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The arrest of a futures trader operating out of a suburban house in London in connection with the US equity market “flash crash” in 2010 has shone a spotlight on trading practices.

The Department of Justice alleges in a criminal complaint that Navinder Singh Sarao, 36, of Hounslow used an automated trading program to manipulate the market for S&P 500 futures contracts — known as E-minis — on the Chicago Mercantile Exchange, the largest US futures market.

Normally orders are placed on the market by traders in the form of a “bid” or an “ask”. When a buyer and a seller agree on a price, the trade is “filled” or “executed”.

The authorities said Mr Sarao used a variety of trading techniques designed to mimic these signals and push prices sharply in one direction, but then profit from other investors following the pattern or exiting the market. These techniques include spoofing and layering.

What do the key market terms of bid, ask and fill mean?

Bid refers to the buying price, while ask refers to the selling price supplied by traders. The difference between the bid and ask is the spread. To complete a trade, a buyer or seller must bridge the spread so they can fill the order.

In simple terms, a security may be quoted at a bid of $99.95 and an offer of $100. To fill a sell order a trader must hit the bid at $99.95. Usually, the trader will nudge their offer down to say $99.99 and see if a buyer raises their bid to say $99.96 or higher.

In that way, the market goes back and forth before meeting somewhere in the middle. Such activity also explains why market prices can move around, typified by buy and sell prices being quickly adjusted or cancelled.

What is spoofing and layering?

Spoofing and layering takes these daily behaviours and tries to fool others in the market, thereby gaining a price advantage over other participants. Spoofing was outlawed months after the “flash crash” in the 2010 Dodd-Frank financial reform legislation, but the practice is hard to distinguish from legitimate trading and when activity is dominated by rapid-fire computers that spit out numerous prices instantly.

The spoofer seeks to fool other traders into chasing them. One example would involve the spoofer selling a futures contract below the current offer level of say $100 at $99.95. As soon as others adjust their selling price lower to $99.95, the spoofer cancels their sell order and buys at the now lower market level. Having artificially depressed the overall price, the spoofer looks to sell at a higher level as prices climb back to where they were just seconds before.

Layering represents a more elaborate way of spoofing, as a trader manipulates others by supplying lots of sell or buy orders that create the illusion of a healthy market, characterised by deep liquidity. Once more, these orders are fleeting and quickly cancelled before others can trade on the prices.

Market manipulation such as price spoofing represents the dark side of trading and authorities are beginning to crack down on the practice. When a spoofer is challenged they usually fall back on the excuse that they had a legitimate reason for cancelling orders, such as a client suddenly deciding not to participate.

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