Dark Pools and High Frequency Trading For Dummies - Vaananen Jay

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affect market prices. Big sell orders increase the supply and can push prices down. Large buy orders increase demand and can therefore push up prices. Before the emergence of dark pools, a large institution could make a large order in only two ways:

      ✓ Try to settle it between brokers after trading hours. There are set hours when a stock exchange is open for trading. By agreeing to a price and amount of shares when the stock market is closed for trading, a large order will not move the market price.

      ✓ Put the order into the displayed market. If the whole order with it’s full volume is displayed, the price will likely move against the institution because its order is so big that it moves the price of the stock. To counteract this, the smart option is to break the order into several parts, drip-feeding it into the markets by sending in orders in smaller 100 or 200 share lots. When these orders are filled the process would be repeated. This process can be laborious, and in fact advanced standard order types (see Chapter 8 for advanced standard order types) were planned to address this issue by automatically slicing a big order into smaller parts.

      Algorithmic computer trading was created to sniff out these types of orders and then trade against them. Institutions were then faced with a need to find an alternate solution to their larger orders being adversely affected by the algorithms.

       Making more profit by avoiding exchange fees

      Brokers and banks could make more profit because their trades wouldn’t be subject to exchange fees. The business of a stock exchange is to match trades. Each time a trade is executed, a stock exchange charges a fee, which is how stock exchanges make their money. Brokers liked the idea of dark pools because they could bypass the stock exchange and not pay any exchange fees and so increase their own profits. All the brokers needed to do was find buyers and sellers among their own clients and match those trades.

       Improving price

      Brokers have a duty to their clients of best execution, which is trying to find the best possible price for their clients. Part of the concept of best execution is price improvement, which means the opportunity, but not the guarantee, of getting a better price for their clients. If a broker has the opportunity of getting her client a better price in a dark pool as opposed to a displayed stock exchange, she can then route the client’s orders to a dark pool.

      Because prices in a dark pool take their prices from the bid and offer of the displayed exchange it and are often executed at the midpoint (average price) of the best bid and offer available on the displayed markets this gives the opportunity for a better price. Because prices can move very quickly, the opportunity for price improvement can be lost while the trade is being routed and the client ends up with an inferior price.

      

The midpoint of a trade is the average price between the best bid and the best offer; this way both the buyer and seller are satisfied because they get a slightly better price. For example, if a stock’s best bid is $10.50 and the best offer is $11.00 and you’d like to sell your shares immediately, you’d receive the best bid of $10.50. If another buyer at the same time wanted to buy immediately, she’d have to pay $11.00. A dark pool would match these orders together at the midprice, which is $10.75. This way you, the seller, get $0.25 per share more for the stock and the buyer pays $0.25 less for her stock. Both of you get a better price than you’d have got in the stock exchange. This is a dark pool working at its best, delivering value to both sides of the market.

Examining How Dark Pools Work: Step by Step

      Dark pools have become an important part of the global markets, and they’re used as a viable alternative to stock markets. Knowing how they work will help you in your investing and help you to decide whether you want your trades to be routed through a dark pool and, if so, which one. This section discusses the ins and outs of how a dark pool works, from sending an order to executing an order.

      In the days before dark pools, when you entered a trade your broker would place it in the appropriate exchange and that would be that. If you placed a limit order, an order that stipulates an exact price at which you’re willing to trade a stock, it would be displayed in the order book. If you were watching the trading book in real time and the stock was one that was trading slowly enough, you could actually spot your order coming into the book. The number of shares and the price you instructed would pop up on the exchange’s book. Here is what happens when you invest in dark pools:

      1. If your bank or broker has their own dark pool or has access to other dark pools, they may place your order there first before routing it to an exchange.

      

If you’re using a limit order and the stock you’re trading is one that moves slowly and isn’t very liquid, a telltale sign of orders being routed via a dark pool is if your order doesn’t show up on the order book.

      With an at-market order, which is an order that says you will make a trade at the best price on offer at that moment, your trade should be executed at the mid-price of the bid or offer if your broker is using a dark pool. (Refer to Chapter 8 for additional information about limit orders and at-market orders.)

      2. If the order is routed through a dark pool and there is an opposite matching order in the pool (a buy order to match your sell order or a sell order to match your buy order), your order will be executed there.

      At worse the price you get should be equal to the bid or offer available on the displayed stock market. Ideally, though, the price you get will be the midpoint of the bid and offer available in the displayed stock market. (Check out the earlier section ‘Improving price’ for more about the midpoint.)

      3. If there is no matching order in the dark pool, your broker may then route it to another dark pool and try to match the trade.

      If a match still can’t be found then the order is routed to the stock market. If it’s an at-market order then it’s executed immediately. If it’s a limit order, it’s placed on the order book until the price of the stock matches the price in the limit order.

      4. If the order is matched in a dark pool, it will then be reported to the exchange.

      This doesn’t happen in real time. Different countries have different rules as to the timeframe in which a dark pool transaction must be reported.

Weighing the Rewards and the Risks

      Trading through a dark pool has both risks and rewards. One thing dark pools have done is brought more complexity and more choice to the markets. Here you can find out about the risks and rewards involved in a dark pool transaction and how to prepare your trading strategy for the potential risks.

       Identifying potential rewards

      Trading in dark pools has two main rewards:

      ✓ Less price impact: If you’re trading in large orders or you’re trading in shares that are illiquid (not traded actively in the market) then any order you send into the displayed market has the risk of moving the price in the direction that you don’t want it to move. For example, when you send a sell order, you obviously want as high a price as possible for the stocks that you’re trying to sell. Sending in a large sell order when not as many buyers are visible in the stock market will move the price down.

      Also, when the order is displayed it sends a signal to the market that there is a large seller and buyers will pull their orders out of the market, anticipating that they will soon be able to buy the stock at an even lower price. This pushes the price of the stock you’re selling down further.

      But when it comes to sending the order to a dark pool, the size of the order isn’t displayed, so your order has less likelihood of moving the price adversely against you. So one of the rewards of dark pools is to be able to buy or sell stock without moving the price against you.

      ✓ Better price than the displayed markets:

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