High Speed Pinging

High frequency traders have received a lot of criticism in the past few years for what many call 'predatory' trading practices. One of the most widely used of these practices is called pinging. What these traders do is send out lightning fast orders (ping orders) in order to detect/learn about larger orders in the market, much like sonar looking for enemy vessels in the ocean i.e. prey.

Large institutional investors (those who buy shares in the millions) aren't able to go into the market with such a large order, so they resort to a tactic called 'iceberging'. This iceberg algorithm takes a stock order (lets say 20 million shares) and breaks it up into smaller components so as to try and reduce market impact (avoiding large price swings). The issue here is that when we have one algorithm trying to make money, there is another trying to compete with it. 

These algorithms, known as predatory algorithms, wait and send out ping orders (small 100 share orders to gauge where potential large orders may be sitting for certain price levels). Once a HFT firm gets a ping or a series of pings in quick succession, they can discern a likely presence of a large order at that price level. They subsequently attack by buying large amounts of stock at that particular price and resell it to the larger buyer for a 1-2 cent premium (since they have the hardware speed advantage). This may not sound like a lot but 1-2 cents for a 20 million stock order amounts to $200,000 dollars in profit. If we think about the daily volume of the US stock market, close to the hundreds of millions, these profits add up quickly. 

Pinging algorithms essentially reverse engineer the iceberg algorithm that's used to hide large order sizes from the market. This activity almost guarantees risk-free profits at the expense of the large institutional investors who receive unfavourable prices. Many professionals have likened this predatory strategy to baiting, luring large investors with large orders to essentially reveal their hand. 

Writing & Image References:

https://www.youtube.com/watch?v=V43a-KxLFcg