Q. So this is a high frequency trading technique that the SEC is making a lot of noise about in the last few days, not to be confused with a “wash sale”…
A. Right. “Wash Sales” are tax planning devices, looking to lock in a gain or loss on a security. A crude example would be to sell a stock at 4pm one day, and buy it back at the open on the next day, to claim a loss (the IRS has lots of rules to prevent that, by the way). A “wash trade” is an HFT trick where the same entity is both the buyer and seller of the security, a stock or futures contract.
Q. Well, that sounds like a lot of trouble for no reason! What’s the point?
A. One of the tricks it can allow is something called “momentum ignition”. An HFT shop can quietly take a pre-position in a stock or a contract… and then start firing wash sales. The idea is to create the appearance of big volume in a stock or contract, so suddenly the other HFT algos that are constantly looking for unusual trading activity find it… they assume something’s really going on and start buying, too. Then the instigator trades out of its initial position.
Q. So it’s kind of a big head fake? How long does this game go on?
A. Exactly… the whole episode might last 3 or 5 or 10 minutes, something like that. And the price moves may not be ginormous– maybe even only a half point or something-but at the right volume and frequency, the profits add up.
Q. So, just to be crystal clear, this is illegal… but the SEC says its common?
A. They do, and other industry observers agree… one estimates that it happens, on average, once a day across the universe of larger stocks. Of course, no one knows exactly, but the estimates are taken from looking at stock patterns of price, volume and volatility. A quiet stock experiences a very short spike in volume and price, then settles back down to historic levels… that’s suspicious.
Q. And since its illegal, aren’t the exchanges trying to prevent it?
A. Yes, and they all say they have wash trade filters that try to keep this from happening. But the SEC is saying that those systems are inadequate, and that, once again, the speed and savvy of the HFT shops are outgunning the system.