October 19, 1987, later known as Black Monday, saw the biggest single-day crash on Wall Street. The general theory is this happened because computers around the world, programmed to execute trades automatically, reacted to pre-set signals and executed sell orders en masse. And a number of puritans who valued human judgements over machines in the financial market swore off computers.
More than two decades later, algorithmic trading (also known as program trading) is making inroads into India. A number of brokerages are launching services to enable machine execution of orders.
Computers were programmed for financial strategy in September 1976 by Harvard professor, Mark Rubenstein who invented the Portfolio Insurance for Berkeley finance professor Hayne Leland to save his family from financial ruin. The strategy became so popular that by 1987, equity assets worth about $60 billion were covered by this strategy. Program trading is designed to respond dynamically to market conditions; Without computers, this speed of response would not be possible.
On the day before the 1987 crash, the S&P 500 was in a negative zone. And there were extremely high sell positions that were being built up. On the day of the crash, portfolio managers that had built their positions for dynamically hedging their portfolios programmed their computers accordingly.
And all hell broke loose when the markets began to fall again. Critics said the crash was accentuated by computers. But some studies conducted after the crash showed volatility was rampant irrespective if computers were used or not.
Over the years, program trading has evolved. Hedge funds and pension funds are now using computers to lower their costs of trading. Algorithms are also being built in understanding trends that would not have been so easily visible to the human eye.
In its crudest form, program trading is not really new to India. Institutional investors have used some kind of computer programs to smoothen their trades and reduce the cost of trading. Last year, Securities and Exchange Board of India, the stock markets regulator, allowed direct direct market access (DMA). This enables investors place orders on their own using their broker’s infrastructure. This is expected to drive the adoption of program trading in the country.
Devang Neralla, director, Financial Technologies, says that brokers are asking for sophisticated software that will help them run proprietary trading books as well as their clients’ money.
But the true test of program trading will come when the market falls steeply. Investors should not then blame the machines for their losses.
(This story appears in the 31 July, 2009 issue of Forbes India. You can buy our tablet version from Magzter.com. To visit our Archives, click here.)