Program trading – trading by computer – is an algorithmic trading strategy usually employed by hedge funds and can be deployed on any type of asset class (foreign exchange, commodities, rates, stock indices, etc.).
As a rule, this approach relies on technical signals or market indicators (trading volume, chart analyses, etc.) to quickly detect trends and then take positions (bet) on the market’s direction. If the algorithm’s prediction is correct, the bank profits when the anticipated price move (up or down) is realized.
One of the main constraints of program trading is that most traders hold portfolios comprised of many different stocks. This can lead to a very diverse portfolio of positions and thus a high notional exposure.
Program trading is particularly beneficial during periods of market stress. Since the process is algorithmic, it is immune to the moments of fear or panic that are typical in financial crises.
It is important to note that the algorithm used by a manager will let winning trades run but will quickly cut losses, which means that the trading style of a program trading strategy is very similar to that of an option position due to the asymmetry between gains and losses.
Thus, program trading strategies are most effective during periods of high volatility. And in fact, this means that program trades have a low correlation with the capital markets and other speculative strategies, making them an excellent diversification in a hedge fund portfolio.
There are, however, a number of risks associated with program trading. Due to the investment style, the returns of program trading managers can be very volatile. Without adequate risk management capabilities, hedge funds that engage in program trading can quickly accumulate substantial losses. In many cases, the weaknesses in the key models and assumptions used by a failing program trading fund do not become clear until after the event.
In addition, the fact that the strategy feeds off market volatility can lead to periods of relatively poor performance in periods of market increase without volatility and thus suffer in comparison to other funds.