Monday, November 12, 2012

Part 1 "Dark Pools"

MetaStock SPRS Series - Week 94 - TechniTrader® Stock Discussion for MetaStock Users - Part 1 "Dark Pools" - November 12, 2012
By: Martha Stokes C.M.T.

Last week we discussed the High Frequency Trading Companies. This week we will examine their counterpart, the “Dark Pools.” These giant share lot orders have always been a part of the market. It used to be that these large lot orders were shown mostly on the market maker limit books, held back from the general exchange activity until price was at their preferred level.

Dark Pools are also called “icebergs” because most of these huge lot orders have moved off of the exchanges. There are about 20 Dark Pool systems that provide the service of order processing for the Dark Pools.

Who are the Dark Pools?

These are the largest of the Mutual Funds and Pension funds. Their typical order size is 100,000 – 500,000 and their intent is to purchase millions of shares of stock over a lengthy period of time. These are not HFTs, or day traders, or intraday professionals. Dark Pools represent the long term institutional investor who uses fundamentals, quantitative analysis, and portfolio management to choose the stocks and the quantity of shares they intend to hold for the long term.

Some purchases are for Charter requirements, others are discretionary to fulfill a specific requirement of the portfolio they are managing. They have hundreds of billions of other people’s money to invest on their behalf.

These giant trades used to be seen on a retail traders day trading platform but not any longer. These huge trades now are done totally off the exchanges.

Why did the Dark Pools move to over the counter transactions? Is it legal? Is it fair for retail traders?

It is legal. The laws of the US only require that every transaction be recorded, documented, with transfer of title, and that this all be sent through the National Clearing House by the end of the trading day. This insures that every transaction where stock is bought or sold is recorded with price, time, and quantity of the trading entities and the close of the transaction. Like all over the counter transactions, not using an exchange has some drawbacks and some benefits.

Nowhere in the law is it required to do a transaction via an exchange. The exchanges only make it easier for buyers and sellers to come together. HFTs of course are not happy about these off the exchange transactions because they want to move price up ahead of the Dark Pools giant orders.

The Dark Pools represent the largest sum of money in the US, pension plans and mutual fund investors. It is imperative that these huge funds are able to buy stock or sell stock at the price level they deem the best for their fund holders. When an HFT drives price upward or downward as a Dark Pool is trying to buy or sell, this hurts pension holders and mutual fund investors because the Dark Pool is forced to buy or sell the stock out of the range the manager determined was an ideal entry.

This is why Dark Pools have become more and more popular with the largest funds investing in the US markets. These funds represent about 8-9% of the total trading and volume in the markets, both on the exchanges and over the counter.

HFTs create far more volume activity but are limited in scope in terms of longer term price movement.

Dark Pools are here to stay. They are not harmful to retail traders, however day and intraday retail traders need to be aware that not all of the volume and activity is now visible to them. So this is the second disadvantage to trying to day trade in the electronic marketplace. HFTs are able to trade on the millisecond, creating advancing prices that can hurt retail sales.

Dark Pools DO NOT move price or volume as the HFTs do.

Dark Pools however DO show up on end of day charts, IF you are using a VOLUME based accumulating/distribution indicator that can expose what side of the trade the giant Dark Pools are on.

The chart below is an example of Dark Pool activity as a stock bottoms and moves sideways in a platform pattern. Eventually HFTS and other professionals will discover the iceberg beneath the exchanges and rush to drive price upward.

Therefore, entering with the Dark Pools is something all retail traders must learn to do. Using price and time indicators is no longer enough. These indicators are not designed to expose Dark Pool activity which does not move price. Since Dark Pools do not move price, alternative hybrid indicators that do expose Dark Pool quiet accumulation must be used.

Chart 1

We will continue this discussion next week.

Trade wisely,

Martha Stokes, C.M.T.
Member of Market Technicians Association
Master Rated Technical Analyst: Decisions Unlimited, Inc.
Instructor and Developer of TechniTrader® Stock Market Courses
MetaStock Partner

©2012 Decisions Unlimited, Inc.

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