InvestHH Archives | Page 11 of 19

Oct

2023

How Does High-Frequency Trading (HFT) Impact Markets?

By Inyoung Hwang | Growing Wealth, invest, Investing | Comments Off

High-frequency trading (HFT) firms use ultrafast computer algorithms to conduct big trades of stocks, options, and futures in fractions of a second. HFT firms also rely on sophisticated data networks to get price information and detect trends in markets.

A key characteristic of HFT trading — in addition to high speed, high-volume transactions — is the ultra-short time time horizon.

How high-frequency trading impacts markets is a controversial topic. Proponents of HFT say that these firms add liquidity to markets, helping bring down trading costs for everyone. HFT critics argue such firms are an example of how bigger, better-funded players have an advantage over smaller retail investors, and that HFT technology can be used for illegal purposes like front-running and spoofing.

What is High Frequency Trading?

Ultrafast speeds are paramount for high-frequency trading firms. Executing these automated trades at nanoseconds faster can mean the difference between profits and losses for HFT firms.

There are broadly two types of HFT strategies. The first is looking for trading opportunities that depend on market conditions. For instance, HFT firms may try to arbitrage price differences between exchange-traded funds (ETFs) and futures that track the same underlying index.

Futures contracts based on the S&P 500 Index may experience a price change nanoseconds faster than an ETF that tracks the same index. An HFT firm may capitalize on this price difference by using the futures price data to anticipate a price move in the ETF.

Another type of HFT is market making. Not all market makers are HFT firms, but market making is one of the businesses some HFT firms engage in.

A big market-making business for HFT firms is payment for order flow (PFOF). This is when retail brokerage firms send their client orders to HFT firms to execute. The HFT firms then make a payment to the retail brokerage firm.

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How HFT Works and Makes Money

High-frequency trading enables traders to profit from miniscule price fluctuations, and permits institutions to gain significant returns on bid-ask spreads. HFT algorithms can scan exchanges and multiple markets simultaneously, allowing traders to arbitrage slight price differences for the same asset.

Bid-Ask Spreads 101

High-frequency trading firms often profit from bid-ask spreads — the difference between the price at which a security is bought and the price at which it’s sold.

For instance, an HFT may provide a price quote for a stock that looks like this: $5-$5.01, 500×600. That means the HFT firm is willing to buy 500 shares at $5 each — the bid — while offering to sell 600 shares at $5.01 — the ask. The 1 cent difference is how the market maker makes a profit. While this seems small, with millions of trades, the profits can be sizable.

How wide bid-ask spreads are is also a marker of market liquidity. Bigger chunkier spreads are a sign of less liquid assets, while smaller, tighter spreads can indicate higher liquidity.

Recommended: What Is Quantitative Trading?

Payment For Order Flow 101

When it comes to payment for order flow, high-frequency traders can make money by seeing millions of retail trades that are bundled together.

This can be valuable data that gives HFT firms a sense of which way the market is headed in the short-term. HFT firms can trade on that information, taking the other side of the order and make money.

Background on High-Frequency Trading

High-frequency trading became popular when different stock exchanges started offering incentives to firms to add liquidity to the market. Liquidity is the ease with which trades can be done without affecting market prices.

Like momentum trading, the HFT industry grew rapidly as technology in the financial space began to take off in the mid-2000s.

Adding liquidity means being willing to take the other sides of trades and not needing to get trades filled immediately. In other words, you’re willing to sit and wait. Meanwhile, taking liquidity is when you’re seeking to get trades done as soon as possible.

During 2009, about 60% of the market was said to be HFT. Since then, that percentage has declined to about 50% as some HFT firms have struggled to make money due to ever-increasing technology costs and a lack of volatility in some markets. These days the HFT industry is dominated by a handful of trading firms.

Pros and Cons of High-Frequency Trading

HFT comes with certain pros and cons.

Pros of HFT

High-frequency trading is automated and efficient, thanks to its use of complex algorithms to identify and leverage opportunities.

HFT may create some liquidity in the markets.

Cons of HFT

Because high-frequency trades are conducted by institutional investors, like investment banks and hedge funds, these firms and their clientele tend to benefit more than retail investors.

Because high-frequency trades are made in seconds, HFT may only add a kind of “ghost liquidity” to the market.

Some HFT firms may also engage in illegal practices such as front-running or spoofing trades. Spoofing is where traders place market orders and then cancel them before the order is ever fulfilled, simply to create price movements.

The Debate Over High Frequency Trading

High-frequency trading is a controversial topic, and HFT firms have been involved in lawsuits alleging that they create an unfair advantage and potentially create volatility.

Criticism of HFT

One complaint about HFT is that it’s giving institutional investors an advantage because they can afford to develop rapid-speed computer algorithms and purchase extensive data networks.

Critics argue that HFT can add volatility to the market, since algorithms can make quick decisions without the judgment of humans to weigh on different situations that come up in markets.

For instance, after the so-called “Flash Crash” on May 6, 2010, when the S&P 500 dropped dramatically in a matter of minutes, critics argued that HFT firms exacerbated the selloff.

HFT critics also argue that such traders only provide a very temporary kind of liquidity that benefits their own trades, but not retail investors. A December 2020 paper published by the European Central Bank also argued that too much competition in the HFT industry can cause firms to engage in more speculative trading, which can harm market liquidity.

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Defense of HFT

Defenders of high-frequency trading argue that it has improved liquidity and decreased the cost of trading for small, retail investors. In other words, it made markets more efficient.

This can be particularly important in markets like options trading, where there are thousands of different types of contracts that brokerages may have trouble finding buyers and sellers for. HFT can be helpful liquidity providers in such markets.

When it comes to payment for order flow, defenders of HFT also argue that retail investors have enjoyed price improvement, when they get better prices than they would on a public stock exchange.

The Takeaway

It’s tough to be an investor in many markets today without being affected by high-frequency trading. HFT firms are proprietary trading firms that rely on ultrafast computers and data networks to execute large orders, primarily in the stocks, options, and futures markets.

HFT proponents argue that their participation helps markets be more efficient. Critics argue that they have a big advantage over smaller investors, given how much they pay for information and data networks.

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FAQ

Is high-frequency trading profitable?

High-frequency trading aims to profit from micro changes in price movements through the use of highly sophisticated, ultrafast technology. That said, HFT investors are subject to losses as well as gains.

Is high-frequency trading illegal?

High-frequency trading has been the subject of lawsuits alleging that HFT firms have an unfair advantage over retail investors, but HFT is still allowed. That said, HFT firms have been linked to illegal practices such as front-running.

What is an example of high-frequency trading?

High-frequency trading can be used with a variety of strategies. One of the most common is arbitrage, which is a way of buying and selling securities to take advantage of (often) miniscule price differences between exchanges. A very simple example could be buying 100 shares of a stock at $75 per share on the Nasdaq stock exchange, and selling those shares on the NYSE for $75.20.

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Oct

2023

Pros & Cons of Using a Moving Average to Buy Stocks

By Kate Ashford | Growing Wealth, Investing, Terminology | Comments Off

The moving average is a tool that can help investors decide whether and when to buy or sell a stock. It presents a smoothed-out picture of where a stock’s price has been in the past and where it’s trending now. Investors may compute moving averages over a variety of time frames, and they are useful to both long-term and short-term investors.

What Is a Moving Average?

A moving average is a metric often used in technical analysis. For a stock, it’s a constantly updated average price.

Unlike trying to track a stock price day-to-day, a moving average smooths price volatility and is an indicator of the current direction a price is headed. A moving average reflects past prices — usually a stock’s closing price — so it’s not a predictor of future direction, just what’s happening now or in the past.

You can compute moving averages using almost any time frame. Common time frames include 20-day, 30-day, 50-day, 100-day and 200-day moving averages.

While a moving average is useful on its own when analyzing different types of investments, it also forms the basis of other types of technical indicators, such as the Moving Average Convergence Divergence (MACD) and the McClellan Oscillator.

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Types of Moving Averages

There are three common types of moving averages that investors might consider when deciding when to buy or sell a stock:

Simple Moving Average:

As the name states, this is the simplest type of moving average. You can calculate the simple moving average by finding the arithmetic mean of a set of data points. For instance, if you had an average daily price for a stock each day for the last 30 days, you would add them all together and divide by the number of days.

The Simple Moving Average (SMA) formula is as follows:

P = Price on a given date

n = The time period

Example: Suppose you were trying to find the simple moving average of a stock price over 10 days.

N = 10 days

Prices (in dollars) = 11, 12, 15, 13, 12, 7, 10, 11, 13, 12

SMA = (11 + 12 + 15 + 13 + 12 + 7 + 10 + 11 + 13 + 12) / 10

SMA = 11.6

Weighted Moving Average

A weighted moving average (WMA) gives more weight to certain price prices. If you overweight recent prices, for example, the measure becomes more responsive to recent price moves and less prone to the lag effect.

Exponential Moving Average:

An exponential moving average is a type of weighted moving average that calculates changes in a price cumulatively, rather than based on previous average. That means that all previous data values impact the EMA, since there is less variation over time.

Why Would an Investor Use a Moving Average?

Using a moving average to analyze a stock can help you filter out the “noise” that comes from random price fluctuations. By looking at the direction of the moving average, you can get a sense of whether the price is generally moving up or generally moving down. If a moving average is moving sideways (neither up nor down), the price is probably sticking within a window and not fluctuating much.

A moving average is sometimes plotted as a line by itself on a price chart to illustrate price trends. And different moving average lines can be used in tandem to spot changes in direction. For instance, an investor might be looking at a faster moving average (one with a shorter period, such as 10 days) versus a slower moving average (one with a longer period, such as 200 days). When these lines cross each other, it’s called a moving-average crossover, and can indicate that the trend is changing or is about to change.

Moving averages can also indicate support or resistance levels. Support levels are a price level where a downward trending line would be predicted to pause, due to demand or buying interest. A resistance level is a price ceiling where an upward trending line would be expected to plateau due to selling interest. Over time, watching moving averages can help investors identify these levels of support and resistance, and use them to make buy/sell decisions.

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Pros of Using a Moving Average

A moving average offers several benefits to investors.

It smooths the data.

Day-to-day price swings can be confusing to track, and make it difficult to determine a stock’s direction. A moving average smooths out volatility, giving you a better look at how a stock is trending.

It’s a simple gauge.

As an analytical tool, a simple moving average is easy to interpret. If a stock’s current price is higher than an upward trending moving average line, the stock is headed up in the short-term. If a stock’s price is lower than a downward trending moving average line, the stock is headed down in the short-term.

Easy to calculate.

A moving average is a relatively easy metric, so the average investor can calculate it on their own.

Cons of Using a Moving Average

It’s important to keep the drawbacks of moving averages in mind when using them to determine whether to buy shares of a company.

They’re not predictive.

As with all investments, past performance is not an indicator of future performance, so a moving average — no matter which type you use — can’t tell you what a stock will do next.

There’s a lag.

The longer the period your moving average covers, the greater your lag — meaning how responsive your moving average is to price changes. A 10-day exponential moving average, for instance, will react quickly to price turns, while a 200-day moving average is more sluggish and slower to react to changes.

There’s trouble with price turbulence.

If prices are trending in one direction or another, a moving average may be a helpful metric. But if prices are choppy or volatile, the moving average becomes less useful, since it will swing along with the price. Allowing for a lengthier time frame may resolve this issue, but it can still occur.

Simple moving averages weigh all prices equally. This can be a disadvantage if a stock’s price has taken a significant but recent shift.

Weighted moving averages may send false signals.

Since WMAs put more weight on more recent data, they’re faster to react to price swings, which can occasionally be misleading.

The Takeaway

Moving averages are just one metric you can use to evaluate a stock. They can help quiet the noise of price fluctuations and show you what a stock is doing over time. That said, in some environments or with specific price patterns, moving averages may lag or send a misleading signal.

With that in mind, knowing what a moving average is can be helpful when learning how to size-up potential investments. It’s critical to consider the pros and cons, of course, but moving averages can be another tool in an investor’s tool chest.

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Sep

2023

How to Invest in Opportunity Zone Funds

By Brian O'Connell | Growing Wealth, invest, Investing | Comments Off

The Qualified Opportunity Zone program is an initiative aimed at incentivizing investors to allocate cash to economically distressed communities who could benefit from the capital.

The Qualified Opportunity Zone program, highlighted by the Community Development Financial Institutions Fund, was rolled out as part of the 2017 Tax Cuts and Jobs Act. The program allows some U.S. investors to offset capital gains taxes under certain conditions by investing in some communities.

What Is an Opportunity Zone Fund?

Opportunity Zone (OZ) Investment Funds are a type of alternative investment fund that offers capital gains tax relief for some investments aimed at revitalizing communities. Opportunity Zones represent what the Internal Revenue Service calls an “economic development tool,” designed to accelerate economic development and job creation in economically struggling U.S. communities.

The Treasury Department determines eligible Opportunity Zones, of which there are thousands spread across the United States. Corporations or partners establish an Opportunity Zone Fund and use it to invest in properties located in a recognized opportunity zone.

💡 Quick Tip: Before opening an investment account, know your investment objectives, time horizon, and risk tolerance. These fundamentals will help keep your strategy on track and with the aim of meeting your goals.

How to Invest in a Qualified Opportunity Zone Fund

To take advantage of the tax-efficient investment benefits of OZ investing, interested partners must first register as a corporation or partnership, complete IRS form 8996, and file the form along with their federal tax returns. After gaining approval by the IRS, the fund must commit at least 90% of its assets to a specific Opportunity Zone. Once that threshold is cleared, the QOF is eligible for capital gains tax relief.

Qualified Opportunity Fund Investment Requirements

The money that Qualified Funds invest in distressed communities must also fit the Treasury Department’s criteria of an Opportunity Zone investor.

• The Fund must make significant upgrades to the community properties they invest in with fund dollars.

• The investment must be made within 30 months of becoming eligible as a Qualified Opportunity Fund.

• The investment must meet specific Treasury Department financial investment standards. In other words, the investments made in community properties must be equal or superior to the original value paid by the Opportunity Zone investment fund. For instance, if an Opportunity Zone Fund purchased a distressed property for $500,000, that investor has the 30-month window to steer at least $500,000 into the Opportunity Zone property improvements.

• Some Opportunity Zone properties qualify for opportunity funds (private and multi-family homes, business settings and non-profit properties) and some don’t. For example, golf and country clubs, liquor stores, massage parlors, and gambling facilities do not qualify as Opportunity Zone investments.

• The investor must commit to a timely investment in Qualified Opportunity Funds – the longer the time, the bigger the capital gain deferral. The IRS says the tax deferral may last until the exact date on which the Qualified Opportunity Fund is sold or exchanged, or by December 31, 2026. By law, the investor has 180 days from a capital gains sales event to turn those gains into an Opportunity Zone investment.

• The funding program is tiered, with a 10% tax exclusion offered to investors who hold a Qualified Investment Fund investment for at least five years. If the investor holds the investment for seven years, the tax exclusion rises to 15%. If the investor stays in for 10 years or more, the IRS allows for an adjustment based on the amount of the QOF investment based on its fair market value on the exact date the investment is sold or exchanged. Any appreciation in the fund investment isn’t taxed at all, according to the IRS.

• Opportunity Zone investors don’t have to physically reside in the communities they financially support, nor do they have to hold a place of business in that community. The only criteria for eligibility is making a qualified financial investment in an eligible, economically distressed community and the ability to defer the tax on investment gains.

Opportunity Zone Investment Considerations

Investors looking to defer capital gains taxes may view Qualified Opportunity Funds as an attractive proposition. Before signing off on any Opportunity Zone commitments, however, investors may want to review some key facts and investment risks worth keeping in mind when investing in OZs.

Real Estate as an Investment

Since Opportunity Zone funding focuses on distressed communities, most investments are real estate oriented, making it an alternative investment that may be part of a balanced portfolio. Typical Opportunity Zone investments include multi-family housing, apartment buildings, parking garages, small business dwellings/strip malls, and storage sheds, among other structures.

Recognize the Up-Front Cost Realities

Opportunity Zones are a high priority for public policy administrators, which is one reason QOFs require high minimum investments. Up front minimums of $1 million aren’t uncommon with Opportunity Zone Funds, and investors should know that going into any funding situation. In most cases, that means that accredited investors are more likely than other individuals investors to take advantage of OZ investing.

Your Cash May Be Tied up for a Long Time

To optimize the capital gains tax break, Opportunity Zone investors should count on their money being tied up for 10 years. Funds need that time to collect and disseminate cash, choose the appropriate potential properties for investment, and conduct the actual remodeling or upgrades needed to turn those properties into profitable enterprises. Thus, lock-up timetables can go on for a decade or longer.

Management Fees Can Eat into Portfolio Profits

Like any professionally managed financial vehicle, Qualified Opportunity Funds come with investment fees and expenses that can cut into profits. While many investors opt for Opportunity Zone investments for the tax breaks, those investors may also expect their investment to generate healthy returns. To get those returns, they can expect to pay the fees and expenses associated with any professional managed investment fund.

The Takeaway

Investing in Opportunity Zone funds allows some U.S. investors to offset capital gains taxes under certain conditions by investing in some communities. These funds are a type of alternative investment that may be an attractive addition to a portfolio.

Above all else, Opportunity Zone funds come with a healthy measure of risk, including investment risk, liquidity risk, market risk, and business risk. While the promise of a tax break and the opportunity to boost worn-down U.S. communities are appealing, any decision to invest in Opportunity Zones should be made with the consultation of a trusted financial advisor –- ideally one well-versed in tax shelters and real estate investing.

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Sep

2023

How Time-Weighted Rate of Return Measures Your Investment Gains

By Samuel Becker | Growing Wealth, invest, Investing | Comments Off

One of the most important and most common methods investors use to measure their returns is the time weighted rate of return formula. That’s because the time-weighted rate of return measures a compound rate of growth.

The time-weighted rate of return incorporates the impact of transactions such as portfolios rebalancing, contributions, and withdrawals. That leaves investors with a clearer picture of their portfolio’s overall performance.

What Is the Time-Weighted Rate of Return?

Starting with the basics, a return on investment (ROI) is a measure of how much money investments earn, or how much they’ve grown in value. Returns can be positive or negative (if a stock loses value following its purchase, for example). But obviously, investors make decisions with the goal of earning positive returns.

A rate of return, then, is a measure of the pace at which investments are accruing value, expressed as a percentage. The higher the rate of return, the better. Essentially, it’s a measure of a portfolio’s or investment’s performance over time. Rates of return can be calculated for certain time periods, such as a month or a year, and can be helpful when comparing different types of investments.

But investment portfolios are rarely static. Many investors make contributions or withdrawals to their portfolios on a regular basis. Many people contribute to their 401(k) with each paycheck, for example, or rebalance when market moves throw their asset allocation out of whack.

During these transactions, investors are buying and selling investments at different prices and times based on their investing strategy. That can make it more difficult and complicated to calculate a portfolio’s overall rate of return.

That’s where the time-weighted rate of return formula becomes useful. In short, the time-weighted rate of return formula takes into account a portfolio’s cash flows, and bakes in their effect on the portfolio’s overall returns. That gives investors a better, more accurate assessment of their portfolio’s performance.

That’s why the time-weighted rate of return calculation is, for many in the financial industry, the standard formula for gauging performance, over both the short- and the long-term.

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The Time-Weighted Rate of Return Formula

The time-weighted rate of return formula can look intimidating for even seasoned investors, but it’s an important step in building and maintaining an investment portfolio. But like many other financial formulas, once the variables are identified, it’s a matter of plug-and-play to run through the calculation.

First, let’s take a look at the basic portfolio return calculation:

Basic portfolio return = (Current value of portfolio – initial value of portfolio) ÷ initial value

While this formula provides a value, it assumes that an investor made one investment and simply left their money in-place to grow. But again, investors tend to make numerous investments over several time periods, limiting this calculation’s ability to tell an investor much about their strategy’s effectiveness.

That’s where the time-weighted rate of return comes in. In essence, the time-weighted formula calculates returns for a number of different time periods — usually additional purchases, withdrawals, or sales of the investment.

It then “weights” each time period (assigns them all roughly equal importance, regardless of how much was invested or withdrawn during a given period). Then, the performance of each period is included in the formula to get an overall rate of return for a specified period.

Calculating the time-weighted rate of return over the course of a year, for instance, would include the performance from each individual month. And, yes, that’s a lot of math. Computers and software programs can help, but it’s also doable the old-fashioned way.

This is what the time-weighted rate of return formula looks like:

Time-weighted return = [(1 + RTP1)(1 + RTP2)(1 + RTPn)] – 1

There are variables needed to calculate the equation:

n = Number of time periods, or months
RTP = Return for time period (month) = (End value – initial value + cash flow) ÷ (initial value + cash flow)
RTPn = Return for the time period “n”, depending on how many time periods there are

Let’s break it down again, and assume we’re trying to calculate the time-weighted return over three months. That would involve calculating the return for each individual month, three in all. Then, multiplying those returns together — “weighting” them — to arrive at an overall, time-weighted return.

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How to Calculate Time-Weighted Rate of Return

To run through an example, assume we want to calculate a three-month, time-weighted return. An investor invests $100 in their portfolio on January 31. On February 15, the portfolio has a value of $102, and the investor makes an additional deposit of $5. At the end of the three-month period on April 30, the portfolio contains $115.

For this calculation, we wouldn’t think of our time periods as merely months. Instead, the time periods would be split in two — one for when a new deposit was made. So, there was the initial $100 deposit that would constitute a time period that ends on February 15. Then a second time period, when the $5 deposit was made, which constitutes a second time period.

With this information, we can make the calculation. That includes calculating the return for each time period during our three-month stretch. So, for time period one, the basic formula looks like this:

Return for time period = (End value – initial value + cash flow) ÷ (initial value + cash flow)

Now, we plug in our variables and calculate. Remember, there was no additional cash flow during this first period, so that won’t be included in this first calculation.

Time period 1:
($102 – $100) ÷ $100 = 0.02, or 2%

Then, do the same to calculate time period two’s return:

Time period 2:
[$115 – ($102 + $5)] ÷ ($102 + $5) = 0.074, or 7.4%

Now, take the returns from these two time periods and use them in the time-weighted rate of return formula:

Time-weighted return = [(1 + RTP1)(1 + RTP2)(1 + RTPn) – 1

With the variables — remember to properly use percentages!

TWR = [(1 + 0.02) x (1 + 0.074)] – 1 = 0.95, or 9.5%

So, the time-weighted return over this three-month stretch (which included two time periods for our calculation), is 9.5%. If we had simply done a basic return calculation, we’d reach a different number:

Basic portfolio return = (Current value of portfolio – initial value of portfolio) ÷ initial value
$115 – $100 ÷ $100 = 0.15, or 15%

That 15% figure is too high, because it doesn’t account for cash flow. In this case, that was a $5 deposit made in mid-February. The basic return formula folds that into the overall return figure. The time-weighted calculation gives us a more accurate return percentage, and one that accounts for that mid-February deposit.

Other calculations

While the time-weighted rate of return is an important measurement, it’s not the only way to look at a portfolio’s returns. Some investors may also choose to evaluate a portfolio or investment based on its money-weighted rate of return. That calculation is similar to the time-weighted rate of return because it incorporates inflows and outflows, but it does not break the overall investment period into smaller intervals.

Another common measure is the compound annual growth rate, (CAGR), which measures an investment’s annual growth rate over time and does not include the impact of inflows and outflows.

The Takeaway

Having an accurate, timely view of a portfolio’s performance is critical for understanding current investments, planning future investments, and considering changes to your asset allocation. While other rate of return calculations can be useful, it’s important to understand their limitations.

The time-weighted rate of return formula is helpful because it takes into account the numerous inflows and outflows of money over various time periods. Armed with that insight, investors can adjust their strategy to try to increase their rate of return. That may mean reallocating or rebalancing their portfolio to include more aggressive investments or less risky securities.

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SOIN0623024

Sep

2023

How Dark Pools Operate – and Why They Exist

What Is a Dark Pool in Trading?

By Colin Dodds | Growing Wealth, invest, Investing, Terminology | Comments Off

Dark pools, sometimes referred to as “dark pools of liquidity,” are a type of alternative trading system used by large institutional investors to which the investing public does not have access.

Living up to their “dark” name, these pools have no public transparency by design. Institutional investors, such as mutual fund managers, pension funds, and hedge funds, use dark pool trading to buy and sell large blocks of securities without moving the larger markets until the trade is executed.

Understanding the History of Dark Pools

The history of dark pools in the trading world starts in the 1980s, following changes at the Securities and Exchange Commission (SEC) which effectively allowed brokers to make trades in large share blocks. Later, in the mid-2000s, further SEC changes that were meant to cut trading costs and increase market competition led to an increase in dark pool trading.

Dark Pool Examples

There are many dark pools out there, and they can be operated by independent companies, brokers or broker groups, or stock exchanges themselves. An internet search would bring up names of specific dark pools.

But to get a sense of how a dark pool can be used to investors’ benefit, say there’s a mutual fund looking to sell 2 million shares of Stock X. Given that selling that amount of shares would create ripples in the market, the mutual fund may not want to sell them all at once. As such, they sell them in blocks of 10,000, 1,500, or 5,000 shares — and find buyers for the smaller blocks accordingly.

This method makes it less obvious that a huge number of shares are being sold, which could avoid Stock X’s shares losing value quickly.

Who Runs Dark Pools?

Investment banks typically run dark pools, but some other institutions run them as well, including large broker-dealers, agency brokers, and even some public exchanges. Some trading platforms, where individual investors buy and sell stocks, also use dark pools to execute trades using a payment for order flow.

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The role of dark pools in the market varies over time. At times, dark pool trades comprise as much as half of all trading in a single day, while at other times, they make up significantly less of U.S. equity volume.

Because trades in a dark pool aren’t reflected in the prices on a public exchange, participants in a dark pool trade based on the prices offered on a public exchange, using the midpoint of the National Best Bid and Offer (NBBO) to set prices.

💡 Quick Tip: Look for an online brokerage with low trading commissions as well as no account minimum. Higher fees can cut into investment returns over time.

Why Institutions Use Dark Pools

Large, institutional investors such as hedge funds, may turn to dark pools to get a better price when buying or selling large blocks of a single stock. That’s because of the way that large trades impact the public markets.

As discussed, if a mutual fund manager, for example, wants to sell a million shares of a given stock because it’s underperforming or no longer fits their strategy, they’d need to use a floor trader to unload the position on a public exchange. Selling all those shares could impact the price they get, driving down the VWAP (volume weighted average price) of the total sale.

To avoid driving down the price, the manager might spread out the trade over several days. But if other traders identify the institution or the fund that’s selling they could also sell, potentially driving down the price even further.

The same risk exists when buying large blocks of a given security on a public market, as the purchase itself can attract attention and drive up the price.

New Risks

The risks of attracting attention from other traders have intensified with the rise of algorithmic trading and high-frequency trading (HFT). These strategies employ sophisticated computer programs to make big trades just ahead of other investors. HFT programs flood public exchanges with buy or sell orders to front-run giant block trades, and force the fund manager in the above example to get a worse price on their trade.

Dark Pool Benefits

Utilizing a dark pool and conducting a dark trade, institutional investors can sell a million shares of a stock without the public finding out because dark pool participants don’t disclose their trades to participants on the exchange. The details of trades within a dark pool only show up after a delay on the consolidated tape — the electronic system that collates price and volume data from major securities exchanges.

There are other advantages for an institutional trader. Because the buyers and sellers in a dark pool are other institutional traders, a fund manager looking to sell a million shares of a given stock is more likely to find buyers who are in the market for a million shares or more. On a public exchange, that million-share sale will likely need to be broken up into dozens, if not hundreds of trades.

Criticism of Dark Pools

As dark pools have grown in prominence, they’ve attracted criticism from many directions, and scrutiny from regulators. For instance, the lack of transparency in dark pools and the exclusivity of their clientele makes some investors uneasy. Some even believe that the pools give large investors an unfair advantage over smaller investors, who buy and sell almost exclusively on public exchanges.

The Takeaway

As discussed, dark pools are sometimes referred to as “dark pools of liquidity,” and are a type of alternative trading system used by large institutional investors to which the investing public does not have access. They’re typically run and utilized by large investment banks.

Given the nature of dark pools, they attracted criticism from some due to the lack of transparency, and the exclusivity of their clientele. While the typical investor may not interact with a dark pool, knowing the ins and outs may be helpful background knowledge.

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FAQ

How can you see dark pool trades?

Investors can access dark pool trading data through various securities information processors, and can be accessed through FINRA’s website as well.

Who regulates dark pools?

The Securities and Exchange Commission, or SEC, is the government body that regulates dark pools and dark pool trading.

What are dark pools in cryptocurrency?

A dark pool in cryptocurrency is more or less the same as a dark pool in other equities markets, and is a place that matches buyers and sellers for large orders outside of a public exchange or view.

How do dark pools differ from lit pools?

As many might surmise, lit pools are effectively the opposite of dark pools, in that they show trading data such as number of shares traded and bid/ask prices.

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The Takeaway

FAQ

How can you see dark pool trades?

Who regulates dark pools?

What are dark pools in cryptocurrency?

How do dark pools differ from lit pools?

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