The investing term program trading refers to the use of computer and network infrastructures, along with buy and sell logic, to identify and automate orders. Program trading allows investors to immediately respond to market conditions, thereby maximizing the potential for profits.
The use of program trading is typically restricted to hedge funds, investment banks and large institutional investors. These systems leverage advances in computer technology and the speed of communications networks to simultaneously conduct a large number of transactions. These types of systems are able to react to market information in near real time. Studies conducted by the NYSE suggest program trading accounts for between 25 and 50% of the exchange's volume.
While program trading can allow financial institutions to execute a large number of transactions simultaneously, it can be used in a variety of ways, including:
Arbitrage: taking advantage of temporary price discrepancies between financial instruments, such as in index, and the individual components that make up the index.
Buy / Sell Order Optimization: includes locking-in profits or minimizing losses as a security's market price hits pre-established threshold values.
These trading systems contain sophisticated logic, including machine learning algorithms, which can analyze a large number of factors and execute buy and sell orders without human interaction. Unfortunately, these systems are not without their shortcomings. For example, if stock prices start to decline on poor economic news, the system may begin to execute a large number of sell orders in an attempt to lock in profits. The large influx of shares into the market can cause an even further decline in prices, thereby triggering even more sell orders.
For this reason, program trading is oftentimes blamed for an increase in market volatility. In fact, it's been cited by a number of systems experts as having contributed to the stock market crash of 1987.
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