'Spoofing': What is it and how does it impact financial trading?

Definition of Bid Price and Ask Price 1. An offer made by an investor, a trader or a dealer to buy a security or commodity. The bid will stipulate both the price at which the buyer is willing to purchase the security and the quantity to be purchased. 2. The price at which a market …

by | June 3, 2015

Definition of Bid Price and Ask Price

1. An offer made by an investor, a trader or a dealer to buy a security or commodity. The bid will stipulate both the price at which the buyer is willing to purchase the security and the quantity to be purchased.
2. The price at which a market maker is willing to buy a security or commodity. The market maker will also display an ask price, or the amount and price at which it is willing to sell.

Bid price is the opposite of the Ask price, which stipulates the price a seller is willing to accept for a security and the quantity of the security to be sold at that price. An example of a Bid price in the market would be $23.53 x 1,000, which means that an investor is willing to purchase 1,000 shares at the price of $23.53.

If a seller in the market is willing to sell that amount for that price, then the transaction is completed. Market makers are vital to the efficiency and liquidity of the marketplace. By quoting both bid and ask prices on the market, they always allow investors to buy or sell a security if they need to.

Definition of a Market Maker

A Market Maker is a broker-dealer firm that accepts the risk of holding a certain number of shares of a particular security in order to facilitate trading in that security. Each market maker competes for customer order flow by displaying buy and sell quotations for a guaranteed number of shares.

Once an order is received, the market maker immediately sells from its own inventory or seeks an offsetting order. This process takes place in mere seconds. The Nasdaq is a prime example of an operation of market makers. There are more than 500 member firms that act as Nasdaq market makers, keeping the financial markets running efficiently because they are willing to quote both bid and offer prices for an asset.

High Frequency Trading

High-frequency trading (HFT) is a primary form of algorithmic trading[1] in finance. Specifically, it is the use of sophisticated technological tools and computer algorithms to rapidly trade securities (financial assets, financial instruments, futures, bonds, shares etc.) HFT uses proprietary trading strategies carried out by computers to move in and out of positions in seconds or fractions of a second.

It is estimated that as of 2009, HFT accounted for 60-73% of all US equity trading volume, with that number falling to approximately 50% in 2012. High-frequency traders move in and out of short-term positions at high volumes aiming to capture sometimes a fraction of a cent in profit on every trade.

HFT firms do not consume significant amounts of capital, accumulate positions or hold their portfolios overnight. As a result, HFT has a potential Sharpe ratio (a measure of reward to risk) tens of times higher than traditional buy-and-hold strategies. High-frequency traders typically compete against other HFTs, rather than long-term investors.

HFT firms make up the low margins with incredibly high volumes of trades, frequently numbering in the millions. It has been argued that a core incentive in much of the technological development behind high-frequency trading is essentially front running, in which the varying delays in the propagation of orders is taken advantage of by those who have earlier access to information.

A substantial body of research argues that HFT and electronic trading pose new types of challenges to the financial system. Algorithmic and high-frequency traders were both found to have contributed to volatility in the Flash Crash of May 6, 2010[2], when high-frequency liquidity providers rapidly withdrew from the market.

Several European countries have proposed curtailing or banning HFT due to concerns about volatility. Other complaints against HFT include the argument that some HFT firms scrape profits from investors when index funds[3] rebalance their portfolios.

[1] Algorithmic trading, also called black-box trading or algo trading, is the use of electronic platforms for entering trading orders with an algorithm which executes pre-programmed trading instructions accounting for a variety of variables such as timing, price, and volume. Algorithmic trading is widely used by investment banks, pension funds, mutual funds, and other buy-side (investor-driven) institutional traders, to divide large trades into several smaller trades to manage market impact and risk.

[2] The May 6, 2010 Flash Crash, also known as The Crash of 2:45, was a United States trillion-dollar stock market crash, in the "course of about 36 minutes starting at 2:32pm ET in which the "S&P 500, the Nasdaq 100, and the Russell 2000 collapsed and rebounded with extraordinary velocity." Dow Jones Industrial Average "experienced the biggest intraday point decline in its entire history," plunging 998.5 points (about 9%), most within minutes, only to recover a large part of the loss.

[3] An index fund (also index tracker) is an investment fund that aims to replicate the movements of an index of a specific financial market, or a set of rules of ownership that are held constant, regardless of market conditions.

Spoofing

Spoofing is an illegal practice in which an investor with a long position (long term ownership of an asset) on a security makes a buy order for that security and immediately cancels it without filling the order. Spoofing tends to increase the price of that security as other investors may then issue their own buy orders, which increases the appearance of demand.

The first investor then closes his/her long position by selling the security at the new, higher price. Spoofing is a form of market manipulation.

Layering is a form of spoofing by which a trader enters several orders to improve the price of a trade in the opposite direction. Thus, a trader who really wants to sell a stock might enter several orders to buy, in hopes of increasing the price. When that has been accomplished, he will cancel those buy orders. Layering is becoming an increasing problem on the London Stock Exchange and the U.K., in the US and internationally.

Long and Short Position

Having a long position in a stock means usually that you own the security. You have the right to collect the dividends or interest the security pays, the right to sell it or give it away when you wish, and the right to keep any profits if you do sell.

Similarly, you have a long position in an option when you hold the option, and you have the right to exercise it before expiration or sell it.The term is also used to describe a position that's maintained by your brokerage firm or bank on your behalf. For example, if your firm holds stocks for you in street name, you are said to be long on their books.

Having a long position is the opposite of having a short position in a security. A short position means you have borrowed shares through your broker, sold them, and must return them, plus interest, at some point in the future. Similarly, a short position in an option means that you have sold the option, giving the holder the right to exercise and committing yourself to fulfilling the terms should exercise occur and you're assigned to meet them.

Pump and Dump

In a pump and dump scheme, a scam artist manipulates the stock market by buying shares of a low-cost stock and then artificially inflating the price by spreading rumours, typically using the Internet and phone, that the stock is about to hit new highs.

Investors who fall victim to the get-rich-quick scheme begin buying up shares, and the increased demand drives up the price.

At the peak of the market, the scammer sells out at a profit, shuts down the rumour mill, and disappears. The price of the stock invariably drops dramatically and the investors who got caught in the scam lose their money.

This is an illegal practice in which investors attempt to artificially inflate the price of a stock by disseminating inaccurate or misleading information. These investors have a long position on the stock in question and seek to inflate the price in order to sell their shares for a higher profit. Pumping and dumping violates securities laws and can lead to hefty fines.

Victims often stand to lose a good deal on pumping and dumping as the price of the stock usually falls to its previous level in a relatively short period of time.

Summary and Conclusion

The financial trading practices described above are either illegal or unethical. They cause sharp abnormal market movements and cause pain and grief to unsuspecting investors. This is because the rules and conduct of the game have now changed and are manipulated. There is no longer a fair play, as technology and human greed create temptations to make huge quick profits by the few at the expense of others.
 

By Professor Dr Rabbi Abe Abrahami, Dean of Bluewater Academic Institute’s Executive MBA programme

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