Dark Pools and High Frequency Trading For Dummies

Jay Vaananen

• Publisher: For Dummies
• Year: 2014
• Print ISBN: 9781118879191
• eBook ISBN: 9781118879306
• Edition: 1
• Topic: Business
• Subtopic: Finance
• Index: Business

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.

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.

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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.

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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.

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My experience with dark pools and HFT

I first got interes...

Table of contents

• Cover
• Title Page
• Table of Contents
• Introduction
• Part I: Getting Started with Dark Pools
• Part II: Diving into Dark Pool Markets
• Part III: Coming to Grips with Automated Trading
• Part IV: Being Aware of the Risks of Dark Pools
• Part V: The Part of Tens
• About the Author
• Cheat Sheet
• More Dummies Products
• End User License Agreement