Dark Pools and High Frequency Trading For Dummies - Vaananen Jay

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that help you to work more effectively and save time when investing in dark pools.

      

You’ll see this icon when I want you to pay special attention to an important piece of information. You can keep those pieces in the back of your mind for regular reference.

      

These icons point out moments that can cause potential risk or problems. Pay special attention to them.

Beyond the Book

      You may find every now and then that you need some additional information or just a quick recap about HFT and dark pools.

      In addition to the material in the print or e-book you’re reading right now, this book also comes with some access-anywhere goodies on the Internet. Regardless of how good your memory is, you can’t possibly remember everything related to dark pools and high frequency trading, so check out the free Cheat Sheet at www.dummies.com/cheatsheet/darkpools, which will bring back the most important points about dark pools and high frequency trading.

      You can also find more helpful tidbits of information and advice online at www.dummies.com/extras/darkpools, including being aware of the risks of dark pools, the basics of automated trading and ten things you need to know about dark pools.

Where to Go from Here

      Like every other For Dummies book, this book isn’t linear, so feel free to start anywhere you like, jump around and read about what you want that interests you. Peruse at your leisure. Because I’ve assumed that you’re already a savvy investor, you may read some information that you already know inside out. Go ahead and skip it and just read the stuff you don’t know. Start by having a look through the table of contents to find what catches your fancy.

      Keep this book close by whenever you’re investing and planning on entering an order into the market. If you’re a finance professional, you’ll get questions about dark pools from clients. Having this book as a reference nearby helps you sound like the professional that you are.

      Part I

      Getting Started with Dark Pools

      

You can discover more about what dark pools and high frequency trading (HFT) are, some basic fundamentals of HFT and other helpful pieces of information about dark pools at www.dummies.com/cheatsheet/darkpools.

       In this part …

      ✓ Explore the world of dark pools and find out why darkness is necessary to so many market participants and how it isn’t necessarily a bad thing.

      ✓ Discover the differences between dark pools and traditional stock exchanges and how dark pools became so popular.

      ✓ Check out how the modern securities markets work after the arrival of dark pools and high frequency traders.

      ✓ Understand how a typical dark pool transaction is conducted from order to execution to confirmation.

      Chapter 1

      Focusing on Dark Pools and High Frequency Trading, Just the Basics

       In This Chapter

      

Looking at what makes a dark pool

      

Defining high frequency trading

      

Naming the cast of characters

      

Identifying the order types

      

Eyeing regulation

      They’re the hot topic in financial markets now. You can’t open a newspaper or click on financial news without coming up against the terms dark pools or high frequency trading (HFT). It’s all happening in the world of dark pools – lawsuits, scandals and accusations of the market being rigged. One thing is certain: all the banks and brokers are involved in one way or another with dark pools. But whenever you mention dark pools, you also have to consider the subject of HFT. One came about because of the other, and then they came full circle and now both operate in the same environments.

      Like the name implies, dark pools are dark and secretive and the banks, brokers and institutions that operate the dark pools would prefer them to remain that way. High frequency traders are no different; they’re even more secretive about their activities and would’ve liked nothing more than to have stayed hidden in the shadows, buying and selling stocks in milliseconds and making money.

      The world has changed, though, and now there’s no hiding in the dark anymore. The light is being shone on dark pools and HFT. This chapter serves as your jumping-off point into that world.

      HFT, dark pools and algorithms can be found anywhere where there’s a working stock exchange. There’s no place to hide from them if you want to invest in the markets. The United States remains the main market by far. With more than ten stock exchanges and dozens of dark pools, the venues are so fragmented that the US market remains the best type of market for high frequency traders to operate in. When it comes to changes and trends in the high frequency and dark pool market, look to the United States first – the rest of the world is sure to follow.

Defining Dark Pools: Why They’re an Investment Option

      Dark pools have been around in one form or another since organised stock exchanges began. In their simplest form they’re a venue other than the stock exchange where stocks are traded. A stock market is one big, ongoing auction with investors and traders bidding and offering shares at different prices. Stock markets display their orders in an order book for all to see. When investors agree on a price, a trade happens and the process of agreeing on a price and making a trade repeats itself and continues all through the trading day as long as the stock exchange is open. But other times an investor may want to do a trade outside of an exchange.

      

That’s where a dark pool comes in. A dark pool is a private venue where investors can exchange large amounts of stock without tipping the market to their intentions and, most importantly, without overly moving the market price. The common attributes of a dark pool are as follows. You can also refer to Chapter 2 for more detailed information about dark pools.

      ✓ Little transparency of trade execution: The broker, bank or whatever entity that is running a dark pool has a huge responsibility of discretion towards its clients to keep the information private and to make sure that information about a large order doesn’t leak. Trying to find buyers without letting anyone know there are sellers and vice versa is challenging.

      ✓ Trades executed within the spread: The spread is the price difference on a stock exchange between a bid (a price someone is willing to buy a stock at) and an offer (a price someone is willing to sell at). A dark pool will benchmark the price it trades at to the prices on a stock exchange with the aim of doing the trade at a slightly better price for both the buyer and the seller. By settling a trade within the spread the price will be better than the price for both buyer and seller on the displayed stock market because the buyer receives a lower price than on the stock exchange and the seller gets a higher price than he would get on the stock exchange. Dark pools tend to be cheaper than a stock exchange because they don’t have the same fees.

      ✓ Owned by a bank or broker: Banks and brokers are keen to use dark pools because it saves them from having

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