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Ins and Outs of Program Trading, and Why It's Being Blamed for Market Collapse

December 06, 1987|From the Washington Post

On Oct. 19, the day that panic selling by investors collapsed the stock market in New York, stock-index futures markets in Chicago suffered their first computer panic.

As stock prices plummeted, the Chicago Mercantile Exchange was hit by round after round of orders set off by two families of computer trading programs--one intended to sidestep fluctuations in stock prices, the other meant to profit from them.

The computer-trading programs that were attempting to minimize the impact of falling prices through a technique called portfolio insurance started flashing sell orders early that Monday morning. That selling pushed down futures prices and set off the computers programmed to exploit changing prices using a procedure known as index arbitrage.

What happened after that depends on whom you believe.

Leo Melamed, chairman of the executive committee of the CME, said the massive selling in the futures markets took pressure off the New York Stock Exchange and kept the 508-point plunge in the Dow Jones industrial average from being worse.

John S. Phelan, chairman of the New York Stock Exchange, said collapsing futures markets pulled stocks down with them, causing a "meltdown" that very nearly destroyed both markets.

Nearly 10% of the shares dumped on the NYSE on Black Monday were sold under orders from computers doing arbitrage trading, according to government reports.

Those trades prompted a nearly equal amount of activity on the CME. In addition, as much as 24% of the CME's stock-index trading that day was produced by computerized portfolio insurance.

The computer programs dumped sell orders for millions of shares of stock into an already overloaded market on Oct. 19, said Philip Erlanger, chief technical analyst for Advest Inc., a Connecticut investment-advisory firm.

Congress to Tackle Problem

"We really needed more sellers on the 19th" Erlanger, a longtime critic of some computer trading techniques, said bitterly. "We got ourselves into a situation where, at the extreme, the programs changed the value of the market."

"You had computers spewing out orders like robots," said Jack Barbanel, a vice president of Granthal & Co., a New York trading firm. Barbanel said he believes computer orders prompted more computer orders, sending prices in the futures and the stock markets much lower than they otherwise would have gone.

The impact of computerized trading techniques on the markets will be the first topic of debate when Congress tackles the question of what to do about the stock market collapse. Half a dozen studies are already under way, and members of Congress have begun choosing sides in the program trading battle.

Program trading is a catchall term that once referred to any technique for buying and selling large blocks of stocks, usually by using computers to calculate possibilities and to execute complex transactions.

Recently, the definition has narrowed to apply only to deals that combine trading in stocks with transactions in stock-index futures or options.

Stock-index futures, an innovation begun five years ago, theoretically allow stocks to be bought or sold for future delivery, in the same way that corn and wheat have been traded for many years. The futures contracts are based on baskets of shares that include all the stocks in the Standard & Poor's 500-stock index, the Value Line Stock Index or some other stock market index.

If for example, someone wants to buy a S&P 500 futures contract on the CME, that person puts up a small deposit and agrees--in theory--to buy one share of each of the 500 stocks and to collect and pay for them months later. The purchase is only theoretical, because in practice the contracts are settled with a cash payment, not by delivering the shares.

If stock prices rise, the futures contract increases in value and can be sold at a profit; if stock prices fall, the futures contract holder must make up the losses.

Generally, traders who think stock prices will go up buy stock-index futures, hoping to sell them for a profit. Traders who think prices are going down can sell futures contracts, hoping to repurchase them at a lower price later. Stock index options work in much the same way and are used in some program trading.

When trading in stock index futures and options was first proposed, critics said it was just a way to bet on the stock market without putting up all the cash needed to buy shares. Stock-index futures might make money for Chicago commodity traders, it was argued, but they had nothing to do with the business of Wall Street.

Five years of stock-index trading have proven those critics were off by 180 degrees. The criticism of stock-index futures today is that they have become so entwined with the stock market that the Chicago futures markets are influencing the prices of stocks in New York.

$12 Billion a Day Traded

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