What is Dark Pool Trading?

Dive into the deep-end: Discover (and utilize) secret stock market trades from hedge funds and institutions.

Justin Nugent

This article was last updated on 11/23/2022.

KEY POINTS: 

  • A dark pool is an ATS (an alternative trading system) — not a public exchange.
  • As such, dark pools are primarily used by financial institutions and wealthy investors to place confidential trades.
  • Investors use dark pool trading to buy or sell large quantities of a security without impacting the market.
  • Though dark pools can be used to hide potential “conflict of interest” trades, their existence is not illegal. There are currently 64 dark pools registered with the SEC.

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Dark Pool: Origins

Dark pool trading. It sounds nefarious — and in some cases, it can be. But it doesn’t have to be. Dark pools came to be in the 1980s. The justification for the creation of dark pools was that large investors looking to make large trades needed to jump through excess hoops in order to avoid causing potential negative impact to the market — and by extension, to their trades. It isn’t hard to see why: When a sudden, massive purchase takes place, it can kick off a wave of unintended market-moving effects. 

Imagine you were a large investor looking to sell your position in a stock. Is it likely that you’ll find someone who wants to purchase multiple-millions worth of shares on the open market? No. You would likely have to sell the shares piecemeal. 

The larger the blocks you sell, the more selling pressure you create, which in turn drives down the price of the security, and reduces your potential gains. In any case, the sale would likely impact not only you, but the price of the stock itself. Thus, the dark pool exchange was born. 

Do Dark Pool ATS Work for Options?

Massive traders, financial institutions, and hedge funds who want to keep their biggest stock market moves a secret will use dark pool trading systems to hide the source of their trades. And yes, that includes options! According to B2BITS, there are dark pool trading platforms that function in a similar way to other options brokers. Here’s the nitty-gritty about how it works:

“ Dark Pool platform is an alternative trading system (ATS) to trade US equity and index options.

Liquidity on the platform is provided by market markers (liquidity providers) who have a special mass quoting interface to enter orders into the system.

Client orders pass the Dark Pool and have an opportunity to cross with orders from liquidity providers, which reside in the order book. If a client order can be matched fully or partially to orders from liquidity providers, a cross order is sent to the exchange, and in the case of success, a fill is reported back to the client. Otherwise, the client order can either be canceled or propagated to the order router to be routed to exchanges as an ordinary single order (depends on parameters of order).”

Dark pool trading works a lot like Tor — the famous proxy browser used for accessing the deep web. Web browsers can attempt to hide their identity by using Tor — a peer-to-peer relay system where web queries are sent through through a series of nodes. By passing the message from node to node, the identity of the original user becomes harder — but not impossible — to track. Similarly, many dark pool trades are made “over the counter” — often sold directly from the buyer to the seller.

So then, how do they get “tracked”?

How To See Dark Pool Trades

Okay, so you can see dark pool trades, then? 

Yes! It isn’t easy — but for those with the right tools, you can look behind the curtain of Wall Street to see the trades they don’t want you to see.

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First of all — dark pools are not required to publish “pre-trade data.” Pre-trade data mostly means information about the presence of buyers and sellers in a particular position or stock. For instance, if you set up an order in a typical brokerage, you’ll often see something like:

$XYZ » $100.00 » Bid: $99.99 x400 » Ask: $100.01 x25

This is an example of pre-trade data. We know there are 25 sell orders at the ask of $100.01 — there are 400 buy orders at $99.99. Dark pool trading systems don’t have to tell you that information. But they do need to report information about the actual trades that occur. This is because things like insider trading and conflicts of interest are still illegal — and there are rules and regulations in place that attempt to prevent them. But they don’t always work out.

Dark Pool Illegal Activity

Just like Tor, despite the fact that they can be tracked, traders still try to abuse the anonymity of dark pool systems. For instance, in the past Barclays and Credit Suisse have both been charged by the SEC for illegal dark pool operations. 

Because the dark pool system is less transparent, there are a wide variety of predatory tactics at play beneath the surface. For instance, dark pools don’t promise prices at open market levels — because they aren’t on the open market! 

Due to this differential, high-frequency traders are able to use a tactic called pinging in order to uncover the sort of pre-trading data featured above that dark pools seek to keep hidden. In pinging, a high-frequency trader will place a series of small orders (perhaps many 100 lots) in the hopes that they get swallowed up in part of a dark pool purchase. 

Once a dark pool purchase is detected, those high frequency traders swoop in, buying up large swaths of the sought-after stock in hopes of front-running the purchase, and then selling the stock to the dark pool trader — who is now locked in to the purchase — at a higher price.

How to Use Under-the-Radar Stock Trades to Your Advantage

Market Rebellion has made it easy to leverage the activity of under-the-radar stock market activity. It’s simple:

Using our state of the art proprietary algorithm, the Heatseeker®, we track every single trade (yes, every single trade) on the open market hunting for one specific trade type: 

Unusual Options Activity

Source: Market Rebellion’s Unusual Options Activity. This example features a massive purchase, far above the open interest, worth millions of dollars on a stock that most people haven’t heard of.

To find unusual options activity, Heatseeker® filters through all of the option trades hunting for red flags — things like big discrepancies between open interest and the trade volume. Goliath purchases that represent a huge, “must-be-institutional” type of trade. (remember: each contract represents 100 share equivalent. 50,000 option contracts? That’s a 50,000,000 share equivalent!)

Then, our hand-picked expert team of professional options traders and former floor traders pore through the results, filtering the Heatseeker® data down even further, until it’s distilled to a series of trades that make even veteran option traders raise an eyebrow. 

Finally, our licensed Chartered Market Technicians take the baton. Their job is to turn these unusual option activity reports into actionable trades — complete with directions on “where to enter” and “where to exit.” Typically, that involves a close examination of the technicals, the RSI, ATR (average true range), and the options chain itself to find the best points of entry and exit. 

Once it’s determined — it’s game on. Traders can ride the coattails of wealthy institutions who may have information or data that individual traders simply don’t have access to. 

Interested in getting started with Market Rebellion?

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