This lecture focuses on equity portfolio trading (also known as program
trading), a business whose primary objective is to provide customers
with liquidity in trading baskets of stocks. A basket of stocks
refers to a group of stocks, such as a stock index (e.g., the S&P 500
is a basket of 500 large cap US equities). A basket can be bought or sold,
or sold short. Customers have numerous reasons for wanting to transact
in basket trades. Among them are:
- Money managers or pension fund managers sometimes want to gain exposure
to a particular set of securities at exactly the same time. For example,
a money manager may be measured by his tracking error to a benchmark.
That is, the manager may be measured by the ability to exceed the return
of a known index, such as the S&P 500. In order to accomplish this,
the manager will construct a portfolio that he or she believes will outperform.
In order to invest assets and realize the return of the portfolio it is
in fact necessary to gain exposure to all securities simultaneously.
- Money managers are sometimes fired leaving large positions (e.g., $500m)
on their books. A firm may want to transition out of this position and
into a new one all at once. That is, the firm may want to exchange one
$500m position for another. This is accomplished by selling all of the
current position and buying into all of the new positon in a single basket
trade. Such trades are known as basket trades.
Basket trading is sometimes also called program trading or portfolio
trading. Whatever its name, it generally refers to the service of offering
large (e.g., large dollar value) trades in many stocks simultaneously.
In what follows we will discuss what services a typical program trading
desk offers, what the risks to the desk are and a little bit about how
the trades are accomplished.
This lecture is divided into several parts. The first part discusses
what program trading is, and the types of trades a desk will do for a customer.
The second part discusses how business is conducted and the third part
discusses market volatility and market impact. Before we begin with any
of that we have to introduce a few useful pieces of terminology:
- Benchmark: money managers often refer to a benchmark when they
are speaking of a specific index (such as the S&P500 index or and MSCI
index) as it relates to their investments. This usually means that the
index's (i.e., the benchmark's) return is the level to which their portfolio's
return is measured.
- Tracking: one portfolio is intended to track another if its
primary aim is to at least match, but hopefully outperform the other. For
example, if portfolio A tracks a benchmark then this loosely means
its returns have a high covariance with the benchmark.
- Tracking Error: this can usually mean one of two things. It
either means the difference in return between a given portfolio and a benchmark,
or the standard deviation of the difference of return between the two portfolios.
It is a measure of how much the tracking portfolio "misses" the
benchmark, either in direct return terms, or in the probabilistic sense
of standard deviation.
- Exposure: the term exposure refers to "exposure
to risk" by owning a security or basket of securities or an index.
Exposure is not bad, for example, money managers want "exposure"
to the market to realized returns. It can be bad, however, in the case
where an exposure is unwanted, and the manager wants to trade out of it.
Exposure is something that a money manager with cash will want to "get"
by purchasing stocks. A money manager may wish to change exposure either
because his views change (e.g., "the market is over valued, sell stocks,
buy bonds"). A money management firm may change managers and therefore
need to put on a completely new set of positions.
- Long-Short Basket: this is a basket of stocks in which contains
both long stocks and short stocks. If a customer wishes to buy $100 of
stock A and sell short $100 of stock B.
- Desk: trading businesses in investment banks are often referred
to as "desks", as they are operated off of long rows of small,
closely spaced desks. When we refer to "the program trading desk"
we are referring to the business of program trading.
Types of Program Trades
Program trades can be broken into a few different categories, according
to the costs and services offered to the customer. The different types
of trades are:
- Agency Baskets: in these trades, the program desk acts as a
dealer. Agency always means the customer pays. The dealers jobs is merely
to execute. The dealer is paid on a commission basis, usually on a cents
per share basis. The price per share is competetive (based on a bidding
process) and depends on the contents of the basket (more on this point
later). The dealers incentive is to do a good job and not "cost"
the customer too much (more on costs later) so that the customer will return
for more business. In this form of trade, the customer assumes all of the
risk, and the dealer takes no risk (why?) Often the customer will specify
a target price for the trade, that is, a guideline for the trading desk
to follow in terms of how to get the trade done. Options include "best
price", "closing price", "volume weighted average price
(VWAP)" and "best effort." This is always negotiated between
the customer and the desk, and the particular form chosen depends on the
needs and views of the customer.
- Agency Incentive: this form is a variation on the theme of agency.
The idea is the same as agency but the commission is increased for good
trading performance (more on trading performance later).
- Principal Trades: a principal trade, also known as a "risk
bid" or "principal bid" is a trade in which the dealer buys
an entire portfolio from a customer at an agreed upon price. The agreed
upon price is usually keyed off of the closing price of each stock in the
portfolio on the day the risk bid takes place. For example, if a money
manager is long a portfolio and would like to sell the entire portfolio
at once at a known price, he or she can bid it to a dealer. The sale will
take place at the closing price at the end of the trade day less a
certain number of cents per share. In this way, the dealer will own the
portfolio at a discount to the market price. In this trade, the dealer
takes all of the risk and hopes to profit by being able to trade out of
the securities at a price less than the price paid. In this trade, the
dealer takes all of the risk and the customer pays a fixed cost. One of
the dealers biggest concern is adverse selection (an important term),
wherein the dealer receives stocks based on the provision of liquidity
without having a view on the value of the stocks, a so-called liquidity
trader. The customer, an smart money manager, may have information
concerning the stock, such as that it is a "dog", making the
customer a so-called informed trader. As a rule, a liquidity trader
trading with an informed trader must charge a premium over market prices
to compensate for the informational advantage that the informed
trader naturally has. One of the keys to the business is having a good
sense of what the correct liquidity premium is.
- Basis Trades: a basis trade is designed for a customer who wishes
to change his or her level of exposure to the market by buying or selling
a basket that closely tracks a futures index (e.g., the S&P 500 contract
or the DAX). That is, if the customer is currently not invested in stocks,
but would like to invest $500m into the market immediately, then a basis
trade is a possible way of achieving this. Likewise, a customer may do
a basis trade if he or she is currently invested in the market and would
like to reduce their level of exposure. The trade is done in conjunction
with futures trades conducted by the dealer. For example, if a customer
wants to buy $500m worth of stock, then ordinarily, the dealer would have
to sell this stock to the customer, leaving the dealer essentially short
the stock. This results in significant risk. However, if the dealer is
also long futures, and if the basket tracks the stocks, then the risk is
largely in the "basis" between the fair price of the futures
contract and the actual price of the futures contract. The trade, then,
proceeds as follows. During the day of the basis trade, the dealer would
purchase futures contracts in quantities designed to hedge the forthcoming
short stock position. At the end of the day, the dealer would sell the
basket of stocks to the customer at a price that reflects the average price
of the futures. This leaves the dealer with a hedged position, short stock,
- EFP (Exchange for Physical): an EFP allows the holder of futures
contracts to exchange the futures for stocks. Sometimes money managers
receive cash from share purchases but do not immediately buy stocks. Rather,
they accumulate futures and then purchases stocks at a later point. To
replace the futures exposure with stock exposure, they may do the trade
in one stroke through a program trading desk.
The Business of the Business
Program trading is a customer driven business in which sales people
have relationships with pension funds and money managers. These money managers
are in constant need of new market exposure or changing old market exposures.
Sales people often bring business to portfolio strategies groups who
help money managers devise particular portfolios for particular purposes.
These strategies can only be carried out by putting on the positions suggested,
and this usually involves a basket trade.
At the point a basket trade is in the offing, there is a fundamental
problem. The customer has a position he would like to buy or sell (or both,
as in a long-short basket), but for many good reasons would not like to
reveal the contents of the basket until such time as the prices have been
agreed upon. This is the case for several reasons:
- Fear of front running: the customer may be afraid that the dealer,
if he knows what is in the basket will "trade ahead" of the customer.
For example, if the customer reveals that he is long $20m of XYZ stock
and is planning to sell it, then the dealer could, in principle, short
$20m of XYZ in anticipation of the market impact incurred in selling such
a large block of a single stock.
- Privacy: some money managers are extremely secretive about their
positions and do not want to reveal their positions to anyone, unless it
is absolutely necessary.
On the other hand, the dealer has to know as much as possible about
the contents of the basket in advance of trading for several good reasons:
- Variation in liquidity: some stocks are extremely easy to trade,
while others are very difficult to trade. That is some stocks are very
liquid and can be moved in large quantity without a great deal of trouble.
Other stocks, are costly to trade.
- Variation in volatility: some stocks are extremely volatility
(e.g., internet stocks) while others are not.
The obvious conclusion of these two points is that no two $100m (or
$500m) portfolios are alike. Yet despite this, for a principal trade the
dealer has to offer a price per share to take the basket and even for an
agency baskset these are issues. As a consequence of this, most firms have
resorted to the following compromise.
Program trading desks are willing to forego specific knowledge in exchange
for generic knowledge about the basket they are bidding on. An example
of the type of information that a dealer will require is;
- Total number of shares: Number of shares on the long side and
on the short side of the basket.
- Number of shares in each market: The number of shares in each
market, e.g., the NASDAQ, NYSE and AMEX (if the basket is a US program
- A Liquidity Breakout: that is, a "histogram" of the
number of shares in different "liquidity bins." For example,
if the basket has 100 long shares, then a liquidity breakout might read:
||Number of shares
- A pricing breakout: similar to a liquidity breakout, but a breakout
of the number of shares in several price/share brackets.
Exercise: explain in detail why each of the above points is useful
for a trader to know. What other facts about a portfolio might you want
Principal baskets are usually usually sold to the lowest bidder, in
the following sense. A customer wants to sell a principal basket and naturally
wants to pay the lowest price. That is, if the customer is selling the
basket, they want to sell it for as few cents below the market close as
possible. If he is buying a basket he wants to pay as little a premium
above the market as possible. To help esnure this, the customer usually
gives the portfolio (in the sense that he gives the above information)
to several program trading desks and asks for a bid. Naturally, each desk
attempts to win the bid (if they want it) by bidding as low as possible.
Ultimately, the desk would like to win business while still making money,
so the bidding process requires the desk to deduce the cost of trading
the basket. This leads us to the final section of this lecture.
Portfolio Trading Strategies
When a program trading desk engages in a risk bid, their profit is the
price per share they bid less the cost of trading. In an agency
trade, these costs are borne by the customer, but the dealers performance
is measured in terms of this cost, and future business depends on good
performance. There are three basic forces at work in portfolio trading:
- Adverse selection: this is the condition of your counterparty
knowing more than you do about the stocks he is selling.
- Market Impact: trading stocks in size generally results in market
impact. Sales of stocks push prices down, while purchases of stocks push
- Volatiltiy Exposure: stocks are volatile and their future prices
are uncertain. Consequently, when holding a portfolio with the intent to
liquidate it, the uncertainty of future movements represent risk. For example,
if a program trading desk wins a long risk bid at 4 cents per share, then
they have contracted to sell a certain basket of stocks to their counterparty
at 4 cents per share less than the closing market price of the stocks in
the basket. This has two immediate consequences: first, the desk is effectively
short the securities in the basket. Why? Because they are required
to sell them to their counterparty. To effect this sale they must buy the
stocks. Until such time as they have purchased all of the stocks in the
basket, they are exposed to all future upward movements of the stocks in
As a consequence of the latter two bullet points, portfolio trading
is a balancing act between the cost of immediate liquidation (resulting
in maximum market impact) and longer term liquidation (resulting in market