Dark Pools and High Frequency Trading For Dummies. Vaananen Jay

to sell at).

      

If you want to buy a stock immediately, you pay the best offer. If you want to sell, you receive the best bid. The bid is always lower than the offer. By trading within the midpoint of the spread, the seller will get a slightly higher price than the best bid, and a buyer will get a slightly lower price than the best offer. When you’re trading large orders in stock, or if you’re trading often, this ability offered by dark pools to match trades at the mid-price can save you a significant amount of money in the long run.

       Recognising the risks and preparing for them

      Trading in dark pools has two main risks. They basically come down to the following:

      ✓ Information leakage: Information leakage is when other traders are able to receive information about orders coming into the market and use that information to profit from their own trading. When a large order is sent to a dark pool, no volume is shown, but it does and can leak information. For example, if a buy order is sent into a dark pool and it comes back unfilled or only partially filled, that shows that there aren’t as many sellers in the market as there are buyers. This information has a tendency to leak and affect the price. Just as in a traditional exchange, when there are more buyers than sellers the price moves up. Whenever investors make an attempt to buy or sell, they’re sending a signal to the market regardless of whether it’s made in the dark or in the lit markets. Refer to Chapter 12 for more information about information leakage.

      If you’re a retail investor investing in small share lots then you don’t need to worry about information leakage, because your trading won’t have a great effect on the price of the shares.

      ✓ Trust: Any investor who uses a dark pool places a great amount of trust in whoever is operating the pool. When you place an order into a dark pool, the operator of the pool will have knowledge of the order. With that knowledge, the operator could trade ahead of the client (known as front running; refer to Chapter 12 for more information), or the operator could sell the information to a third party who could then do the same. Both of these issues are widely discussed when it comes to dark pools.

      If you’re concerned about trust, consider whether you trust your broker not to use predatory high frequency traders for liquidity. If your broker does, you could well find yourself often getting a worse price than what you expected. If you don’t trust your broker then you may need to find another broker. Refer to the later section ‘Asking your broker the right questions’ to make sure that your broker is providing you with the best service.

      

To develop trust with your broker, your broker needs to be open with you about how she routes your trades and what specific dark pools she uses. Your broker needs to show that she follows and is up to date on the debate and public discussion on dark pools and HFT. Doing so shows you that she is competent and is able to adapt to any possible changes in how dark pools work and are regulated.

Investigating Whether Your Trades Are Exchanged in Dark Pools

      Brokers aren’t often upfront with their clients about how they route their clients’ trades. Sometimes you may notice that you enter an order into the market and it doesn’t show up on the exchange’s order book. This can be particularly apparent in a slow-moving and illiquid stock; it’s likely that your broker is trying to execute the trade in a dark pool.

      Your broker may execute in a dark pool without asking you. Nothing is wrong with doing so if it helps you get a better price for your transaction. But dark pools do have some risks (which I discuss in the previous section), so you want to know if and when your trades are being executed in a dark pool and whether doing so is to your advantage or your broker’s advantage. These sections explain what to do to ensure that you get the best from your trades.

       Asking your broker the right questions

      In order to find out whether your trades are being executed in dark pools, the best thing to do is to discuss the matter with your broker. Remember that dark pools can be good for you because they give you the opportunity to get your trades matched inside the spread of the displayed market and therefore get a better price. There is nothing inherently sinister about your broker using a dark pool, so the more you know about how your order is routed, the more it increases the chances of you getting a good price for your trade.

      

To have that discussion with your broker (or bank), come right out and ask whether your broker uses dark pools and which dark pools she uses. Seek to have a phone or face-to-face conversation so that you can have an open dialogue. Be sure to follow up on that dialogue with a written letter or email outlining your discussion; you want to keep some form of proof about the matters you have addressed with your broker about dark pools. Here are some additional questions that you can ask to uncover important information:

      ✓ Do you have a default action regarding when orders are routed to a dark pool and when directly to an exchange? Or is it just at your discretion? This question can tell you what route your order is likely to take and what venues it will go through. If any dark pools have been fined or are under investigation then you’ll know which dark pools to avoid.

      ✓ Do you accept payment for order flow? If so, from whom? Some brokers accept payment from third parties, often high frequency traders, so that the brokers send their orders first to the entity that is paying for the order flow. Order flow can contain important, market impacting information and those whose orders are part of that order flow are at risk of predatory traders. In the United States, brokers are obligated to inform if they accept payment for order flow, but remember to ask, because it’s always in the fine print.

      ✓ Where have my executed orders been routed during the past six months? In the United States, a broker is obligated to supply this information to her clients. This information will show you if your broker has a preference for certain markets. If so, be sure to ask why.

      Check out the Cheat Sheet at www.dummies.com/cheatsheet/darkpools for more questions to ask your broker.