Dark Pools: Good or bad for the average trader?

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 advantagesdarkpool over traders and investors in order to boost its trading activity and revenues.

In this article I’m going to explain what dark pools are, how they can be used by traders to reduce trading costs and when they should be avoided in order to achieve the same purpose.

First, what is a dark pool? The technical term for them are 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 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 and Credit Suisse are both being  probed for potential 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.

To summarize, I created the following table of how traders and investors can use dark pools to decrease trading costs. The definitions of small, medium and large orders have to do with how much of a market impact you expect to have. For instance, if you want to buy 400 shares of ABC and there are 5,000 shares bid and 6,000 offered, you have a small order as this is not expected to have much of a market impact. If you are trying to buy 5,000 shares, it’s a large order. A medium sized order would be somewhere in between. There is a forth category for huge orders (say 50,000, 100,000 or even 1 million shares), these are institutional orders that require more advanced techniques to conceal your intentions and require multiple executions over many hours/days. Those techniques are beyond the scope of this article.

Keep in mind that some larger spread stocks without a lot of liquidity (typical of small caps), sometimes even something as little as 200-300 shares is expected to have market impact. Also, when I say Dark Pool, I also mean Dark liquidity like orders that are sent to internalizers.

table1

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.

table2

Brokers: Retail brokers like CenterPoint Securities give access to a lot of dark liquidity through their special routes like CPCIT(Citadel), CPKCG (Knight), CSFBDESK (Credit Suisse), and others. That extra liquidity can help when traders are looking for price improvement or for fills when dealing with the Short Sell Restriction.

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.

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.

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