The Passive Agressive Order Type
Some people claim that a passive order could not have caused the Flash Crash. While I certainly don't believe there is a single cause, I also do not believe that just because an order is passive means it can't drive down prices. A smart spoofing strategy can get a predictable algorithm to do some interesting things. But it isn't just computers that can be predictable, humans can be too. (I wouldn't be surprised to find human traders are more predictable than computers, but computers might be easier to target.) According to the CFTC and the Justice Department a guy trading futures from England was very predictable, placing orders of either 188 or 289 lots. That's like announcing to the world "Hi, it's me again the 188/289 guy. Pardon me, I'm just back to trade 10% of the market volume and take out my $500,000." (These are roughly what the CFTC alleges in its complaint). I'm kind of amazed just writing these words. I should point out that analyzing changes in order book data in incredibly difficult due to the volume of information and recently enough was beyond the capability of agencies such as the CFTC.
I do not know much about the logic of the passive sell order in place during the Flash Crash so nothing I say here refers in particular to that sell order and the algorithm used. But it is reported that the algorithm was passive and had some constraints tied to volume. This is a typical way investors attempt to minimize the impact of large orders. The most common order of this type is the Volume Weighted Average Price (VWAP). This order type attempts to match the price over the course of the day, weighted by volume. Sometimes volume measures are problematic (or instance, in currency trading), so there are variations such as the Time Weighted Average Price. In other cases the constraint is just a stay below percentage of daily volume (say 15%). Any combination of active and passive orders can be used meet one of these objectives. But if an order is passive and is tied to the volume traded or the size of the order book it could be identified. Smart firms will make an extra effort to disguise the logic of the order.
So how can a passive order move prices? Aggressive orders cross the bid ask spread and make new prices. Passive orders might just join the best offer. For example, if the market for S&P 500 futures is 1170.00 bid for 400 contracts and 300 offered at 1170.25, the passive order might offer 60 contracts at 1170.25. If the market trades lower and takes out all the 1170.00 bids the new inside market might be 1169.75 bid for 300 contracts and 200 offered at 1170. The passive algorithm might modify its order to offer 60 contracts at 1170.00. But if the algorithm is programmed to be 20% of the offer then it would only offer 50 contracts. Now 250 contracts are offered at 1170.00 and 20% of that offer is the passive order. If the passive order keeps updating in this way it could be identified and a strategy can be created to take advantage of this information.
Imagine that Clever Trevor Trading, LLC has identified the passive order and the market is now 1169.75 bid for 20 contracts, behind that the book is pretty thin with a bid of 1169.50 for 20 contracts and 1169.25 for 50 contracts. 250 contracts are still offered at 1170.00. Clever Trevor puts in an order to sell 220 contracts at 1169.75. That clears out the 20 in the book and now 200 are offered at 1169.75 and the passive order modifies its price to offer 50 contracts at 1169.75. Clever Trevor has priority in the queue but if he bids 1169.75 for 20 contracts he wouldn't trade with himself since this is not permitted. The exchange would cancel his order and he would trade with the passive order to scratch the trade. This is close to a free option but he still has he risk that someone else will lift his offer. His advantage lies in the thinness of the bid side of the book. But he could be clever and get rid of this risk. He could add new orders to the 1169.75 offer that are behind the passive order in priority, then cancel his earlier offer that were ahead of the passive order This way the passive order maintains its 50 contracts on the offer, but Clever Trevor can now bid 1169.50 to cover his 20 contracts and know that if the market starts to trade at 1169.75 he wont be lifted first. That way he can close his trade by lifting the remaining passive offer.
Repeated use of this strategy would drive the market down with aggressive orders while the passive order follows, offering a sort of option-like protection. This is very much like what other people mistakenly call "front running." (It may not be nice but it is not “front running”). The problem is the passive order has given away its strategy and someone else uses an aggressive strategy to monetize this information. So how does spoofing come into play?
If the passive order depends on the size of the order book, then increased depth in the order book could increase the size of the passive order. Now there is an increased amount of protection offered to the predatory firm trading ahead of the passive order, thus increasing the number of bids taken out of the order book and leading to a steeper drop in the market.
Is this Possible?
The example is totally made up to make a point but there is real evidence that people can capitalize on the predictability of others. In 2010, two Norwegians who had profited from interacting with a predictable trading bot and were convicted of manipulation and later this conviction was reversed. It is also obvious that the spoofer was leaking information by entering in orders of 188 and 289 contracts. (It could be that the 400, 500 and 2000 lot orders were obvious as well, but it could also be tricky to spot in real time). In equity markets a form of information leakage goes like this: A mutual fund wants to sell 50,000 shares of a mining stock through a broker. The broker then tries, in good faith, to minimize the impact of that order. The problem is that he puts in an order to sell 16,667 shares and follows that up with another 16,667 share order and a 16,666 share order. These are not common order sizes and it isn't difficult for a firm like Clever Trevor to divine that the first of these is part of a larger sell order and profit from this. But it isn't easy either and those who really know what is feasible and what isn't probably wouldn't say.