Explaining Layering in Stock Trading

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It is a scheme used by securities traders to manipulate the price of stock ahead of transactions that they wish to execute, creating more advantageous executions for themselves. It is a variety of a stratagem that has come to be called spoofing, a rare but unfortunate element of high-frequency trading.

How Traders Layer

Through layering, a trader tries to fool other traders and investors into thinking that significant buying or selling pressure is mounting on a given security, with the intent of causing its price to rise or fall. The trader does this by entering multiple orders that he has no intention of executing but instead plans to cancel. As well as triggering trading algorithms who watch order placement and frequency, the psychological effect comes into play, leading traders to believe they are missing either a buy or sell, and who make a rash decision.

These decisions almost always favor the person layering.

Buying Example

A trader is looking to buy 1,000 shares of XYZ stock, which is trading at $20.00 per share. In hopes of pushing its price down, he enters four large orders to sell:

  • 10,000 shares at $20.05 per share
  • 10,000 shares at $20.10 per share
  • 10,000 shares at $20.15 per share
  • 10,000 shares at $20.20 per share

Note that the trader has layered these sell orders at incrementally higher prices above the current market price. Thus, they will not execute unless the current market price moves upward. The trader intends to make other market participants believe that selling pressure is mounting among holders of XYZ stock and that the price thus is bound to fall below $20.00 per share.

If the scheme works, other traders eager to sell will enter orders below $20.00, anticipating that those orders to sell 40,000 shares soon will be re-entered at even lower prices. The trader then will be able to purchase 1,000 shares of XYZ at less than $20.00 per share and cancel the layered sell orders.

The trader runs a risk that orders to buy XYZ will intervene, instead pushing the price above $20.00 per share. In this case, the trader will have to deliver up to 40,000 shares to buyers, shares that he might have to obtain at yet higher prices, incurring a large loss in the process.

Selling Example

A trader looking to sell 1,000 shares of XYZ stock would do the opposite, to push its price up. He would enter four large orders to buy:

  • 10,000 shares at $19.95 per share
  • 10,000 shares at $19.90 per share
  • 10,000 shares at $19.85 per share
  • 10,000 shares at $19.80 per share

If the strategy works, people eager to buy will enter orders above $20.00 per share, expecting that the layered orders (which they do not know to be a mere ruse) will be re-entered at yet higher prices. The trader will be able to sell at over $20.00 per share and cancel those buy orders. Once again, there is a risk. Genuine orders to sell may intervene at less than $20.00 per share, forcing the trader to buy shares that he did not want, as those buy orders get executed.

Regulatory Response

The Dodd-Frank Financial Reform Bill of 2010 made all forms of spoofing illegal in the United States. Under its provisions, for example, the U.S. Justice Department charged a U.K.-based day trader with illegal actions that allegedly caused the May 6, 2010 “Flash Crash” in which stock market prices plummeted suddenly. Meanwhile, the SEC has taken enforcement actions against traders and firms who engaged in spoofing and layering even before the passage of Dodd-Frank.

Regulators in the U.K., as well as the London Stock Exchange (LSE) also have been concerned about spoofing and layering. Various proposals have been floated in the U.K. to ban these practices.