Today more stocks are traded on the dark pools than stock exchanges. Dark pools are private stock exchanges operated by big banks where they allow big investors to buy and sell stocks anonymously. The trading information on these dark pools is a private thing. Nothing is disclosed about the investors and all transactions take place in the darkness of secrecy. Transparency and free flow of information is the fundamental requirement for preventing market failures. Did you read this post on how a trader trading from home crashed the market? Trading on dark pools allow big investors to avoid sharing information with other traders which they couldn’t if they had bought sold stocks on the regular stock market. Regulatory authorities are concerned by the rise of dark pools and are trying to enact new rules and regulations that will ensure more transparency when trading on these dark pools.
If you have been trading stocks for a while, you must have sometimes seen strange things happen to your trades. Most of the traders don’t have any clue as to what is happening to their trades and why they are losing. In this post I want to lift the veil from the world of Dark Pools and how they can be responsible for your losing. Knowing how the modern stock market works is important for you if you want to succeed as a stock trader. Knowing how the stock market works is also know as knowing the market microstructure. In simple terms, Dark pool is just a network of brokers and investors who trade stocks outside the stock market. Those who do the buying and selling of stocks outside the stock market have some advantages which compel them to go to the Dark Pool. But we retail traders need to be careful with the dark pools as sometime we can get burned by them. Watch this Money and Speed documentary. So read on if you are interested in exploring the world of Dark Pools.
What Are Dark Pools?
Dark pools are now an integral part of 21st century financial markets. Orders placed at the dark pool do not appear on the public order books. Dark pools and stock markets are almost similar. Both are auction houses. Hundred years back, it was the open outcry system. New York Stock Exchange had specialists. It was the job of specialists to make market in the stocks that they represented. But then came computers and large scale automation. Today almost all stock exchanges have become electronic. What used to be done by humans in the open outcry is now be done automatically electronically. But one thing has not changed and can never change: the pricing mechanism. Price is at the heart of every market. Buyers want to buy low and sellers want to sell high. Markets are structures that help buyers and sellers find best prices for their products and services. Transparency and free flow of information is considered essential in making the process of price discovery work. Dark pools don’t display any price for the stocks that get traded on them.
Let’s make this clear with an example. A hedge fund manager wants to sell 10 million shares. The hedge fund manager wants discretion rather than speed. Placing the sell order with the broker can draw a lot of attention and result in an adverse sale price as the order becomes visible in the public order book. When the order become visible in the public order book, other investors might try to jump ahead of the big order execution by selling the same stock. So the hedge fund manager decides to route the order through the dark pool where he gets anonymity and better price without any adverse market reaction. There is nothing wrong with going to dark pools. Most of the time, you will get a better price than the regular stock market.
Dark pools however use the prices displayed on the stock exchange as a reference for their transaction. The transaction that takes place on a dark pool is always between the bid-ask spread displayed on the stock exchange. This way the buyers benefit by getting a lower price than they could get on the regular exchange and the sellers also benefit by getting a higher price than they could get on the regular exchange. There is another advantage on doing the transaction on the dark pool. Parties don’t have to pay any exchange fee. So they save on the stock exchange fee as well. When a large order gets displayed on the order book of a regular stock exchange, it moves price in the direction of the trade. For example, you are a big investor and want to sell 10 million shares of a stock. When your order gets displayed on the order book of a regular exchange, this way signal the other participants to lower their bids so the price that you get is worse than you had anticipated. Dark pools avoid this problem by hiding the volume of the order. So nobody knows how big the order is.
In a regular exchange parties post their bid and offers alongwith the size in the order book. In a regular stock exchange, the system of best bid and best offer ensures that the clients get the best price. This system of best bid and best offer ensures that you receive the best price available at the given moment of time. When the The volume that we see in the order book is the liquidity. Liquidity is important for a trader. If the stock has high liquidity, it means there is enough buy/sell volume and there is little chance of a few orders to move the stock price much.
Unseen liquidity arises when only part of the order is shown in the order book. For example, you want to sell 10,000 shares of a stock. But you only show 200 shares in the order book. When those 200 shares get sold, you post another 200 shares and so on until you have sold all 10,000 shares. But at no time, you show more than 200 shares in the order book.Off market liquidity is when you give a verbal order to your broker to check if he can match your order. Off market liquidity also rises when a large order gets send to the dark pool which of course is now shown in the stock exchange order book. All orders that get send to the dark pool represent off market liquidity. When you go to a dark pool, you don’t know whether your order will get filled. Algorithms are used to judge how much liquidity is available with a dark pool. Algorithms send small orders to the dark pool and check if they get filled. Based on this information, algorithms judge whether the dark pool has enough liquidity to fill the order.
How Dark Pools Effect Liquidity in the Market?
Phantom liquidity is a new thing introduced by high frequency trading firms. When you look at the order book of a regular stock exchange, you see lot of bids and offers with a lot of volume posted there. But is the volume real? High frequency trading firms post high volume bid offers which they can cancel in milliseconds. This is one of the main causes of a flash crash. Suddenly the market goes dry with zero liquidity when HFT firms withdraw liquidity in matter of milliseconds. This is what happens in a flash crash when suddenly no one is there is take the buy side. Flash crashes always happen on the downside. So when no one gives the offer, price plunges down so fast that no one can control it. Watch this documentary on Quants.
Market makers are very important in this process of bid and offer. Now a days market makers are using algorithmic trading models to automate their bidding models. Majority of these algorithmic trading models use Volume Weighted Adjusted Price (VWAP). If the stock can be bought below the VWAP, it is a good price. If the stock price is above VWAP, it is a bad price. High frequency trading firms, big financial institutions and of course market makers are using VWAP. From this VWAP, we can build a moving volume weighted adjusted price (MVWAP). VWAP is calculated throughout each day. Next day we start afresh with VWAP. To overcome this shortcoming of VWAP, MVWAP has been developed that overcomes the high volatility that we observe in VWAP at market open.
What is Direct Market Access (DMA)?
Market order routing is very important in determining the price that you get. Today as said above all orders are routed electronically in milliseconds. Understanding what happens during that short period of time during the order routing process can help you avoid a bad and dishonest broker from a good and honest broker. Order routing is important in understanding market microstructure, dark pools and HFT. If you don’t have direct market access, your order will first be send to your broker who will send it to a dark pool. If the order is not matched in the dark pool, it will be returned to the broker and sent to the regular stock exchange. All of this happens in milliseconds. While this is happening, trading algorithms are watching your order. Information is being leaked to these trading algorithms in the order routing process. If your order is big enough, the trading algorithms watching your order can cause the price to rise. So you end up paying more in the end even though the process took only a few milliseconds to complete.
HFT firms, big investors and hedge funds have direct market access. Direct market access means they bypass the broker and directly place the order to the stock exchange of their choice. Active traders with high volume also prefer direct market access (DMA). As a retail trader, if you are not trading frequently and your trading volume is low, DMA can be costly to you. You have to fulfill a minimum trading volume on a daily basis if you want DMA. With DMA, you get faster execution and lower commissions. But you need to have the knowledge of how to route your orders. You need to decide what special order type to use and which stock exchange to send the order. You need to know the different special order types which can be a laborious thing.Watch this documentary on Bond Market.
Types of Dark Pools?
Dark pools are a major part of the global financial system. Today more than 40% of the orders get routed through dark pools in US while 15-20% of the orders get routed through dark pools in Europe.There are many dark pools available managed by different banks and brokers. You will often read news in financial media on dark pools getting fined by the regulatory authorities. You should know the bad dark pools from the good ones. Getting your order routed through a bad dark pool can mean paying more for your trade. You need to know which dark pools your broker is using. This is something important for you to know so ask your broker point blank about the names of dark pools that he is using. Once you have the names you can do online research on whether anyone of these got fined from the regulatory authorities.
Block oriented dark pools have minimum block size that can be tens of thousands of shares per order. Because of a large order size requirement block oriented dark pools are mostly free of HFT firms and retail traders and only used by big players. Streaming liquidity pools on the other hand have no minimum share requirement. Streaming liquidity pools can route your orders of a few shares. High frequency trading algorithms are constantly sniffing the orders being routed through the streaming liquidity pools using small orders. If they find a big order, these trading algorithms can immediately push the price against your order. Currently streaming liquidity pools are important. Just keep the risk of information leakage and the predatory high frequency trading algorithms in mind when placing an order which involves a few thousand shares.
Crossing pools are defined by how they match your orders.Scheduled cross pools takes the orders and then matches them at a predetermined time. This helps in gathering liquidity before the orders are matched. Matching times can be minutes or hours depending on the scheduled cross pools rules. On the other hand, in continuous cross pools orders are matched as soon as a matching order is received. Hybrid markets have special structures and usually use a bench mark like the VWAP. Major banks are operating their own dark pools. Barclays LX, CrossFinder, CrossStream and BLOX owned by Fidelity Capital Markets, Sigma X run by Goldman Sachs, ConvergEX owned by Bank of New York Mellon, Alpha Y, DBA and Super X owned by Deutsche Bank are a few well known dark pools operated by big banks. Barclays LX, Sigma X and ConvergEX have been fine heavily by regulatory authorities. Chi-X Global is owned by a number of banks like Bank of America, Goldman Sachs, Morgan Stanley and UBS. Instinet is a global dark pool that was qcquired by Nomura a few years back. Instinet is providing services in around 60 countries.
Stock exchanges have also started setting up their own dark pools in order to compete with the big bank dark pools and stop them taking away their business. Big block orders can get negotiated after trading hours and then get executed at the agreed price when stock exchange opens. International Securities Exchange was the first to establish its own dark pool and provide its clients with option of either using its dark pool or the regular stock exchange. New York Stock Exchange is also now offering a sort of dark pool for retail investors that doesn’t allow algorithmic traders into the pool. NYSE has named it Retail Liquidity Programme. Since NYSE Retail Liquidity Programme does not allow high frequency traders, it is considered safe by many retail investors.Watch this documentary on Wall Street.
The job of the market maker is to make the market by always providing offer to a sell and a bid to buy. So in essence market makers are responsible for providing liquidity to the market. Market makers are essential for the running of a regular stock market. Market makers are also required in dark pools as they provide liquidity. Market making business requires savvy risk management and big volume as market makers make pennies per stock.Market making has also been automated over the last decades. Venue is the place where people and institutions who want to trade the market come and close the deal. Trading venue is the most important place for a market. Each trading venue has got its own rules and regulations.
Stock market has been the traditional trading venue where traders and investor meet to buy/sell stocks. Trading is done openly and all orders send to the market are shown in a public order book. But big institutions over the years wanted better execution of trades on their own terms without making the order information public. This led to the development of dark pools where the orders sent are considered private information and never made public.Stock markets are transparent as compared to dark pools. Stock markets make public bid/ask as well the volume of each order whereas the dark pool does not make this information public. Now dark pools cannot exist without a stock market. Stock markets are bigger than these dark pools and these dark pools take the bid/ask from the stock market.
High Frequency Trading Firms
Brokers and dealers are important players who route your orders to a different dark pools. Data centers provide the place where high frequency traders can house their powerful superfast computers that execute their high frequency trading algorithms. Data centers are placed as close as possible to the stock exchange. This shortens the time for information to reach the data centers and provides a few millieseconds in time edge that then gets exploited by HFT algorithms. This time edge of few milliseconds is enough for HFT algorithms to corner the market. All HFT is automated trading. But not all automated trading is HFT, you should keep this in mind. HFT firms use fast data connection to make rapid trades that means getting into and out of the market in a few milliseconds something a human trader is unable to do. HFT firms don’t carry their positions overnight. This is one the reasons why you see heavy trading now a days at the end of the day as these HFT firms are closing their positions.
HFT firms depend on hi technology to beat the markets so these HFT firms constantly invest in new state of the art cutting edge technology. HFT firms make maximum use of co-location and place their servers as close as possible to exchange servers so that they get the information ahead of the crowd. Speed is what matters in today’s markets. HFT firms use algorithmic trading also known as Black Box to analyze the market and then decide what to buy and what to sell. All this is done and executed by computer programs in matters of milliseconds. These black boxes are usually programmed in C++/C#/JAVA. These programs then use the FIX protocol to communicate with the exchange servers using the FIX Algorithmic Definition Trading Language.
It has been argued the HFT firms have been responsible for reducing the spreads in the market. HFT firms are infact responsible for reducing the spreads but they are not the traditional liquidity providers. HFT firms are different from market makers. HFT firms can post limit orders to the order books and then withdraw them in milliseconds. The Flash Crash of 2010 has been blamed on HFT firms withdrawing orders which made the market highly illiquid. HFT firms enter the market and then exit within milliseconds to make a small tiny profit. This process is repeated throughout the day. HFT firms have been blamed for quote stuffing which is designed to slow down the market and manipulating the price.
Most of the big financial institutions employ automated trading programs that is used to buy/sell millions of shares in such a manner so as not to adversely affect the price. When the big mutual fund or for that matter big financial institution decides to buy/sell a stock, it uses a automated trading program to drip feed that order to stock market and different dark pools according to the criteria provided. HFT is different from this automated program trading. HFT algorithm places large amounts of small orders and tries to make profit by quickly entering and exiting the market. On the other hand, automated program trading is designed to execute very big buy/sell orders comprising millions of trades with as much anonymity as possible without adversely moving price.
Dark pools and HFT developed taking advantage of legal loopholes in the regulatory framework. So any changes in the regulatory laws can have far reaching consequences for dark pools and HFT. The market crash of 2008 was blamed on HFT by many although the jury is still out. Supporters of HFT point out that HFT brings more liquidity to the market and helps lower the spreads which has infact practically happened. In recent years, studies have shown that HFT is on the decline. The purpose of regulation is to make markets transparent and fair for all participants. In US Regulation National Market System ( Reg NMS) is the legislation that deals with dark pools and HFT.
Rule 610 is meant to provide best possible price to all market participants. Rule 610 bans locked and crossed markets. Rule 611 is known as the Order Protection Rule. So if an order comes into the market and can be executed at a better price at another market venue, it should be routed to that market venue for execution according to Rule 611.This rule is also known as the Trade Through Rule. All market venues are required to ensure trade through trades from taking place.This rule is designed to encourage limit orders being placed more as compared to market orders. Limit orders ensure better price discovery so they have been encouraged more. Rule 612 is known as the Subpenny Rule. What Rule 612 stipulates is that stocks can only be traded in increments of $0.01. In Europe was have Markets in Financial Instruments Directive also known as MiFID. MiFID II deals with algorithmic trading.
Automated Computer Programed Trading
Automated Computer Programed Trading is the major liquidity provider in today’s financial markets. This is not HFT. Today, market makers, traders and big institutions use automated trading to execute big orders in the market. As a retail trader, when you buy and sell your order get executed against an automated trading program.Today more than 60% of the trades placed at NYSE are made by algorithms. Rise of algorithmic trading has unleashed new forces in the market like the Flash Crashes that can happen anytime and no one predict them. The last flash crash that took place was blamed on a rogue algorithm. Developing algorithmic trading strategies is fun if you know how to code. If you are interested in algorithmic trading, start by learning R or Python. At a latter stage you can also learn C++ and Java.
Volume Weighted Average Price (VWAP) trading algorithm tries to execute trade close to or better than VWAP.In US, most trading takes place in the morning and late afternoon with a lull in the afternoon when most traders and quants are busy having their lunch. This produces a U shaped curve. On the other hand, in Europe most trading takes place in afternoon when the US market is also open. This produces a rising slope curve.VWAP algorithmic trading strategies are popular with big institutions interested in buying/selling large positions. Order execution close to VWAP works well for large liquid stocks with tight spreads. In contrast, participation rate strategy enters a trade based on certain percentage of the volume. This is done to ensure that the order does not impact price too much. Dark algorithms run solely in the dark pools mostly by the banks that operate them. Watch this documentary on a genius who challenged Wall Street.
The speed with which the information travels from one place to another is of utmost importance in automated trading. Just keep this in mind information cannot travel faster than the speed of light. So there is an upper limit to how fast information can travel. Let me give you an example. New York Stock Exchange (NYSE) and NASDAQ are located at Wall Street new York. Futures and options market is located at Chicago. Distance between NY and Chicago is 750 miles. It takes around 15 milliseconds to send information at the speed of light between these two cities. Once you receive the information their is the problem of latency. Market information that has been received will now be processes and analyzed by a computer algorithm that can also take milliseconds or even more to produce results. So we are dealing with pretty tight time limits when we do automated trading.
Standard Order types
Now if you are a retail trader, you will always be at a disadvantage. You cannot process this information at this speed. This is the main cause why retail traders are now always on the losing side. Algorithms have got the time edge that they use to their advantage to the fullest. At the end of the day, who has the speed wins. Knowing which orders to use when using a dark pools is important for you as an investor. Using right order types can help in cost reduction which is an important consideration in the trading business in the long term. You should have a good understanding of how you orders interact with the markets and what conditions apply to different order types. Standard order types originate in the regular stock market but also get used in dark pools when the orders get routed through them.
Let’s start with Price Time Priority. You need to understand what Price Time Priority means. Price Time Priority means whenever an order comes to the market, it is prioritized first by price and then by time. What this means is that when you place an order it is matched with the other orders having the best price but your order will be below the orders that have been placed before you with the same price. The most common orders are the at-market orders. At-market order means you are willing to pay whatever price is available at the moment. So an at-market order clears the order book immediately at whatever market price is available.
However there are risks associated with at-market orders. At-market buy/sell orders are signs of desperation on your part. Using an at-market order tells that the market that you are desperate to buy or sell a certain stocks. An at-market order can move the price significantly against you. At-market orders are basically fodder for high frequency trading algorithms who are hunting for these types of orders. When high frequency trading algorithms spot such an order with sufficient volume, they can adversely move the market against the order. If you find your at-market orders executing at worse price than you should feel assured that high frequency trading algorithms are causing this slippage.
Limit orders are when you tell your broker the maximum price you are willing to pay for a buy order or a minimum price that you are willing to pay for a sell price. A way to tell whether high frequency trading algorithms are active is to place a small limit order and check if new orders immediately appear above or below your limit in the order book. If you observe that orders have immediately appeared after you placed your limit order, cancel your order and see if those orders disappear from the order book. If this happens then you should be sure that an algorithm is trying to trade against your order.
Stop orders let you manage your risk. Now if you have been trading, you must be familiar with the stop order. but you might be knowing this that when price hits a stop order, it becomes a market order and your stop order gets filled as a market order. A stop order can disappoint you if the stock market moves rapidly or crashes. When the stock market crashes, liquidity disappears from the market immediately and there is no one willing to take the buy side as the price is falling down rapidly. So when price hits the stop order there might be no one willing to take the other side and price keeps on falling and there is no one to take the buy side and price crashes more and more and your stop order doesn’t get executed as it is a market order.
Your stop order gets executed only when there is some one on the other side willing to buy. So placing s stop order is no guarantee that it will executed especially if the broker is handling your stop orders manually. However if your broker uses an algorithm for placing stop orders, you can feel somewhat safe that your stop order might get executed. But keep this in mind, in crashing markets stop orders are of little use as the market liquidity dries up pretty fast.
Advanced Standard Orders
If you have a large position, you should know these advanced standard order types that can help you execute your trades at a better price. Iceberg order is an order that doesn’t show the full order in the order book. An iceberg order is executed by an algorithm. Problem with iceberg order is that only partial order gets filled before price moves against your order. High frequency trading algorithms are constantly fishing for iceberg orders. Suppose you have a big client who wants here money withdrawn from the fund. You will use an iceberg order to hide the amount and place the order in small chunks throughout the day using an algorithm. You are facing a deadline by the client and execute the order before the end of the day. As soon as high frequency trading algorithms find your iceberg order, they will trade ahead of you and move the price down so you are forced to make the trade despite the price going down constantly. A dark pool can help you in this situation get a better price in this case. So in this case avoid using an iceberg order and go to a good dark pool.
Fill or Kill orders (FOK) are used when you want the full order to be filled at a specific price. FOK orders have risks. Suppose you have an open position. Your FOK order might not get filled and market moves down rapidly with your position still open. Immediate or Cancel orders (IOC) are similar to FOK orders. For an FOK order to be executed both price and volume ha to be matched but a IOK order can be executed even if the volume is partially filled. High frequency traders use IOC orders to niff out the market a lot and find the hidden orders in the order book.
Special Order Types
As a retail trader, you might not be aware of these special order types as these can only be placed by trading algorithms. As a retail trader, when you open your account, you will not be shown these special order types. New special order types constantly get added and old special order types get deleted. However all special order types tend to hide volume and only become visible in the order book on the preset bid-ask spread. Knowing what these special order types are however is going to help you in your investing. Special orders are a combination of pegged, hidden and post only types.There can be a difference between special order types between US stock markets and EU stock markets. We will focus on special order types on US stock markets since they are more difficult than those available on European stock markets. Once you understand special order types on US stock markets, it would be easy for you to understand special order types on other stock markets in the rest of the world.
A company stock can be displayed on a multiple stock markets and dark pools. So when you post an order to a stock market, it may not have the best possible price. So when you post an order, it will routed to the stock market that has the best possible best available. Some stock markets provide rebates to its clients for providing liquidity. You might prefer to stay with the stock market that provides rebates. Each special order type has Routable option available as a default. But you can also choose Non-routable option. You choose this option if a stock market is providing rebate for providing liquidity to the market. Some exchanges also provide takers rebate for taking the liquidity.
There are some special order types that are unique to algorithmic trading. As said above, exchanges and dark pools provides rebates for providing liquidity. Liquidity is gauged by the number of limit orders on the order book. More limit order on the order book means more liquidity available. When an order is matched, the exchange or the dark pool provides rebate to the liquidity provider. Post only special orders are posted to the order book but these orders don’t get matched even if there is a matching order. Surprising you might think? Once you understand how rebates work, you will understand why post only orders are not matched in the usual manner. When you post a limit order to the order book, you are telling everyone in the market that you want to buy/sell stocks at the posted price. You are providing liquidity. When you post an order that is matched, it is executed immediately. Post only orders are never routed. Post only orders are meant to catch the rebate provided by the exchange or the dark pool so they never get routed. There are many HFT firms with the trading strategy based on catching rebates in the market. Post only orders are mostly used by institutional traders.
Hide not Slide orders are designed to bypass the regulatory ban on locked markets. When you post a limit order that is not routable and it is not matched with an existing order, it will lock the market which is not allowed by regulatory authorities in US. Slide means when the order is posted and there is a matching order at that price available in the order book, it will slide up/down to the next level and wait for the matching order to get executed. Once the matching order gets executed, the limit order slides down to the intended price. HFT firms use an additional trick known as Hide and Slide order. Hide not Slide order is posted to the order book but never shown so it never locks the market. Hide not slide orders are controversial as they violate price and time priority. You make a few pennies with each hide and slide orders. So unless you have a huge order, you don’t make much with these orders.
Peg orders have been developed for volatile and fast moving markets. Peg orders have three types: 1) Primary Peg Orders, 2) Market Peg Orders and 3) Midpoint Peg Orders.Primary Peg Orders are pegged to either the buy side if you have a buy order or to the sell side if you have the sell order.You place a limit on your order also known as peg. You get a better price below your set limit. Market peg orders are also known as Reverse Peg Orders. Your order is pegged to the opposite side unlike the primary peg order. So if you are buying, your order will be pegged to the offer price and if you are selling, your order will be pegged to the bid price.Midpoint Peg Orders are matched to the midpoint of the spread.
Intermarket Sweep Orders (ISOs) have been designed for large institutional traders.ISOs help to avoid the trade through rule based on the order protection rule. Order Protection Rule stipulates that the order should be routed to the venue with the best price. Searching for the best price can take time. In today.s fast moving markets, orders can get changed quickly so it can difficult to find a match easily.ISOs allow you to lock to order to just one order book in the market. Institutional traders and market makers are allowed to use ISOs. Retail traders are not allowed to use ISOs. ISOs allow you to get ahead of the queue in fast moving markets. Many analysts think ISOs are controversial. This was a short introduction to the dark pools, automated computer program trading and HFT. If you are a retail trader, you should know these things if you want to avoid losing without knowing what is happening to your trades.