"Strap on Your Seat Belts!"

By Stephen Koepp

The day is quiet, at first, for 26-year-old Joseph Schmuckler, program trader for Kidder Peabody. The blinking number on his computer screen, which will signal him when it is time to unleash his electronic firepower, is advising him to wait. But suddenly the stock market begins to move downward, and the telltale digit on Schmuckler's screen starts changing like a countdown at Cape Canaveral. The trader and his two assistants erupt in a frenzy of shouted telephone conversations as they advise colleagues in New York City and Chicago to get ready for a blast of trading orders. "Strap on your seat belts, folks," says Schmuckler. "It looks like it's going to be another wild and woolly one! Get ready for Program C! Program C!"

With that, an assistant leaps into the chair at a computer terminal designated for just one important job: to execute Kidder's preset trading program called Firedown. Triggered by a few keystrokes, Firedown zips a massive order to the New York Stock Exchange for the sale of 685,000 shares of stock in 500 different companies for a total of $31.2 million. At the same time, Schmuckler telephones an order to Chicago traders who will buy futures contracts on the stocks he is selling. The simultaneous deals, equivalent to a precomputer blizzard of paper shuffling, take just a few minutes to complete. Schmuckler is pleased. The quick transactions will bring a return several percentage points higher than the interest on a more traditional investment like Treasury bills. "God, this is exciting!" he exclaims. "It's so much fun."

Perhaps too exhilarating, in fact. Program traders like Schmuckler have been accused of sharply accelerating the ups and downs of the stock market and making the rest of Wall Street seasick from the volatility. Computer-driven program trading began quietly enough in the early 1980s, when investment houses started employing advanced software to carry out, in a few minutes' time, complex transactions that previously took hours or days to complete. This gave investors the ability to buy or sell quickly a group of securities as if it were just one stock.

That capability gave rise about three years ago to a particularly canny and complex form of program trading. It is a kind of arbitrage in which traders make lightning transactions to take advantage of fleeting discrepancies in the prices of related financial instruments in different markets. One of the most popular such plays involves the Standard & Poor's 500 index, which rises and falls according to the performance of 500 stocks. A program trader will use a computer's calculating ability to monitor constantly the difference between the level of the S&P index and the price of an S&P 500 index future, a financial instrument that has been traded since 1982 on the Chicago Mercantile Exchange. The stock-index future is basically a contract in which the investor wagers whether the market will go up or down between the moment of purchase and the time when contracts expire, which occurs about every 90 days.

The futures price, since it registers the market's expectations of where the actual S&P stocks are heading, often veers substantially above or below the current level of those stocks. When the futures price strays far enough from the real index, it creates a golden door for the arbitrage traders. They play both sides of the gap, knowing they will make money on the difference. For example, if an arbitrager sees the S&P futures price rising well above the S&P stock index, the trader would buy a package of the 500 stocks that make up the index, which are cheap at that moment, and sell the more expensive futures.

Prices could swing up or down before the contract is settled on its expiration date, but because of the original gap in prices, the trader has already locked in a profit, often called synthetic cash. If stock prices rise, the arbitrager will make a handsome return upon selling the shares; the money lost on the futures side of the transaction will not be enough to offset the profit because the price at which the futures were sold was overly high to start with. In the opposite scenario, falling stock prices will cause the trader to lose money on the stocks but more than make up for that loss on the sale of the overpriced futures. The deal is often called a perfect hedge because any money lost by one side of the equation will be more than made up by the other side.

Program trading may bring a safe return for its participants, but it creates distress for other, unsuspecting investors. As traders load or unload enormous amounts of stock, they can magnify the rise or fall of the market. Sharp volatility has occurred at the so-called triple witching hour (on the third Fridays of March, June, September and December), just before stock-index futures and two related types of financial instruments expire at the same time. That is the last point at which arbitragers can decide what to do with the stock they have accumulated, and their herdlike decisions have often wrenched the stock market in wild and woolly one-day movements.

With reporting by Lisa Kartus/Chicago and Thomas McCarroll/New York