Algorithms can have unintended and expensive consequences
It’s fairly well known that some of the largest market participants trade algorithmically. In fact most of them do. Trading using algorithms is better in almost every way.
The algorithm always sticks to the plan and isn’t influenced by emotions that create self-doubt. They’re also faster and more efficient. Speed of algorithms are only limited by their creators design capabilities.
Naturally, this means algorithms are better positioned than humans to make successful and emotionless trades, which are some very key characteristics to have in order to be successful in the global markets.
Of course, with these extra superhuman capabilities, traders will try their best to find ways to profit using algorithms. A certain illegal method of doing so is called “spoofing”.
The word “spoof” can be used to mean “deception” or “a ruse”, which is quite fitting for the process used by these rogue traders.
In this case, “spoofing” is when the rogue trader deceives other market participants by creating a ruse that makes it seem as if a security has a lot more supply or demand than it actually does. When a security has significantly more supply than demand, this will push the price down and vice versa, simply due to the laws of supply & demand.
So, as you can imagine, having the ability to make it seem that there is a huge demand for a security that you own can be very profitable, because it will push the price of the security up.
How is spoofing actually done though? In line with the concept previously discussed, “spoofers” use their algorithms to almost instantaneously create numerous (can be thousands or more) bids and/or offers. Then, just as quickly, they will cancel these orders before they have a chance to execute, thereby achieving the desired result without actually placing any orders in the order book.
The consequences of this can be disastrous for a market. A real world example lies in the Flash Crash of 2010. In this case, the appearance of huge selling pressure led U.S markets to lose approximately $1 trillion in the space of less than an hour.
The subsequent investigations of the huge crash attributed one of the causes to a trader in London, who had spoofed the market for S&P 500 stock index futures contracts — which is a relatively illiquid market in comparison to the regular S&P 500 stock index market.
With this particular example, it seems quite obvious why not to spoof markets. The consequences are obvious and drastic, and it is relatively easy for the authorities to uncover who is responsible and bring them to justice. However, it is actually quite difficult to accurately determine whether an order book is spoofed or not. This is because, at a fundamental level, spoofing is just making orders then cancelling them.
This is not necessarily an illegal practice. For instance you may just simply change your mind about an order before it has been executed. For small time traders, this would go unnoticed because the magnitude of the order is insignificant, and the consequent price-action is indistinguishable from the volatility in the price of the contract. So a lot of the time, spoofing just goes unnoticed.
However, when the magnitude is relatively large and noticeable, there is still another factor to consider when authorities investigate spoofing allegations. This is the fact that it’s difficult to prove intent of spoofing. As mentioned before, this could just be a change of mind, and not actually intentional market manipulation.
