The stock market is basically a venue where traders and investors meet to buy and sell shares and other types of assets. In the United States, brokers provide their investors a lot of information that help them understand the order flows and movements of key assets.
We have covered briefly about this information when we looked at level 2 and time and sales (reading the tape) concepts.
In this report, we will look at another relatively unknown concept known as dark pools and how you can use it in the market.
Table of Contents
What is a dark pool?
A dark pool is an alternative trading system (ATS) that allows large buyers and sellers to execute orders without moving the market significantly. Dark pools solve the problem by hiding these transactions from the overall market.
In the public markets like the New York Stock Exchange (NYSE) and Nasdaq, such transactions are usually recorded and can have significant impacts on the market.
For example, if an influential institutional investor like Warren Buffett is buying shares in a company, the stock could jump sharply. However, with dark pools, this information is hidden, which prevents this volatility.
This concept has been around for decades. It started in the 1980s, which forced the Securities and Exchange Commission (SEC) to study and analyse it. The commission started creating rules to guide the industry in the 1980s. And in 2010, it published a paper on equity market structure, which expressed concerns on these pools.
Today, all dark pools in the US are registered by the SEC. Also, in 2014, the Financial Industry Regulatory Authority (FINRA) made new rules to make some information in dark pools public to traders.
Where to see dark pool trading activity
A common question that we have encountered is where people get information on this alternative trading system. Unfortunately, it is not possible to get this data, which explains why they are called dark pools.
It is not possible to see this information since dark pools have off the exchange trading venues. Still, analysts recommend using daily and weekly charts and some technical indicators to find patterns that imply dark pools are taking place
DP Index
Real Trading offers its partners some dark pool indices for day trading.
- Canada Dark Pools (included Matchnow)
- Aequitas Neo-D
- Barclays LX Dark Pool
Different types of dark pools
There are three primary types of this alternative trading system in the market.
Independent
An independent dark pool is provided by individual companies. These companies must register with the regulators such as SEC and FINRA. They are known to offer low transaction costs and solve issues associated with low liquidity.
Some of the most popular independent dark pools are owned by Instinet, which is owned by Nomura, and Smartpool, which is owned by HSBC, JP Morgan, and BNP Paribas.
Broker-dealer owned
A broker-dealer is a company that buys and sells stocks for its accounts and for clients. These darkpools are known for offering price improvements through the National Best Bid and Offer (NBBO).
Some of the broker-dealer owned dark pools are offered by Barclays and Credit Suisse.
Exchange-owned
These dark pools are owned by exchanges like the NYSE, Nasdaq, and BATS. These dark pools are mostly used by high-frequency traders and usually tend to provide liquidity to the market.
How to trade dark pools
Another commonly-asked question about dark pools is how to trade them. Unfortunately, for most retail traders, it is not possible to trade them since they are mostly used by large institutions to prevent market swings in the market.
Related » DMA vs Retail Trading
One way of trading dark pools is to focus on stocks that are in a consolidation mode. When this happens, it is usually a sign that some large investors are buying them. As such, you can wait for a breakout to happen.
Benefits of dark pools
Dark pools offer advantages, mostly to the institutional investors who benefit with the fact that their trading information is not public. As such, the investor is buying blocks of shares, is able to keep their information private and thus buy at a good price.
Also, these buyers are able to keep their transactions anonymous. In addition, among the dark pool providers, there is also excellent trade execution. Finally, there is the benefit of using this data in high-frequency trading.
There are other pros of using dark pools in trading. For example, they reduce volatility during the accumulation process. Also, they lower fees for day traders and provide competition for exchanges.
Cons of using dark pools
There are a few disadvantages of using these alternative trading systems. First, they don’t promote transparency when trading the financial market. As such, they hinder many traders from making the right decisions.
Second, they can lead to conflicts of interests, especially among large traders and investors. Further, these dark pools are not easy to identify among small retail traders.
Uses for dark pool trades
There are many reasons why dark pool trade exists. Some of these uses are:
- Institutional investors – Large investors like hedge funds have billions of dollars in assets under management (aum). These firms use dark pools to buy stocks without causing large swings in the market.
- Share repurchases – Buybacks are one way in which companies reward their shareholders. By buying back their shares, they boost the stock’s EPS. Therefore, these firms acquire these shares over a long period.
- High Frequency Traders – HFT are companies that use algorithms to execute large share purchases. These firms use dark pools to lower fees and to ensure that the market is orderly.
- Broker-lead dark pools – An online broker like Schwab can group several transactions among its clients before sending them to a stock exchange.
FAQs about dark pools
Are dark pools legal?
Yes. These dark pools are completely legal in most countries including the United States. The SEC regulates these dark pools as part of their alternative trading systems.
Can individuals investors trade dark pools?
As mentioned above, it is normally not possible for individuals to trade in dark pools since they are used by large institutions.
What is the difference between dark pools and insider trading?
The two are not related. Dark pools are legal systems of implementing large orders in the market. Insider trading is a situation where people with non-public material information about a company.
Final thoughts
Dark pool is an alternative trading system that is offered by independent companies, broker-dealers, and investment companies. They help large investors and small market participants get involved in the market anonymously. They are also essential tools used by high-frequency traders.
However, for beginner traders, dark pools are relatively difficult concepts that are relatively impossible to execute. For one, they are not offered by many brokers they use.
External useful Resources
- SEC ‘Looking Closely’ At ‘Dark Pools’. Here’s What They Are And Why Reddit Traders Are – Forbes
- RallyingDark Pool Trading System & Regulation – CFA institute
