Traders who want to make extremely large purchases or sales may use what are called dark pools to execute their trades. By doing this they seek to avoid having their trades affect market prices. As dark pools have grown as a fraction of total market trading volume, understanding dark pools and their impact on day trading has become increasingly important. When a large portion of market activity takes place out of sight, this makes both fundamental and technical analysis less accurate and riskier for those day trading futures, foreign currencies, or stocks.
What Are Dark Pools?
The majority of folks trading futures, currencies, or stocks trade on exchanges like the CME Group, the electronically distributed Forex marketplace, the Nasdaq or New York Stock Exchange. In each case, trades are transparent and affect prices as they take place. Alternatively, those who trade in dark pools are privately organized trading platforms where trades are only reported after they have fully executed. Large institutional buyers like pension funds or mutual funds claim that by using this approach they save money which is passed on to their clients. This has yet to be proven. Dark pools began in 1980 when the SEC ruled that trading large blocks of shares was legal and accelerated with the advent of electronic trading in 2005. The advent of high frequency trading drove even more large trades into dark pools so that by 2022 the USA had sixty-four dark pools in operation. While trading in a dark pool lets a big trader execute a huge trade without having the market react while they seek buyers, this process also serves to blindside the average day trader who has been using market activity to guide their trading.
How Dark Pools Operate
Dark pools operate via buyer to seller via over-the-counter trades whether they are facilitated by a broker, with the exchange itself acting as an agent, or via independent operators. In each case, because trades are OTC, the presence of large orders to buy or sell do not disrupt prices in the public markets, at least until they may become public knowledge later on. These trading platforms are useful for those placing big trades. In open markets the time it takes to find multiple buyers for large blocks of futures, stocks, or Forex contracts allows the market to see what is going on and adjust its pricing accordingly. Via dark pools the ownership of large quantities of assets moves from buyer to seller without everyday traders having a chance to buy or sell or even have a chance to profit from price fluctuations.
Advantages and Disadvantages of Dark Pools
If you run a huge state pension fund and want to buy or sell a huge block of stock, using a dark pool can be advantageous. Your buy order will take time to fill and will likely drive up the price of the asset you want to accumulate. Likewise, the price of a stock, Forex pair, or future that you wish to sell will probably fall before you can complete all of the necessary transactions. Using a dark pool and trading over the counter helps you avoid these issues. For the average day trader there is no real benefit of trading through a dark pool and a set of very real risks.
A hallmark of stocks traded OTC is that they are commonly less liquid, have much larger bid to ask price spreads, and have much less practical information available then when assets trading on public exchanges. All of this adds up to greater risk for the average trader. Pump and dump schemes are common in OTC markets and threaten to suck an unwary day trader into a seemingly great trade only to be trapped in a losing position as liquidity disappears! In many cases, technical indicators may be virtually worthless for thinly traded OTC assets and “fundamentals” may be misleading or outright lies!
The Impact of Dark Pools on Day Trading Strategies
For the serious day trader the impact of dark pools on day trading strategies is where one needs to focus. As a disciplined day trader you are following the market with two or three technical indicators and are paying attention to the fundamentals that drive prices over the long term. You are paying attention to pertinent news feeds. Then someone in a dark pool makes a trade that should have driven prices up or down dramatically. What you see is not a big market price swing but rather a virtual evaporation of market interest in the asset in question. This tends to depress the asset price. The point is that you can be a disciplined day trader following a rational trading strategy and be blindsided by a hidden trade in a dark pool. Your only immediate protection is to have set your stop-loss and take-profit levels and not to have invested excessively in any single trade. However, these trades happen for reasons that are either related to the needs of long term investors or well-heeled short-term traders. Being aware of where a market is likely to be headed will often help a day trader position themselves so that they benefit from a big trade even when they do not see it play out in real time.
Regulatory Environment and Future of Dark Pools
Dark pools are legal and subject to current regulations. Because the volume of trading via dark pools can approach nearly half of all trading, there can be interest from time to time in restricting their activities due to unwanted effects on public markets. However, the benefits of dark pools for large and politically connected traders are such that reining in dark pools could end up in a political cat fight in Washington with no useful changes that would help the average investor or day trader. As such, dark pools are simply one more aspect of day trading that the savvy trader needs to account for when developing and executing trading strategies and working to limit every-day trading risk.