Technology amplifies human response, as the 1987 stock market crash demonstrated. On October 19, 1987, the Dow Jones Industrial average declined 22.6% in the largest single-day drop in history. “Black Monday,” as it has become known, was almost twice as bad as the stock market crash of October 29, 1929. The 1987 crash was caused in large part by the combination of technology and the herd-like mentality of investors. Program trading allowed automatic sell orders to be placed at preset prices, investors immediately responded by selling issues of their own, and then additional program trading kicked in to drive stocks even lower. The result was a vicious whirlwind that produced a financial meltdown in a matter of hours.
In response to the 1987 crash the NYSE prohibited certain forms of program trading, and the SEC implemented “circuit breakers.” Under the SEC's rules, a drop of 350 points in the Dow would bring a 30-minute halt in NYSE trading. If the Dow declined another 200 points, trading would cease for one hour. The circuit breakers were needed to keep technology and the ability for rapid exchange of information in check. The markets mainline information each and every day, and the circuit breakers help to inoculate traders before an uncontrollable chain reaction can occur.
Program trading are transaction
s, usually computer
, that result in orders to sell huge amounts of stock under pre-set
circumstances. At first this type of trading occurred when index funds and other institutional traders got on board with large-scale buying or selling movements or "programs" to spend in a method, which simulated a marked stock index
. Today the phrase commonly describes, “computer aided stock market buying or selling programs, portfolio insurance, and index arbitrage.” Nearly half of the index arbitrage
accounts for trading that involves the stock market and futures and options markets. In theory arbitrage is simply purchasing what is cheap and selling what is expensive for profit without risk. The largest parts of program trades in the United States are completed on the New York Stock Exchange, using computerized trading systems.
For example a portfolio manger will try to net gains from the price spreads between a selection of equities comparable or equal to those at the core of a designated stock index. One popular index that investors model at this time is the Standard & Poor's 500 Index. Rather than buying and selling one lot of stocks at a time the trading these stocks trades include the buying or selling of a “basket” that includes “15 or more stocks with a total market value of $1 million or more. “
Computerized trading programs can examine a large diversity of markets and securities designed for detecting indicators. When there is a match they issue orders to buy and sell. The New York Stock Exchange collects program trading statistics daily.
A common effect of this kind of arbitrage are the opportunities that crop up from the short term mis-pricing of securities on different exchanges. One example cited is, selling short stock index futures contracts on the Chicago Mercantile Exchange while at the same time the program buys a basket of securities mimicking the S&P 500 index on the floor of the NYSE. This is purposefully calculated to reap the benefits of the transitory disparity that is sandwiched between the actual value of the stocks that make up a “popular index and the value represented by futures contracts on those stocks.” To reduce to a bare bones explanation, if the stocks' worth are more than the futures contracts show, computer programs issue instructions to buy futures contracts as soon as they sell the stocks. When the value of the stocks are less than what the futures contracts show, the computerized program trading purchases stocks and sells the futures. The end result is practically risk-free earnings for the program traders. Because of the immense numbers of shares required to make the method work it burdens the market with an additional instability.
The computer is programmed to detect price discrepancies and enter the buy and sell orders directly into the market's computer system, which are automatically executed. Many are of the program trades are set in motion without human supervision or directions. These automated executions to buy and sell large numbers of stock have been blamed for excessive volatility in the markets, especially on Black Monday in 1987.
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