What You Don’t Know About Dark Pools Can Hurt You

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This week, we’ve talked about short squeezes…

We’ve discussed short interest…

But let me blow your mind.

Do you know what “dark pools” are?

The U.S. Securities and Exchange Commission is looking at issues like payment for order flow, cryptocurrencies, and even stock shorts.

But dark pools are on a different level.

In fact, they might be the biggest disadvantage that you face as a retail investor. Let me explain what they are and why they matter to you.

This is Wall Street’s Real Advantage

A dark pool sounds like something out of a Marvel comic book.

But there’s nothing supernatural about this trading term.

A dark pool is a private exchange for trading stocks, derivatives (like options), and other assets that can’t be accessed by the public. It’s like someone is trading behind a curtain, and you don’t know who they are or why they are doing what they are doing.

The point of dark pools is to ensure that institutional investors can execute large “block trades” of different equities without immediately impacting public sentiment. By default, the trades are anonymous, so, for example, a big institutional investor who has been bullish on a stock for a long time might sell in a dark pool to prevent a huge sell-off.

On the surface, this makes sense. Think about Bill Ackman, one of the world’s top hedge fund managers and a person who has an incredible influence on the markets. Let’s say he has been bullish on a stock for years.

If he were to suddenly liquidate shares — and sell half of his position — he might dramatically influence the public perception of the stock. If the market believes he is now bearish on the stock (even if he keeps the remaining 50%), then the market will sell the stock off as well. And his remaining stake would take a hit.

Now, I mentioned “block trades” a moment ago. Let me explain what these are. A block trade is pretty simple. It’s a sale or purchase of a VERY large number of assets between two parties. There are no real rules for a trade of this type. You know it when you see it.

When a purchase or sale is that significant, it usually impacts the underlying price.

Think of it this way. When a CFO or CEO buys their own stock, it usually drives the price higher because people believe that the executive has confidence in the stock.

Well, when a block trade happens, it can have a similar effect. People see the size of a trade and they believe that someone influential is drawing a line in the sand and trading the asset with conviction. Traders love to follow big trades, and block trades are a clear sign of confidence in a specific asset.

But there’s another matter behind block trades that most investors don’t understand: robots.

You see, upwards of 70% of trades are executed by computers and algorithms every single day. So, the combination of algorithmic trading and high-frequency trading (HFT) leads to the execution of big trades within dark pools in fractions of a second.

These buys and sells are not necessarily based on the conviction of a hedge fund manager, either. So dark pools can allow these machines to break up the larger trades into smaller blocks across multiple exchanges, further lessening the potential impact.

Now, let me explain the pros and the cons of dark pools.

Advantages (at least for big buyers and sellers)

1. Protecting Existing Positions

Dark pools allow traders to break up big buys or sells into smaller orders. This ensures that there isn’t any significant price movement over a period of time, as markets can’t tell, for example, that a big money manager is piling into or selling off large quantities of a stock.

• Anonymity

Again, I stress that the anonymous nature of these trades ensures that there is not some wild public reaction to the sale or purchase of a stock. Most big institutions want to ensure that they can buy or sell at the best price possible, and they can make a move on a position over time.

The Downside of Dark Pools

Yes, there is a downside, and it impacts you as a retail investor.

1. All is Quiet

Naturally, you can’t tell who is trading. At TradeSmith, we are always interested in  what billionaires and company insiders are doing with their money. If we don’t know that they are selling the stock, we can’t follow them. When we don’t know why people are buying or selling, we don’t have the information we need to make decisions.

• Valuation Woes

If a dark pool allows a big investor to divest or break a trade into blocks, we can’t see the devaluation of a stock in real time. It can take days or weeks for a stock to move in the way it could have and should have in a matter of minutes.

Dark pools allow an investor to make a move or series of moves without informing the public of their motivations. If you’ve noticed, the advantages are almost the same as the disadvantages. These pools are great for the trader making the trade, but they’re bad for anyone else who trades on sentiment and information.

I know the idea of these dark pools might be new to you. They matter because the SEC is looking to change the rules in the future about how they operate. Such rules could quickly change the way liquidity and trading works. The status quo we operate in now could experience a dramatic shake-up, and if you’re an active investor, you’re going to need to have signals and trailing stops in place.

Imagine that instead of a seller using dark pools to break up trades, they had to make the move out in public. A dramatic sell-off could ensue. And if you’re not following the rules and setting trailing stops… then you could be the person without a chair when the music stops.

I’ll be back next week to talk about some other changes on the table from the SEC. For now, enjoy your weekend.