What it is:
Program trading refers to automated trading by investors using computer programs.
How it works (Example):
Program trading is used by institutional investors for large-volume trades through direct connections with the market's computers. Trades are automatically triggered based on reaching a threshold point on a specific market index, for example.
Program trading has become increasingly sophisticated, allowing for phased buying or selling in order to minimize disruptions to the markets. Also, program trading has become an important tool forfunds that analyze historical stock and index data and purchase or sell long and short futures quickly in order to manage risk.
Why it Matters:
With the direct connection and the automatic response (i.e. buy or sell order), a program trader can act more quickly than typical floor trades. But automatic trades can be flawed. They react without understanding or taking into account larger trends or events that may have caused the movement in the market in the first place. In addition, because of the large volumes, they can compound or accelerate market declines because they have the potential to snowball into much larger market movements. Program trading has been blamed for a variety of volatile market slides (e.g., 1987 crash) throughout the 1970s-80s, when they became popular.
Major exchanges have imposed restrictions on the use of program trading at various times, particularly around sudden events that may have cause of flurry of program trading to sell off stock and cause a panic.