The impact of program trading on stock returns

This paper examines two competing views about the impact of program trading on stock returns. The first view is that program trading destabilizes the stock market by making market participants overreact to the program trading. This view, which is popular among practitioners and regulators, implies that program trading increases market volatility. The proponents of this view claim that the market crash of 1987 is a typical example. On the other hand, the second view is that program trading is a vehicle that transmits valuable information which has arrived first in the futures market to the stock market. According to this view, program trading plays a role in making the stock market efficient. We test these two views by examining dynamic relationships between program trading and stock returns. Specifically, we build a bivariate VAR model with two key variables: program trading order imbalances and KOSPI200 Index returns measured in five minute intervals. Using this VAR framework, we also conduct a Granger-causality test and the impulse response analysis. The Granger causality test shows that the causal relation between program trading order imbalances and KOSPI200 index returns is bidirectional. The impulse response analysis suggests that a unit shock in the program trading variable affects the KOSPI200 index returns only for 10 minutes, and the effect dissipates quickly. These results are not sensitive to the choice of the program trading definition such as arbitrage program trading and non-arbitrage program trading.