset his loss on the stocks. If prices go up, of course, the investor loses on the future what he is gaining on the stocks, thus limiting potential gains.

That limit is the cost of insurance, explains Larry D. Edwards, president of Leland O'Brien Rubinstein Associates of Los Angeles, a firm that originated the concept of portfolio insurance--a business that now covers pension funds totaling $30 billion in assets.

But there is more to program trading than such useful hedging. There is also arbitrage, in which traders capture quick profits when S&P futures prices, as they frequently do, get out of line with the price of the stocks in the S&P index.

When bearish sentiment gets particularly intense, for example, futures contracts--which are nothing more than a bet on where the stock market is headed--will fall faster than stocks themselves. As the computer spots such anomalies, traders instantly sell millions of dollars worth of the stocks and simultaneously buy the futures contracts. As the price of the futures returns inevitably to a synchronous relationship with the stock prices, program traders reap big profits.

All very neat, except that the price swings such trading causes are driving out the small investor and upsetting a good many institutional ones as well. The commodity markets impose day limits to prevent such volatility--the price of wheat or corn futures can only rise or decline 10 cents a bushel in a single trading session. When the limit is reached, trading shuts down until the next day. If such limits were applied to the S&P futures contract, it would seriously curtail program trading, because arbitrageurs would fear being locked in overnight in any position.

Will the government or the exchanges impose such day limits? Wall Street is already defensive, arguing that in the long run, prices are no more volatile today than they ever were.

But most people are understandably skeptical of that claim, believing that Wall Street once again has found a way to support speculation and avoid investment. A few more days like last Thursday and Friday and people will be saying, "There oughta be a law."

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