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high frequency traders and outside investors.

      ✓ High frequency traders: High frequency traders make up a large amount of the daily trading volume today, both in the displayed markets and now also in dark pools. They send out large amounts of small orders, trying to make a profit from tiny changes in the prices of stocks.

      ✓ Large, institutional investors: Investment fund managers and pension funds use dark pools and their own trading algorithms to try to disguise their large orders so their orders have as small a price impact on the market as possible.

      ✓ Regulators: Regulators monitor and enforce the laws regarding trading and markets.

Looking at the Order Types

      To buy or sell stock in the markets, you need to send out an order that defines what it is you want to do with a stock (buy/sell), at what price and how many shares. Buy or sell orders used to be a rather simple affair, but in recent years order types have become more numerous and complex as HFT has evolved. Originally, only a handful of regular order types made trading in markets possible.

      With the emergence of dark pools, multiple trading venues and algorithmic trading, special order types have been created that add a whole new level of complexity to trading. Knowing about both the regular and the special order types is important so that you can know which to use and how you can get the best of your trades. These sections give you a quick overview.

       Considering the regular order types

      The regular order types come in a few basic forms. Some orders execute immediately at the current price and others execute at a limit price. All orders include the amount of shares to be bought, sometimes with an additional caveat of only showing a certain amount of the order. Head to Chapter 8 for the ins and outs of these regular order types.

       Eyeing the special order types

      Special order types are complex and have many different criteria in addition to the regular order types. Literally hundreds of these special order types exist, with each market venue having its own. The one thing they all have in common is that they have been designed for use by algorithmic trading programs. Chapter 9 examines the most commonly used special orders in dark pools and explains what you need to know if they’re right for you.

Regulating the Markets: Legislators Take Action

      Legislators have taken an interest in HFT and dark pools because it’s their job to set the rules that provide a fair market to all investors. HFT was born out of legislation, or perhaps a more apt description is to say that it was born out of legal loopholes.

      As technological changes have outpaced legislative changes, new, superfast trading algorithms and computers have made it possible to execute trades faster than the eye can see. The speeds have become so fast that regulators haven’t had the tools or expertise to see what’s really going on in the markets. Regulators are now catching up with HFT and trying to crack down on those operators whom they suspect of trying to manipulate the market and take advantage of other investors.

      Now legislators from all over the world are trying to block those loopholes. Doing so is a difficult task, but one thing is sure: more lawsuits and more legislation are sure to come that will change how both dark pools handle, route and execute their orders.

      Legislation will also affect high frequency traders, and as a result the HFT market will also change, with some players unable to adjust to the new ways of doing business and new players taking their place. Refer to Chapter 6 for an in-depth discussion on how legislators are trying to regulate dark pools and HFT.

Information is a winner-takes-all race

      HFT has become so fast that when news breaks that has an effect on market prices the price movement is over within a millisecond. There’s no way you can compete in this market without the same speed as the high frequency traders and the best algorithms. The speed has become so fast that it is in fact a winner-takes-all race, with the first one to make the trade on the news being the one who takes all the profits. Refer to Chapter 10 to see how the information game is important in HFT.

Chapter 2

      Taking a Dip into Dark Pools

       In This Chapter

      

Knowing what dark pools are (and aren’t)

      

Comprehending how dark pools work

      

Identifying the rewards and risks

      

Figuring out whether dark pools are right for you

      The term dark pools has been bandied around in the past few years in the financial world. What are they? What happens in them? Who runs them? The name is actually far more sinister than the real thing. Dark pools are simply places where stocks are traded ‘off exchange’. In other words, they’re an alternative to stock exchanges.

      Stocks were traditionally traded in a stock exchange. Now, thanks to computer algorithms and increased volumes in stock trading, these new venues called dark pools have sprung up where stocks are traded. They pool together different investors’ orders and match them up. In fact, they do exactly what an exchange does; the only difference is that executed trades aren’t disclosed to the public immediately.

      This chapter examines dark pools and explains what they are, how they operate and why they came about. This chapter tells you how they evolved and changed as the market changed and how they operate today. I also explain the pros and cons of dark pools and what you need to know to determine whether they’re right for you.

Taking a Snapshot of Dark Pools: What They Are and Aren’t

      Dark pools have many similarities with a traditional stock exchange. Both are venues where stocks are bought and sold by traders and investors. There are, however, significant differences in how orders are priced and matched with each other in a dark pool and in a stock market. These sections show you exactly what dark pools are and what they aren’t, so you can decide whether and when they are a good place for you to execute your trades.

       Settled outside the public eye

      Trades that are settled (also often referred to as executed) in a dark pool aren’t immediately reported publicly. Usually, they’re reported to the exchange sometime after the trades have been done. The timeframe of reporting trades differs from venue to venue and can also be dependent on the local financial rules and regulations. When the trades are reported after the fact and not in real time, there is less likelihood of a significant price impact on the stock.

       Need for secrecy: Dark versus lit

      Dark pool trades are anonymous and they aren’t immediately reported, which is why they’re referred to as dark. Any market that isn’t a stock exchange quoting its trade data in real time is a form of dark pool.

      On the flip side, traditional stock exchanges rely on transparency and openness. To exchanges, the very idea of a fair market is that all trading data regarding price and volume is open, which is why stock exchanges are referred to as lit markets. Today’s global market place is a combination of trading done in the dark or in the lit markets.

      

You may think that the anonymity and secrecy of dark pools sounds sinister. However, allowing trading and the settlement of trades to be done out of the public eye, and in real time, is important for a couple of reasons.

       Getting orders matched without moving the market

      Brokers and banks have some options at their disposal to match orders without moving the market, which means that the price of the stock

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