‘Dark Pools,’ Low Liquidity Cast Shadow on the Rally

Trading techniques could help undermine the market's stability

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There is a fair amount of focus on volume lately, as a sign that either the recent rally will last or that it will fade.

Volume is a measure of market liquidity at its core, representing the number of shares being bought and sold each day, but it also is a measure of confidence. The more transactions taking place, the more players there are in the game — meaning the more traders there are willing to stick their neck out in some way or another.

The current situation? Unfortunately, trading volume is at historic lows this year.

Even worse: The liquidity we have is in many ways fabricated.

Here’s why the low-market volume is a sign of trouble for the stock market, and could throw the recent rally into question:

High-Frequency Trading

Consider the impact of high-frequency trading, where shares are bought and sold within a window of just a few seconds. These fast-paced trades artificially inflate volume. In fact, Bank of America (NYSE:BAC) stock — the equity du jour for high-frequency traders — represents 5% to 10% of total NYSE volume in a given day, regularly turning over upward of 300 million shares of BAC stock in a single session.

Equally damning is that as much as 98% of “trades” are cancelled by HFT investors. These computers that engage in high-frequency trading are simply cruising along based on a set model, and the amount of orders that go unfilled shows just how synthetic the volume must be for the orders that actually go through each day.

If market volume is at a record low even with machines making a huge number of trades under HFT algorithms, then just imagine how weak trading liquidity is among “real” market participants.

‘Dark Pools’ of Stocks

If you think these points on HFT tactics are bad for the market, even more disturbing are “dark pools” of stocks that are very much in fashion right now.

Dark pools of stocks aren’t open for public trading but instead are reserved for a select group of investors. They typically represent big trades by big financial institutions — a way to get in and out of large positions without “moving the market.” But they increasingly are being used by traders who want differentiated trading from the typical Wall Street environment.

Information on dark stock pools is hard to come by — especially for little fish like me who don’t get to play by these preferential rules. However, reports indicate that dark pools are generally very similar to standard markets with similar order types and pricing rules. The advantage, however, is that liquidity is deliberately opaque. This way you won’t know what your neighbor is buying or selling, or how much.


Article printed from InvestorPlace Media, http://investorplace.com/2012/03/dark-pools-low-liquidity-cast-shadow-on-the-rally/.

©2014 InvestorPlace Media, LLC

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