Portfolio Trading or Program Trading is the process of trading a basket of stocks in large volumes with the use of computer-generated algorithms. Once the algorithm is set and running, the program begins to generate trades.
Rules on Portfolio Trading
- Maintain the portfolio or the basket’s integrity
- Maintain control of the trade
- Route orders
Understanding Portfolio Trading
In Portfolio Trading, orders are executed in the market with predetermined instructions. Investors like mutual fund traders or hedge-fund managers use portfolio trading when executing large volumes of trade. This way of trading reduces possible risks as orders are placed simultaneously, which maximizes returns because of market inefficiencies. Large volume trades to be executed by humans would not be as efficient as computer-generated algorithms.
Program trading follows these concepts:
- Trading a diversified portfolio of financial instruments lessens trading risks.
- Institutions trade a higher fraction of equity at present and using portfolio trading allows trading in diversified strategies.
- Advancement in technology led to reduced costs, which makes portfolio trading more efficient.
The volume and frequency of portfolio trading depend on each firm’s strategy and program used. Some firms use portfolio trading strategies that execute thousands of trades per day, while others every few months.
Types of Portfolio Trading
Portfolio trading can be classified into different categories based on the costs and offered services to the customer.
- Principal Trading
Some firms use portfolio trading to buy a portfolio or a group of financial assets which they anticipate to increase in value. The firm also generates additional revenue when they onsell these to customers, wherein they earn commission. However, the success of using this strategy depends on how good the firm’s analysts are.
- Agency Trading
Portfolio trading is used by firms who trade exclusively for their clients to buy stocks within the firm’s model portfolio. The shares are then transferred to the client’s accounts after purchase. Fund managers also use portfolio trading for rebalancing matters, such as in cases where funds use portfolio trading to buy and sell stocks to rebalance a portfolio.
- Basis Trading
Portfolio trading can be used to manipulate the mispricing of similar securities. Portfolio trading is used by investment managers to buy undervalued stocks and overpriced short stocks. When the prices of the two groups of financial assets converge, it results to profits.
The three basic forces at work in portfolio trading are:
- Adverse Selection – when the counterparty knows more about the stock they sell than the buyer
- Market Impact – trading large-volume stocks generally result to market impact. As prices go down when selling stocks, conversely, prices go up when buying stocks.
- Volatility Exposure – as the market price of a security fluctuates by the minute, it means the uncertainty of the price of the portfolio is at risk.
Finally, Portfolio Trading is a balancing act between the cost of immediate liquidation, which results to market impact, and longer term liquidation, which results to market exposure.