Q. So this describes a tactic high frequency trading firms use but that a lot of people are unhappy about… How’s it work?
A. The very basic idea is that an HFT shop will put it an enormous series of trades in a particular security, often acting as both buyer and seller so there’s no net risk to the firm. The explosion in volume attracts other HFT algorithms, which are programmed to instantly buy on volume spikes to catch the momentum that purportedly indicates. As a result, the price spikes. So, the first shop is engaging in “momentum ignition”.
Q. So its essentially algorithms fooling other algorithms?
A. Pretty much. And with HFT algos such a big percentage of total trading volume these days, this can have a big impact. Many folks suspect “momentum ignition” was behind the crazy action in Treasury futures last Friday, when a huge burst of orders preceded– by a couple of seconds– the release of the NFP jobs data. On big order went in, it looks like other algos instantly jumped on the bandwagon, and the system got so overloaded that the CME actually had to halt trading in what really should be a super liquid market.
Q. So how would someone profit from that, exactly?
A. The simplest way is to have taken a pre-trade long position. Then set of momentum ignition, let the price spike higher, and sell out. A more sophisticated approach is to use the momentum ignition trades to explore just liquid a market it – how much trades will move prices– and then exploit that information with bigger trades.
Q. And what’s the regulatory response been?
A. The CFTC says it will investigate what happened last Friday, and the SEC also says its investigating the issue more generally. But the issue probably doesn’t get the attention it deserves… it only takes a couple of seconds of fooling the market to make the whole thing work. It all happens so fast, and things appear to return to normal, that these trades don’t attract much attention.