Dark Pools and High Frequency Trading For Dummies E-Book

Jay Vaananen

• Herausgeber: John Wiley & Sons
• Kategorie: Fachliteratur
• Sprache: Englisch

Seitenzahl: 389

Veröffentlichungsjahr: 2014

Beschreibung

A plain English guide to high frequency trading and off-exchange trading practices

In Dark Pools & High Frequency Trading For Dummies, senior private banker Jukka Vaananen has created an indispensable and friendly guide to what really goes on inside dark pools, what rewards you can reap as an investor and how wider stock markets and pricing may be affected by dark pools. Written with the classic For Dummies style that has become a hallmark of the brand, Vaananen makes this complex material easy to understand with an insider's look into the topic.

The book takes a detailed look at the pros and the cons of trading in dark pools, and how this type of trading differs from more traditional routes. It also examines how dark pools are currently regulated, and how the regulatory landscape may be changing.

• Learn what types of dark pools exist, and how a typical transaction works
• Discover the rules and regulations for dark pools, and some of the downsides to trading
• Explore how dark pools can benefit investors and banks, and who can trade in them
• Recognize the ins and outs of automated and high frequency trading

Because dark pools allow companies to trade stocks anonymously and away from the public exchange, they are not subject to the peaks and troughs of the stock market, and have only recently begun to take off in a big way. Written with investors and finance students in mind, Dark Pools & High Frequency Trading For Dummies is the ultimate reference guide for anyone looking to understand dark pools and dark liquidity, including the different order types and key HFT strategies.

Leseprobe

Dark Pools & High Frequency Trading For Dummies®

Published by: John Wiley & Sons, Ltd., The Atrium, Southern Gate, Chichester, www.wiley.com

This edition first published 2015

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A catalogue record for this book is available from the British Library.

ISBN 978-1-118-87919-1 (hardback/paperback) ISBN 978-1-118-87929-0 (ebk)

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Printed in Great Britain by TJ International, Padstow, Cornwall

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Dark Pools & High Frequency Trading For Dummies®

Visit www.dummies.com/cheatsheet/darkpools to view this book's cheat sheet.

Table of Contents

Introduction

About This Book

Foolish Assumptions

Icons Used in This Book

Beyond the Book

Where to Go from Here

Part I: Getting Started with Dark Pools

Chapter 1: Focusing on Dark Pools and High Frequency Trading, Just the Basics

Defining Dark Pools: Why They’re an Investment Option

Explaining What High Frequency Trading Is

Knowing Who’s Involved When Investing in Dark Pools

Brokers can make or break you

The other important folk

Looking at the Order Types

Considering the regular order types

Eyeing the special order types

Regulating the Markets: Legislators Take Action

Chapter 2: Taking a Dip into Dark Pools

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

Settled outside the public eye

Need for secrecy: Dark versus lit

Improving price

Examining How Dark Pools Work: Step by Step

Weighing the Rewards and the Risks

Identifying potential rewards

Recognising the risks and preparing for them

Investigating Whether Your Trades Are Exchanged in Dark Pools

Asking your broker the right questions

Sleuthing on your own if you don’t use a broker

Making the Best of Your Transactions

Chapter 3: Grappling with the Ins and Outs of Securities Markets

Figuring Out Pricing: The World of Bids and Offers

Grasping how pricing works

Looking at opening and closing prices

Looking at the highest and lowest prices

Making Buying and Selling Easier: Liquidity

Market liquidity

Off-market liquidity

Understanding the Importance of Market Makers

Using VWAP and MVWAP

Getting to grips with order routing

Focusing on price/time priority

Eyeing direct market access

Part II: Diving into Dark Pool Markets

Chapter 4: Introducing Dark Pool Providers

Comparing the Different Types of Dark Pool Providers

Big-time investments: Block-oriented dark pools

No minimum shares required: Streaming liquidity pools

Crossing pools

Looking at Bank- and Broker-Owned Providers

Barclays LX Liquidity Cross

CrossFinder

Fidelity Capital Markets

GETCO/KCG

Sigma X

ConvergEx

Alpha Y

DBA/Super X

Looking at Exchange-Owned Providers

International Securities Exchange (ISE)

New York Stock Exchange/Euronext

BATS Global Markets

Eyeing Some Providers That Have Been Bought Out

Chi-X Global

Instinet

Chapter 5: Meeting the Players and Places

Recognising Who the Market Makers Are

Heading towards extinction: The human touch

Going the automated route

Examining the Venue: Where All the Action Takes Place

Knowing the venue options

Differentiating between stock markets and dark pools

Identifying the Cast of Characters

Brokers and dealers

Private investors

Regulators

Data centres

Journalists, bloggers and writers

Academia

Automated traders

Chapter 6: Regulating Dark Pools

Relating to Regulation

Defining regulation and legislation

Taking action to be more empowered about legislation and regulation

Eyeing Regulation of Dark Pools in the United States: Reg NMS

Rule 610: The market access rule

Rule 611: The order protection rule

Rule 612: The sub-penny rule

Looking at Europe — the Fastest-Growing Dark Pool Fixture

Markets in Financial Instruments Directive

Financial transaction tax (FTT)

Considering Other Markets

Canada

Asia

Australia

Part III: Coming to Grips with Automated Trading

Chapter 7: Comprehending Automated Trading

Identifying Quantitative Analysts

What makes a good quant

What quants do

Why quants are essential

Entering the Realm of the Algorithm

Knowing what an algorithm is

Building an algorithm

Letting an algorithm loose on the markets

Chapter 8: Grasping Standard Order Types

Identifying the Standard Order Types

Comprehending price time priority

Gobbling up everything: At-market orders

Setting the price on a matching trade: Limit orders

Managing risk: Stop orders

Identifying Advanced Standard Order Types

Hiding behind the full amount: Iceberg orders

Wanting it now: Fill or kill orders

Executing only a portion: Immediate or cancel orders

Chapter 9: Identifying the Special Order Types

Getting a Hold of the Basics of Special Order Types

Eyeing their characteristics

Differentiating between routable and non-routable orders

Providing Firms with Rebates: Post-Only Orders

Moving to the Next Level: Hide and Not Slide Orders

Getting the Best Possible Price: Peg Orders

Lining up first: Primary peg orders

Buying based on offer price and selling based on bid price: Market peg orders

Matching in the middle: Midpoint peg orders

Executing Quickly: Intermarket Sweep Orders (ISOs)

Chapter 10: Delving into High Frequency Trading

Tackling the Definition of High Frequency Trading

Eyeing HFT: What it’s all about?

Recognising characteristics of high frequency traders

Examining what high frequency traders do

Predicting the Future of HFT

Technology — staying ahead of the times

Markets — looking for new venues

Legislation – preparing for future regulations

Academic study — listening to the whizzes

Chapter 11: Understanding Key High Frequency Trading Strategies

Scalping for Your Pennies

Peering into the world of scalping

Identifying what can go wrong with scalping

Scalping the automated route

Pinging to Gather Valuable Information

Identifying what pinging does

Examining whether pinging is fair

Looking at pinging in action

Gaming like a Casino

Manipulating quotes

Taking advantage of prior knowledge: Front running

Part IV: Being Aware of the Risks of Dark Pools

Chapter 12: Jockeying Too Much for Position

Understanding How Front Running Impacts Your Investments

Looking at insider information

Having priority access to information

Feeding the news data quickly

Leaking news

Locking up the news

Examining Order Cancellations

Gathering information

Stuffing quotes

Playing games

Identifying the Impact of Slippage

Knowing What You Can Do to Mitigate These Risks

Chapter 13: The Ins and Outs of Flash Crashes

Grasping How Flash Crashes Happen

Blaming the news flow

Holding humans responsible

Computer programming loops

Eyeing How Flash Crashes Spook the Whole Market

Flash crashes draining liquidity

Going from a lively market to a ghost town: Volume isn’t relevant

Examining the Greatest Flash Crash of All Time

The perfect storm triggered

Theorising about the causes

The SEC Speaks: The Official Version of the 2010 Flash Crash

Noting the market’s appearance

Identifying the participants

Tracking the 2010 Flash Crash, Moment by Moment

Criticising the SEC’s Report

Considering an Alternative Version of the 2010 Crash

Finding the exact moment

Blaming HFT

Analysing a Flash Crash

Part V: The Part of Tens

Chapter 14: Ten of the Best Dark Pool/HFT Websites

Banker’s Umbrella

Haim Bodek

Themis Trading

Scott Patterson

Zero Hedge

CFA Institute

Nanex

Able Alpha

The Trading Mesh

Healthy Markets

Chapter 15: Ten Ways to Swim Safely in Dark Pools

Watching the Bid Offer Spread Action

Checking to See Whether Your Market Order Slips

Identifying Changes in the Bid Spread

Spotting 100 or 200 Block Orders in the Order Book

Checking for Your Limit Number in the Order Book

Verifying the Stock’s Spread

Recognising Flash Crashes

Reading a Tick-by-Tick Chart

Talking to Your Broker

Perusing the Executed Orders

Chapter 16: Ten Common Algorithmic Strategies

Market Making

Getting Liquidity Rebates

Deviating from the Norm with Statistical Arbitrage

Catching the Short-term Momentum

Employing Latency Arbitrage

Following the News

Igniting Momentum

Combining a Dark Pool and Lit Markets

Factoring in the Participation Rate

Weighting for Time

Chapter 17: Ten Things to Know About Market Microstructure

Market Access Speed

Order Types

Networks

Algorithms

Fragmentation

Order Routing

Regulation

Transparency

Price Formation

Market Intermediaries

About the Author

Cheat Sheet

More Dummies Products

Guide

Table of Contents

Begin Reading

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Introduction

Really only a few completely understand the domain of dark pools and high frequency trading (HFT). Even experienced finance professionals have a limited understanding of how both work. In fact, many still remain baffled. However, because dark pools and HFT have gone mainstream, more and more professionals and investors are interested in discovering as much as they can. Now you can’t read the business pages without someone discussing dark pools or HFT.

The discussion around dark pools and HFT is the most divisive in finance at the moment. Despite the fact that the operators of dark pools and the traders behind HFT algorithms are slowly being forced out into the open to discuss their actions, much remains a mystery.

From flash crashes to theories about rigged markets and billions in profits made out of tiny changes in prices, dark pools and HFT are a part of modern markets. If you aren’t knowledgeable in how they work and affect your trading, you’ll be bait for the sharks.

I’ve spent my career as a private banker, dealing with and managing large amounts of money, finding myself and my clients up against high frequency traders, and using dark pools to get the best possible price for my clients.

Dark Pools and High Frequency Trading For Dummies shows you the ins and outs of dark pools, including what dark pools are, how they differ from a traditional stock market and how HFT has made day trading next to impossible. I have written this book for the savvy investor who has experience with stock markets and knows how stocks are traded on an exchange. This book is also helpful if you’re a finance professional, particularly if you’re in a client-facing role.

About This Book

If you’re an active investor or a financial advisor, you’re already more than likely aware of the growth of HFT and the use of dark pools. You’ve watched the prices on an exchange and seen some strange movements. With or without your knowledge, trades you have been involved with have most likely been conducted in a dark pool or executed against a high frequency trader, or even both.

The difficulty that you may have had is the lack of information as to what your role is and what your effect is in these circumstances. Some literature out recently has discussed dark pools and HFT, and the pages of newspapers are also full of information. The problem is that most information you read leaves you either feeling that it fails to explain what is really happening or that it’s too technical and difficult to understand. This book corrects that.

Whether you’re an experienced financial advisor or an active investor, this book gives you a clear overview of how the modern market works and what you can do to avoid yourself, or your clients, becoming victims of predatory algorithms. This is all set up in the easy to understand Dummies format.

Within this book, you may note that some web addresses break across two lines of text. If you’re reading this book in print and want to visit one of these web pages, simply key in the web address exactly as it’s noted in the text, pretending that the line break doesn’t exist. If you’re reading this as an e-book, you’ve got it easy – just click the web address to be taken directly to the web page.

Foolish Assumptions

I made the following assumptions about you when I wrote this book. I assume that

You already have experience in investing or managing your and/or other people’s money.You’ve heard about dark pools and HFT and already have an interest in the subject.When you’ve bought or sold stocks, you suspect that the trades may have been executed in a dark pool.You’re willing to accept that there are unfair practices in the financial markets.You’re trying to find ways to invest and trade better while operating against high frequency traders.You would like to know how different dark pools work.You understand that trading in markets is risky.You aren’t naive enough to believe what financial services providers tell you.

No matter whether one or all of these assumptions applies to you, I’m confident that you can find tons of useful information to help be better informed as you wade through dark pools.

Icons Used in This Book

The icons that appear in the book’s margins can help you navigate your way through the book. Here’s what they mean.

This icon calls out suggestions 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 to pay the exchange’s fees. Although stock exchange fees seem small, just fractions of a cent, for a bank or broker they add up. It’s much more cost effective to be able to match a trade internally in a dark pool.

Thanks to superfast computers and the ability to route trades through many locations inside of a millisecond, for many banks and brokers dark pools have become the first point to try to execute a trade before routing it to a stock exchange.

There are now dozens of dark pools all over the world. Brokers often first try to settle a trade between their own clients (called internalising) in their own dark pool. If they can’t find a match, they will then route it to another dark pool, trying to find a match. Often the last port of call will be the traditional stock exchange.

On the darker side of the dark pool market, trading outside the displayed markets may give the broker an opportunity to take a small extra slice. Accusations have been made and even fines levied against some dark pools due to actions that haven’t been in the clients’ favour. Because of little transparency in the market, trading venue providers may be tempted to try to skim the little extra bit for themselves. Trading venue providers are those who operate a dark pool, most often banks and brokers. (Refer to Part IV for some risks associated with dark pools.) As a result of the suspect behaviour of some dark pools, legislators have stepped in to regulate and protect the investor. Head to the later section, ‘Regulating the Markets: Legislators Take Action’, for more information.

The growth in dark pools in recent years has been accelerated by the growth in HFT.

The evolution of dark pools and HFT

The modern dark pool market was created and has grown as large as it has because of high frequency traders. As HFT became better at detecting big orders, large institutions felt they were being used as fodder for the high frequency traders. They then wanted to hide from the high frequency traders and execute their trades out of sight of the algorithms. This is why dark pools were so attractive to big investors.

Now the situation has come full circle. The dark pools became successful businesses and therefore they wanted to grow. This meant they needed new traders in their pools and some opened the doors to high frequency traders and let them into the dark pools to trade. Now there are dark pools that allow high frequency traders in, the very group they were invented to keep out.

Explaining What High Frequency Trading Is

High frequency trading (HFT) is the use of algorithms to trade shares at a high velocity of turnover, sending orders to the market in large numbers and using computer algorithms at great speed. Thousands of trades are sent out and executed inside milliseconds, and it all happens at a pace faster than the human eye can detect.

Here are the defining parts of HFT:

Run by fast algorithms: An HFT algorithm tries to catch tiny differences in the price of a stock – just a penny or even a fraction of a penny. It tries to repeat that thousands and thousands of times a day, so those pennies add up quickly into big money. Chapter 7 takes a closer look at algorithms.Fast computers are co-located with exchanges: High frequency traders are able to do what they do by using fast computer algorithms and placing their own computers close to the stock exchanges’ own computers. Refer to Chapter 10 for more information on co-location.Use of special order types:Special orders are complex buy/sell orders used by algorithmic trading programs that define how an order is placed in a market, how it’s shown on the order book and how it interacts with changes in the order book. Head to the later section ‘Eyeing the special order types’ for more.The sending out and cancellation of lots of small lot orders: High frequency traders send out small orders of 100 to 200 shares at a time, trying to find information about larger, hidden orders. They then trade against those orders to make a profit. Chapter 10 provides more information.

For a while HFT was touted as bringing down the cost of investing and trading in the markets, but as information about the nature of HFT started to leak out, cracks began to appear. Some players in the markets started criticising HFT as something that gave an unfair advantage to some, using predatory behaviour and taking advantage of other investors.

This debate split financial professionals into two camps. Some defended HFT as bringing down trading costs and providing liquidity, making the market a better, well-oiled machine. Then there were those who argued that HFT was akin to the market being rigged and should be outlawed. What’s clear is that some shenanigans have been going on, and often the retail investor and the large institutions have been on the receiving end of the antics of some high frequency traders.

My experience with dark pools and HFT

I first got interested in dark pools and HFT when, as a private banker, I started noticing funny (not funny ha-ha; I mean funny as in strange) things happening when placing trades on the markets for my clients. The price would suddenly move against me, only to immediately move back to the original price after my execution was done at a less favourable price. Then there were the times when I placed an order in the market and it wouldn’t appear on the order book. I’d call my trader, asking what was wrong. He’d call the broker (yep, we still used phones in the early days) who would confirm that the order was in the market, but still I couldn’t see it. Round and round we’d go. Like a Christmas pantomime. My trader and broker telling me, ‘Oh yes it is!’ about my assertion that the order wasn’t in the market, and me saying, ‘Oh no it isn’t!’

This situation started to get on my nerves, so I started looking into what was going on, asking questions and doing research. This led me to dark pools and HFT. At the time I had no idea how all-encompassing these two things had become for the market. The amazing thing was that so few top market participants, fund managers and CIOs had any idea of what was going on.

Through my research and the reach of my website, www.bankersumbrella.com, I’ve got to interact and discuss HFT and dark pools with many influential people on both sides of the HFT debate. I’ve learned a lot and continue to follow closely the changes in the market. I try to report on these matters and explain them in an easy-to-understand format, both on my website and on Twitter.

Knowing Who’s Involved When Investing in Dark Pools

All those involved in the financial markets are in some way involved with dark pools and HFT. Some swim deeper in the pools than others, and some investors actually having no idea that their trades are involved in the world of HFT and dark pools. To grasp how the world of dark pools works you need to know who’s involved, to what extent and how their activities might affect you. Chapter 5 looks at the cast of characters involved in dark pools and what their responsibilities are.

Brokers can make or break you

Brokers are the ones who match the trades. They find buyers for sellers and sellers for buyers. Without brokers there would be no market. In the world of dark pools and HFT, brokers operate their own dark pools and also run their own algorithms that execute trades and route orders to exchanges and dark pools.

The actions of brokers have a direct impact on you getting the best or worst out of your trade, so it’s important for you to know how brokers operate, particularly how your own broker operates.

The other important folk

Plenty of other important operators are involved in dark pools. Here are the main ones. Turn to Chapter 5 for information on what role they play in dark pools and HFT.

Banks: Banks operate their own dark pools in which they match trades for investors. Originally, banks’ dark pools matched trades from their own clients, but their dark pools have grown to include 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 doesn’t move while the order is being filled. Supply and demand 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