22 October 2016
Individual retail investors account for around 80 percent of the total trading volume of Chinese stock markets. Photo: HKEJ
Individual retail investors account for around 80 percent of the total trading volume of Chinese stock markets. Photo: HKEJ

How program trading works in China stock markets

The recent market crash in A shares has exposed various problems.

The China Securities Regulatory Commission has restricted 34 stock accounts that have been short-selling A shares using program trading.

These accounts have been locked up between July 31 and Oct. 31, and are not allowed to buy and sell any stocks in the Shanghai and Shenzhen markets.

It’s quite clear that program trading has far-reaching implications in the deep market correction of A shares.

Program trading may not represent a big percentage of the total market trading, but the trading strategies applied have not been mastered by many mainland brokerages and even the regulators.

Indeed, China’s financial market regulation still lags far behind market development.

The CSRC rushed to stop short-selling through program trading. However, regulators should understand all the latest market developments, such as investment strategies and tools, so they can yield twice the result with half the effort.

What is program trading? It is large-volume trading made by systems, usually automated, based on an underlying program covering various metrics like market trend, volatility, trading volume, etc.

The trading volume contributed by program trading systems in Shanghai and Shenzhen exchanges ranks among the largest in the world.

Some large financial institutions can use direct market access and directly interact with the order book of an exchange at faster speed.

They can also use the co-location service which provides space in the same data center where the central matching engine resides and operates.

However, program trading is quantitative trading, which uses very sophisticated models and state-of-the-art scientific technologies to calculate the impact of various factors on stock and other asset prices.

It would also take into account factors like trading volume to decide whether a certain stock is attractive, potential trading costs and market impact, as well as when to sell.

The market situation can be described with a set of metrics including market trend, volatility, and correlation between different assets.

A trading strategy would have different performances in various markets. Medium and large-sized quant trading funds usually need substantial trading strategies.

For instance, one of my friends works in quant trading of foreign exchange, commodities and warrants, aad has more than 500 trading strategies available.

A filter program is used to pick out the most suitable trading strategy for a certain asset class based on market conditions.

The system trades a stock or a basket of stocks depending on a series of criteria.

But why is the CSRC so anxious about program trading?

The obvious reason is that institutions seem to aim to get rid of individual investors through program trading or high-frequency trading.

The Chinese stock market is known to be led by individual retail investors, who account for around 80 percent of the total trading volume.

By comparison, institutional investors in the United States contribute about 70 percent of the trading volume while individual investors only make up more than 20 percent.

Since management fees and restrictions are imposed on the trading of publicly offered and privately offered funds, Chinese investors trade on their own.

However, as individual investors, they are excluded from many trading strategies, especially those for hedging risks.

It is believed that the future trend is to motivate Chinese investors to switch from making individual investments to letting fund managers run their investments.

The recent volatility of the stock market has shown to individual retail investors that there is no way they can compete with institutional investors.

Regulators naturally felt the need to protect individual investors. However, since they have little knowledge of program trading, they decided to halt it abruptly.

This article appeared in the Hong Kong Economic Journal on Aug. 18.

Translation by Julie Zhu

[Chinese version中文版]

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adjunct professor in the Department of Finance at HKUST Business School

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