The current debate about high frequency traders continues. Barclays, the United Kingdom based bank group is being taken to court by the New York state Attorney General. The State of New York alleges that Barclays falsified data about high frequency trader concentrations, used private customer information improperly and routed virtually every trading order through its dark pool first. The bottom line here is that regular traders and investors were pushed to the back of the line. No matter how good their technical analysis was they had to work harder for profits and to avoid losses because their orders who queued up behind high frequency traders. Traders and investors need to beware of dark pools where trades are hidden from the outside world and transparency does not exist.
A dark pool is a trading network which allows traders to buy or sell large orders without transparency. An issue for someone who owns huge amounts of stock is that when they want to sell their sell orders are typically large enough that they drive the market price down. These folks like dark pools because no one else sees their order. However, this fragments the market. Imagine that you are looking for a house and want to know what prices have been selling for in your area. You are told that everything to the North, West and South of you is a dark pool of real estate. You have no idea what prices are being paid for homes and may end up paying way too much or selling your house for way too little. Dark pools fly in the face of the concept of efficient pricing and the efficient market hypothesis of the stock exchange. In our article about low volume trading we talked about the efficient market hypothesis and how this facilities fair pricing.
Running Fast and Being Left Behind
Not knowing what is going on in the trading room next door is one aspect of why you should beware of dark pools. The other reason to beware of dark pools is that those who run dark pools, like Barclays, have the bad habit of running all trades through the dark pool before regular traders see and have an opportunity act on them. This is in addition to the complaints about high speed and high frequency traders that they step in front of regular traders. No matter how hard a regular trader studies, evaluates the market and makes smart trades he or she is always second, or third or fourth in line. For a long term investor who accurately predicts that a stock will grow tenfold in a decade it may not be necessary to beware of dark pools. But for the trader who wants to scalp profits from a volatile market the mere presence of dark pools may result in diminished profits or even losses. Also remember that a trader working in a dark pool can also see the regular markets. This he can place trades on the NASDAQ or NYSE that will be profitable once his huge trade in the dark pool is completed and published. This can be a very profitable form of arbitrage if a trader in a dark pool just sold a huge block of stock in the pool only to pick it up again in the regular market after the price plummets. In trading volatile stocks this can be especially profitable.
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