'Flash Crash' course: What is 'layering?'

With the arrest of a high-frequency trader for allegedly causing the May 2010 "flash crash," many people are left wondering just exactly what one person could do to crash the entire market and what some of these terms like "spoofing" and "layering" mean.

The Justice Department charged United Kingdom day trader Navinder Singh Sarao with wire fraud, 10 counts of commodities fraud, 10 counts of commodities manipulation and one count of spoofing. Specifically, he is accused of manipulating the market using E-Mini S&P 500 futures contracts.

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Donald Civitanova works at a post on the floor of the New York Stock Exchange in New York, U.S., on Thursday, May 6, 2010.
Daniel Acker | Bloomberg | Getty Images
Donald Civitanova works at a post on the floor of the New York Stock Exchange in New York, U.S., on Thursday, May 6, 2010.

I have traded the S&P mini futures for many years and it is a very deep and liquid product. Here's a quick primer:

What are 'spoofing' and 'layering?'

On Wall Street, spoofing is defined as when a trader places a bid or offer on a stock with the intent to cancel before execution. Layering is a more specific form of spoofing. Layering is when a trader places multiple orders that he does not intend to execute. These fake orders allegedly trick other market participants by creating the false impression of heavy buying or selling pressure.

How is layering done in practice?

Layering is an advanced form of spoofing because it implies there are multiple orders and market participants on one side of the market. For example, if I wanted to buy S&P mini futures but at a lower price, I would "layer" five big sell orders above the current market price.

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S&P mini futures trade in 25-cents increments. E-minis were recently trading near $2,100. If I wanted to use layering, I would put in a sell order of 2,000 futures for sale at $2,100.50, 2,000 for sale at $2,100.75, 2,000 for sale at $2,101, etc. An algorithm or a trader might see this and believe there is selling pressure and jump in front of these orders and push the futures price lower. Then I would put in a buy order to pay $2,099 for 100 futures, a much smaller amount. After my buy order gets executed, I would immediately cancel all my large "layered" sell orders.

Should this be illegal?

I think the answer is no. Spoofing wasn't specifically made illegal until the 2010 Dodd-Frank bill. Sell-side traders would sometimes use some type of spoofing, especially in illiquid markets. In a security that was more illiquid and one I didn't trade often, I would put a big order above or below the market to see how the market reacts.

If I did this, I did so knowing this is a big boy's tactic. In fact, doing this puts me at more risk. Layering exposes you to an excessive amount of risk if you miscalculate the pressure or speed of one side of the market. If you miscalculate, you can lose tens of millions of dollars in the matter of minutes and have an uncomfortably large position on.

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In the example above where I offered 6,000 e-mini futures between $2,100.50 and $2,100, say Goldman Sachs receives an order to buy 20,000 e-mini futures at the market. In a matter of seconds, the market could be trading up to $2,102 and I could be short 6,000 e-minis at lower prices even when I really wanted to be long.

If that happened, I wouldn't go home crying to my mommy like Dodd-Frank and their supporters. Good Wall Street traders are aware of the risk and reward of the game and we live with the consequences.

Was Sarao responsible for the 'flash crash?'

I doubt it. I find it hard to believe that one man's layering was responsible for the "flash crash." S&P Minis trade an average of 1.9 million contracts per day. In notional terms,that is $200 billion of market exposure. [ 1.9M (contracts) x 50 (futures multiplier) X $2,100 (S&P Price) =$200,000,000,000 ]

Let's look at e-mini volume around the time of the "flash crash." An average of 2.8 million contracts traded in that time period. There was a spike on the day of the "flash crash" and the day after but that is normal in a more volatile market.

It is alleged that Sarao made a million dollars trading during the "flash crash," when the market lost over $1 trillion in market cap. That is a minuscule amount of money in the grand scheme of things. I knowmultiple traders that made tens of millions during the "flash crash" and definitely weren't manipulating anything.

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For Sarao, to expose himself to that much risk for a relatively small profit doesn't make economic sense. If he did what is alleged, the only thing he is only guilty of is being dumb and using poor risk management. Plus, why did it take five years to find him?

I know this is unpopular opinion because the general public loves a hanging. Especially, if it's a rich, arrogant foreigner. However, the numbers don't add up to blame Sarao for the "flash crash" and I think he is simply a scapegoat for the authorities' own incompetence.

Commentary by Raj Malhotra (Raj Mahal is his stage name), a former Wall Street trader-turned-stand-up-comedian. By day, he works as a senior trading mentor at the Institute of Trading and Portfolio Management (ITPM). He has worked at Wall Street firms covering three continents, including at Bank of America, BNP Paribas and Nomura. By night, he is a comedian who draws from his unique ethnic background and Wall Street career to entertain audiences, highlighting the struggles of the 1 percent. He can be seen at Gotham Comedy Club, Broadway Comedy Club, NY Comedy Club, Greenwich Village Comedy Club, and the Tribeca Comedy Lounge. Follow him on Twitter @RajMahalTweets and @RajWSGuru.