How Spoofing and Layering Impact the Markets

How Spoofing and Layering Impact the Markets

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Every trader should understand the games played in the markets they trade. Spoofing and layering are one of those games. If you understand the impact spoofing and layering have on the market you can use it to your advantage.

Spoofing and Layering is the act of placing a large order or multiple large orders on one side of the market and cancelling those orders soon after. This creates an artificial supply or demand. The reason for placing a large order or multiple large orders is to try and influence the market in a certain direction.

For example, if I place a large order on the bid or multiple large orders it gives the impression that there is an imbalance to the supply side. Other traders will see these orders and start to buy the market ahead of the large orders. Thus creating an artificial price.

Now I’m not condoning spoofing and layering because it is an illegal practice. Any orders placed in the market must be done so in good faith and the orders are intended to actually trade.

But as long as there is money to be made, then spoofing and layering will exist in the markets in some form or another. Therefore it is important to understand the impacts that it can have on the markets you trade.

Spoofing and Layering Can Provide Valuable Information

Spoofing and layering can give you an enormous amount of information about a market in the short term. One of the basic tenets of short term trading is seeing how the market reacts to large size coming into the market.

How a market reacts to size is a huge tell.

If you’ve ever played poker at a high level you’ll appreciate the advantage that can be gained from observing subtle tells of an opponent. It gives you a probabilistic informational advantage. This is also true in the markets.

For the bigger players spoofing and layering can be a feeling out process. They can gauge market sentiment by how the market reacts to them placing sizable orders in the market.

Let’s do a quick thought experiment. If you are a large trader and are looking to see where the weak hands are in the market. You will place a large spoof order on the bid. If the market immediately goes up and runs away from the large order then you now have a new bit of information, you know the market is susceptible to going up if large orders come in.

However if you place large orders on the bid and the market rise is checked very quickly and trades down toward where you’ve placed your orders then you have now got a huge amount of information. The market is not scared of your size.

What this tells us is that there is a slightly higher probability of trading down in the short term.

Obviously this is very contextual but I’m sure you can appreciate how small informational advantages can be used by bigger players. It’s important to understand and recognise the games played if you want to be a short term trader.

Famous Cases of Spoofing and Layering

Paul Rotter is easily one of the most famous traders in the trading community. He is thought to be one of the best day traders ever. If this is true or not no one knows but he is certainly one of the higher profile ones and is no doubt one of the most successful ever.

He was given the nickname “The Flipper” because of the trading strategy he employed. He made large amounts of money trading Eurex fixed income markets placing large orders on the bid, get filled short and flip those large orders to the short side sending the market into free fall when other traders realise the market wasn’t going up. Hence the nickname “The Flipper”.

Navinder Singh Sarao is one of the most famous traders convicted of spoofing. He is thought to have contributed to the 2010 flash crash by spoofing the market before the cash US open. The claim that he caused the crash is widely disputed.

Spoofing and Layering supposedly causing the flash crash

Sarao used an algorithm to place large spoof orders on the bid or offer in the Emini contract to give the illusion of supply or demand. He would profit by taking small profits on large size.

Context Dependent

To execute a spoofing and layering strategy correctly it must be very context dependent. The traders who execute spoofing strategies are very aware of what context the strategies work best. Spoofing will normally occur during quiet periods of the day. There is less liquidity and lower volume so the market can be bullied and pushed around a little.

Spoofing is also more prevalent in the middle of a trading range. Spoofers know that they are much less likely to encounter resistance in the middle of a trading range. They are much more likely to encounter genuine size as you approach new daily highs or lows.

The reason we look at famous cases of spoofing and layering is to highlight the point that spoofing and layering as a strategy is very context dependent. Paul Rotter was known for executing his strategy at quiet times of the day when he could bully the market around.

Navinder Singh Sarao identified that algorithms would try and front run his large orders in and around the US Cash open at 14:30 GMT. The main point is that spoofing works better at certain times of the day than others. It works better in certain liquidity conditions than others. It works better in the middle of the range than at extremes. It is very context dependent.

Real Order or Spoof Order?

How do you differentiate between a spoof order and real large order? The main difference between the two orders is in their intentions. A spoof order does not want to get filled and a real order does.

The spoof order will pull once the market comes close to it or trades into it. The real order will either stay at the same price as the market approaches or it will move toward the market. Spoof orders can be seen jumping around the place, entering and exiting the markets repeatedly.

Spoofing is quite often executed with all the subtlety of an elephant in a china shop. You can spot it a mile away. A spoofer will normally repeatedly spoof. However someone with an intent on trading will move their orders up or down alongside the market. The spoofer will try and not get filled, so when the market approaches him he will either use a fill or kill order or pull his order completely.

Niche Trading Style

Trading off of spoof orders is a niche trading style executed profitably by very few. But you only need one good trade setup to make a living in trading.

There are different ways to captalise off of spoof orders that give you slightly higher odds depending on how aggressive you want to be.

The majority of the time when someone is spoofing and layering on one side of the market, they are trying to get filled on the opposite side. Let’s say a trader is long, if they place large orders on the bid other traders will try and jump in front of him thinking that a big order is coming into the market. Once the trader is filled on his shorts he will pull his large spoof order making a profit of a few ticks in the process.

This is where your inner contrarian comes out because you can use this information to your advantage. For example, if you already have a long bias on a trade and you blatantly see someone attempting to spoof the market on the offer then you can assume that there is a higher probability of two scenarios:

1) A trader is caught short and is attempting to spoof the market down to get out of his position before the market moves against him.

2) Someone is planning on buying a lot more of a market and is trying to hold it down to get a better average price before he hits the market with a lot more.

Either scenario the outcome is probably the same. The market will end up going higher. If we see any sort of absorption on the bid we can join the bid and profit when he pulls his order.

Aggressive Trading

For those among you that like to trade a little more on the wild side. I know a trader who makes a lot of money by “calling out” spoof orders in the gold market.

There are specific times of day that an algorithm will attempt to spoof and layer the gold market. This trader knows that if someone takes all of the spoof order in one clip that the spoof order will immediately puke.

Let’s say a 300 lot spoof order appears on the offer, this trader will take all 300 in one go. From previous experience he knows that this algorithm is designed to puke immediately and will have to buy all 300 back at higher prices. This creates a temporary situation where the trader has a high probability trade to make a few ticks.

Ballsy!

It is very much a scalping strategy and a risky one at that but if you can identify these strategies they can be very profitable.

Spoofing in and of itself is a difficult strategy to trade on its own, but used alongside other variables it can give a higher probability of a trade working. It’s all about slightly putting the odds slightly more in your favour, you need to be able to detect the weak hand.

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