You Really Need To Care About Dark Pools

by: SqueezeMetrics

Summary

Every investor should know a little bit about dark pools.

Dark pool volume makes up about 30% of U.S. equities volume, and much of that is short sales.

Consider this your executive summary.

Dark pools are private stock exchanges.

That means you're not allowed to access them or see what's going on inside. They're dark, as opposed to the "lit" exchanges, like the Nasdaq and NYSE.

Dark pool customers are generally well-capitalized investors and funds. They pay to trade in the dark, where other people can't watch them, trade with them, or intervene.

A lot of dark pool volume is large blocks of shares being swapped anonymously between funds.

Dark pools don't move prices.

For dark pool customers, a dark pool transaction "mitigates market impact." That means that they can avoid bad fills and "slippage" (filling an order at $5.00, $5.01, $5.02, etc.) by trading solely with other large-block holders and turning many small transactions into one large transaction.

Often, for large funds, this ends up cheaper than trading on the exchange.

Unfortunately for the rest of us, this means that the price we see on the exchange isn't quite what it used to be. Without larger investors proportionally moving the price on the exchange by buying or selling, the process of "price discovery" (the purpose of a national market system) doesn't really work the same way.

Your concept of the market is outdated.

Buying pressure, selling pressure, fund movements, liquidity, momentum - everything that you thought you knew about the way price and volume are related becomes less relevant as now 30% of volume is traded away from the exchange.

"But what does this mean for me?"

Well, here's an example: A little over a year ago, Kinder Morgan (NYSE:KMI) decided to consume itself, like some sort of protozoan. On Seeking Alpha, this was overwhelmingly well-received, and, for a while, it looked like the market agreed.

It's illuminating to see what happened in the dark pools.

The big shorts.

On August 11th, 2014, if you wanted to say "I don't like the idea of a merged Kinder complex," (for any reasons ranging from dilution of your KMP holdings to plain disbelief) you would have shorted KMI.

Usually, when you look at a stock chart, it's difficult to derive any great meaning from a single day's price and volume - but what if you knew that nearly 38M shares ($1.49B) were sold short in dark pools that day? And what if you saw that on a chart?

Click to enlargeSource: sqzme.co. Red volume is dark pool short sales.

When $1.49B talks, we tend to listen, especially when dark pool short sales represent the boldest, most well-informed contrarian bets in the market. Would you reconsider your opinion in a stock if you saw that reaction in the dark pools?

Ok, enough about KMI.

But wait, it gets worse.

The greater the percentage of a stock that's traded in dark pools, the harder it becomes to figure who's doing what and why. Also, the easier it becomes for dark pool short sellers to take advantage of the way dark pools work.

You'd think it'd be hard to sell short 27% of a day's volume (see above), right? But apparently it's possible. What about 82%?

Click to enlarge

Yes, that happened in Stage Stores (NYSE:SSI) on August 4th, a few days before earnings. Over 1.8M shares sold short in a single day, and it didn't budge the price - not even a bit.

So yes, this definitely happens.

And to help you get over the denial phase more quickly, we leave you with a table of a few well-known stocks and the percentage of their shares that are traded in dark pools:

Apple Inc. (NASDAQ:AAPL) 38%
Netflix Inc. (NASDAQ:NFLX) 47%
Facebook Inc. (NASDAQ:FB) 41%
SunEdison Inc. (SUNE) 49%
Kinder Morgan Inc. (KMI) 39%
Click to enlarge

Yikes.

Data is compiled from multiple sources, including FINRA's TRFs. Our numbers are only accurate if their numbers are accurate — and golly, we hope they are.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.