On Jan. 8, the Dow Jones industrial average made headlines when it fell 39.10 points -- the second-biggest one-day drop ever recorded. Few took note at the time, but since then Wall Street has recognized that ``program trading'' accounted for much of the plunge. Now, almost every day one hears ``program trading'' blamed for wild fluctuations in the stock market.
Program trading requires a computer to monitor stocks and stock indexes. It also requires quick reflexes and huge sums of cash -- usually $10 million and up. That means that a handful of well-heeled institutions and brokerages dominate it.
The strategy involves setting up simultaneous positions in both stocks and a related futures or options index. The most popular: futures contracts on the Standard & Poor's 500 index traded on the Chicago Mercantile Exchange and options on the American Stock Exchange's Major Market index.
Computers calculate the theoretical value of the futures or options based on the price of the stocks the index follows. When prices and values get out of whack, the traders move in. For instance, speculators trading options on the Major Market index may be very bullish about the stock market. Computers detect the option prices getting ahead of the value of the 20 stocks making up the Major Market index.
Before the spread disappears, traders will simultaneously buy a group of stocks that mimics the index and sell short the overpriced options. By locking in the spread, the trader has an almost risk-free profit: often about a 12 percent annualized return. If the stock prices tumble, then the shorted options increase in value, more than countering the stock losses.
The practice bothers some investors, since the swings in stock prices have nothing to do with fundamental changes in the value of the corporation the stock is supposed to reflect. Others say it's a game that gives an unfair advantage to the institutions, further disenfranchising the small investor.
Some analysts counter that the swings simply speed up changes that would happen anyway and make for a more efficient market.
The Securities and Exchange Commission, which essentially cleared the practice a year or so ago, is now studying it again. Congressional hearings may soon be held.