When you think about spoofs maybe some classic movies come to mind such as “Airplane!,” “Austin Powers,” “Hot Shots!,” and “Naked Gun”, to name a few. Though we could have some good laughs recalling some of the good one-liners like, “stop calling me Shirley”, but let’s take a deeper look at trade spooking, not parody movies. Last week a Chicago jury found Michael Coscia guilty on 12 criminal counts against him as authorities attempt to clamp down on deceptive trading driven by computers.
So what is spoofing? Trade spoofing is a disruptive algorithmic trading activity employed by traders to outpace other market participants and to manipulate market prices. Under the 2010 Dodd-Frank Act, spoofing is defined as “the illegal practice of bidding or offering with intent to cancel before execution.” Spoofing can be used with layering algorithms and front-running, activities which are also illegal. In a nut shell, (from Austin Powers, “Hey Look, I’m in a nutshell!) spoofers bid or offer with intent to cancel before the orders are filled and by doing this they can improve entry and exit prices by manipulating orders and thus profiting from the price movement.
In July 2013 the US Commodity Futures Trading Commission and Britain’s Financial Conduct Authority brought a milestone case against spoofing and indicted Panther Energy Trading and Michael Coscia, a high-frequency trader for using a “computer algorithm that was designed to unlawfully place and quickly cancel orders in exchange-traded futures contracts.” They placed a “relatively small order to sell futures that they did want to execute, which they quickly followed with several large buy orders at successively higher prices that they intended to cancel. By placing the large buy orders, Coscia and Panther sought to give the market the impression that there was significant buying interest, which suggested that prices would soon rise, raising the likelihood that other market participants would buy from the small order Coscia and Panther were then offering to sell.”
The world of trading “bots” that use algorithmic and high-frequency trading has greatly changed the way markets are traded, and arguments can be made on the merits of liquidity, and the disasters of flash crashes caused by such automated trading.
For example, a spoofer might dupe other traders into thinking oil prices are rising, say, by offering to buy futures contracts at $44.45 a barrel when the market price is $44.43. After other buyers join in with bids at that higher price, the spoofer pivots, canceling the buy orders and instead sells at the $44.45 price he set with the fake offer. By doing this the spoofer was ultimately able to sell two cents higher than the true market price. The spoofer can flip and then turn around and buy back his short position by pretending to place a sell order with the reverse operation that just took place, and repeated many times, spoofing can produce big profits. Not only does this strategy work to get better entry and exit prices, but spoofers are able to use this method to game other market participants stop-loss levels, and “flush” others out of their positions.
Now we have over simplified the process as the bids and the offers are placed and withdrawn in milliseconds, and this is just one of many strategies that “bots” using algorithmic and high-frequency trading play to “game” the system. Anytime you have competition and money involved people are going to find ways to get ahead. Think of spoofing as the edge used by traders that athletes use to get ahead by using performance enhancing drugs. Look at bicycle racing, to ride in the Tour de France you have to be a very good racer, maybe you have seen old black and white pictures where riders used to smoke cigarettes to “open up their lungs” as a way to get ahead, well, in hindsight that may not have been the best idea, but the point is that competitors were and are always looking for ways to get ahead of the competition.
Lance Armstrong was arguably one of the greatest athletes of all time, winning 7 Tour de France races. Lance never tested positive for performance enhancing drugs while competing, but was later banned as it was found out that he was just always one step ahead of testing methods. The argument is that if other riders were doing the same enhancement then it was a level playing field, and if no riders were enhancing including Armstrong he likely would have won anyway.
Spoof trading gives an edge to a solid trade strategy, just like steroids in the hands of a great baseball player makes him hit the ball just a bit further. There is no way that you could take an “average Joe” off the street and give him steroids and he would instantly be able to hit a homerun in a major league baseball game. Whether it is Lance Armstrong, steroids in professional baseball, or traders spoofing to front-run orders, it is that little edge that makes others follow suit to keep up.
The case is made that cycling and baseball and other sports are “cleaner” now that regulation has clamped down on cheating, but then again is a normal “average Joe” off the street any more likely to win Tour de France with or without steroids? The savvy algorithmic and high-frequency traders are always one step ahead and working to make sure that the “average Joe” does not win.