Dark pools recently have been subject of many headlines, mostly due to alleged illegal activities from the banks that operate them. For instance, Barclays is said have given high-frequency traders (HFTs) unfair advantages over traders and investors in order to boost its trading activity and revenues.
First, what is a dark pool? The technical term for them is ATS (alternative trading system). They are essentially mini exchanges that match buy and sell orders without displaying them to the market. If you route a buy order (say, buy 50,000 shares of MSFT) to a dark pool, in theory, nobody knows your order is there. You have the possibility of getting filled for your entire order without “spooking” the market by displaying a large bid in the Level 2 Window. A lot of smart routers tend to go through dark pools first before they hit the displayed exchanges/ECNs, as a result your order would be exposed to that order flow before other participants.
Another benefit of dark pools is that because the order is not displayed, sometimes you get the benefit of not having to hit the bid or ask in order to get your order executed. If you send a displayed order and have it appear in the Level 2, frequently, high frequency traders will jump ahead of you by one cent. This sort of “penny jumping” is done automatically by computers, while it has to be adjusted manually by us humans, this is annoying, time consuming and inefficient. By having that order in a dark pool, you can be in front of the HFT bids and asks without, in theory, they knowing about it and you can get the order flow of that dark pool to save you the spread.
Another benefit of dark pools is that when you send liquidity taking orders that go through them first, you tend to get access to additional liquidity not shown in the Level 2 that is inside the NBBO (National Best Bid and Offer). This tends to reduce your trading costs because it reduces the spread that you have to pay. Example: You try to buy 1,000 shares of PG at 80.02 in a market quoted at 80.01 x 80.02, your smart router hits a dark pool before the displayed market and gives back a fill for your entire order at 80.015. You just saved half a cent which comes out at $5. Over the course of a year, these savings add up.
Does that mean that dark pools are the Holy Grail for traders and investors to reduce their trading costs?
No. In addition to the unfair advantages that high frequency traders might be getting in dark pools, there are other issues even through legal means. For instance, Eric Hunsander from Nanex recently did an expose on how modern markets are rigged See http://www.nanex.net/aqck2/4661.html.
In it he demonstrated that a large order (in this case a buy order for 20,000 shares of Ford) alerted HFTs about his buying intentions because it hit dark pools first before the displayed
markets. The HFTs then proceeded to cancel their orders from the displayed exchanges. The trader behind the order ended up only getting 12,133 shares (and 600 were from the dark pool). In this case, having the order go through the dark pool first was an extremely bad deal.
The question now is, if you are looking to decrease trading costs, when should a trader use dark pools and when he should avoid them?
It all depends on your order size. As a rule of thumb, if you are executing a small liquidity taking order (you are hitting the bid or ask), you want to go through as many dark pools as possible. The additional liquidity will give you fills inside the NBBO and reduce the spread that you pay. Some brokers allow you to expand the number of dark pools that your order will go through, being aware of this option can help you expose your order to dark pools when you think that is valuable. Ask your broker if they offer such option.
If you are sending a small liquidity providing order, you want to use a dark pool that has a lot of activity in that stock. This will enable you to not have to sit with a bid or offer for very long, get taken and save the spread. Not a lot of retail brokerages allow routing to dark pools. Ask your broker if they have such option.
On the order hand, if you are executing a liquidity taking large order, you want to go through as few dark pools as possible.
As explained by Nanex and evidenced by a lot of frustrated traders, when HFTs notice dark pool activity a lot of the time, they tend to cancel their orders in the displayed market. HFTs know that dark pools are used by institutional traders looking for liquidity. Since institutions usually have a lot of stock to buy and sell, HFTs can make more by widening their spreads. In the case of large liquidity adding orders, it’s also problematic to use a dark pool. Barclays is being accused of wrongdoing when dealing with institutional orders. And these are just two banks, there are dozens of dark pools out there. Every time you send your larger orders to dark pools, you run the risk of being taken advantage of by executives looking to increase their market share. The benefit of you having your block trade executed is significant, but so is the cost of having your intentions exposed to HFTs. Choosing the right dark pool becomes crucial.
When taking liquidity: You want to go through as many dark pools as possible.
Some brokerages allow you to expand the number of dark pools you order goes through. Turning this option on is an attractive choice. Example: Interactive Brokers has an option called “Seek Price Improvement” that is turned off by default. If your order is small, turning the option on can decrease your trading costs and expose you to additional intra NBBO liquidity.
When taking liquidity: This is where trader discretion and experience comes in. You have to be able to judge whether your order will have a market impact or not. The more impact you expect to have, the less you should rely on dark pools.
When taking liquidity one wants to go through as few dark pools as possible, such as IEX. IEX has a 350 microsecond delay to its HFTs and participants that prevents them from outracing the IEX router and cancel their orders from displayed exchanges. By not going through dark pools first, you can avoid a cascade of cancellations that happen when dark pool activity is detected by HFTs.
When adding liquidity: You want to use a dark pool that has a lot of activity in that stock. This will help you quickly get filled and save the spread. Not a lot of retail brokerages allow routing to dark pools but some do.
When adding liquidity a trader’s discretion and experience comes in. You have to be able to judge whether your order will have a market impact or not. The more impact you expect to have, the less you should rely on dark pools.
When adding liquidity one also wants be as careful as possible. A lot of dark pools are alleged to have engaged in wrong doing. Some might be leaking out information about orders. You should only use a dark pool that you really trust.
Two other variables you have to take into account are, how quickly you want to get in or out of a stock, and how fast is the stock moving.
You want to get your orders executed fast…
You are not in a rush to your orders executed…
Because you want to get in or out as fast as possible, you should go through as little as dark pools as possible. Having your intentions exposed while routing your orders becomes a bigger issue given that you going to be hitting the bid or the ask more aggressively. Getting executed becomes more important than a small price improvement a dark pool could bring.
Because you are not in a rush, you should hit as many dark pools as possible for the price improvement. Having time to work your order means that you can break a larger order into smaller blocks. The same principles for smaller orders would apply in this case, even if the order were large.
It’s a fasting moving stock…
It’s a slow moving stock…
You want to go through as little dark pools as possible. In a fast moving stock, the downside of having your intentions exposed will be large. The subsequent HFT move will be more costly, likely several times any price improvement a dark pool could bring.
You want to go through many dark pools routing your order. The downside here is not as large. If HFTs detect your intentions, it might not even impact the price very much (especially if you can wait a few minutes until you route another order). Unless your order is quite big, you can afford to seek price improvement in these types of stocks.
Conclusion: Dark pool orders definitely have a place in a trader’s toolbox. Don’t be scared by the headlines you read on the financial websites. If you understand them and know how to use them, you can use your judgment of when they are likely to decrease or increase your trading costs. Being aware of how much market impact you are likely to have and how your broker routes your orders can further help you in decreasing those costs.
Fernando Luiz de Oliveira is a full-time retail trader who trades under Aquatoid Corp.
The views represented in this commentary are those of its author and do not reflect the opinion of Traders Magazine or its staff. Traders Magazine welcomes reader feedback on this column and on all issues relevant to the institutional trading community. Please send your comments to Traderseditorial@sourcemedia.com
