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

Trading techniques could help undermine the market's stability

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

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.

Why does this matter? Well, because it allows you to make your trades without tipping your hand or moving the market. In a low-volume environment, it is increasingly likely that a block trade could move even a fairly large stock. This is a way for big firms and their best clients to protect themselves and play by a more favorable set of rules.

Another disturbing aspect of dark pools is the anonymity they provide. While some traders are lured by the fact that other investors cannot see the trades executed and prices agreed upon, a small group undoubtedly is drawn in by the idea they their personal identity is just as opaque as the substance of their orders.

To be clear, dark pools eventually report volume back to the major exchanges — they have to, since the transactions get resolved as “over-the-counter” trades. But detailed information about the volumes and types of transactions isn’t there, and the true impact on the public market doesn’t happen until the trades have long been resolved.

What Is ‘Real’ About the Rally?

When you consider these troublesome developments in trading, coupled with the basic admission that investors remain largely scared out of the stock market and volume remains at record lows, it is difficult to imagine the rally will continue much longer.

The seasonal “sell in May” phenomenon might just be an old wives’ tale, and there are plenty of cautionary tales that prove market timing doesn’t work. Had you sold in May 2009, for instance, you would have missed out on one of the strongest rallies in history.

But there are many reasons to fear this summer’s typical low-volume lull. The bottom line is that liquidity remains very weak, and that is unlikely to change anytime soon.

And in a low-volume stock market, it only takes a few bad headlines or a handful of panic sellers to tip the market into a full-fledged bearish move.

I hope that doesn’t come to pass, since the market needs some stability after a choppy 2011 and the alternative of Treasury bonds offers returns that barely keep up with inflation.

But you can’t hope your way into retirement. Protect yourself with stop-losses and keep an eye on market volume as we approach the dog days of summer.

Jeff Reeves is the editor of InvestorPlace.com, and the author of “The Frugal Investor’s Guide to Finding Great Stocks.” Write him at editor@investorplace?.com or follow him on Twitter via @JeffReevesIP.


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

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