We're flattered, but are you sure you want to do this?
Alright, grab a coffee.
Pretend you're a big, boring asset manager for a minute. Now, what if I told you that there's a magical piece of software that gets you better prices in the market?
So, hear me out. Say that if XYZ is trading at 5.00/5.01, you can buy and sell at 5.005 instead. That's 0.1% saved every time you trade. So if you're trying to buy or sell, say, $100,000 worth of shares, you'll get a cool $100 in savings.
If you were the kind of investor who traded in great volume - or somewhat frequently - you'd probably say:
And that's what a lot of brokerage clients said when people agreed to trade at the midpoint of the bid-ask spread in dark pools, away from the public, "lit" stock exchanges.
But wait, it gets better: You know how you're saving 0.1% on that trade? Someone else, by transacting with you at 5.005, can turn around and push those shares onto the bid or ask of the exchange and make another 0.1% for themselves!
So, investors are happy (cheaper trades), brokers are happy (happy customers), and market-makers are happy (free lunch). Nowadays, over a third of stock volume trades in dark pools - and with these advantages, it should be easy to see why.
So, what's the catch?
You might think that this happy dark pool arrangement sounds a bit too perfect. Well, there are small consequences. Chief among them is that it damages the whole price-discovery process.
So now imagine that you're a market-maker in XYZ. Your goal in life is to capture the spread and stay market-neutral.
Well, unfortunately for you, the XYZ company just filed a confusing 8-K and people are selling shares on the exchange, plowing into your resting 5.00 bids. In a few minutes, the price is several cents lower (say, 4.89) and you have +1,000,000 shares of XYZ.
But - lucky you - you're starting to find bids from investors in dark pools at these new low prices (which seem like a bargain). So what do you do? You sell your inventory to them, gradually offloading your 1,000,000 share position. You're now back to 0 shares - but the price is still at 4.89, down 2.2%.
The sustained imbalance.
Does the above scenario seem weird? It should.
In our usual concept of an efficient market, all trades carry tiny bits of information about investor's opinions and what the fair price should be. Ultimately, with all of these little bits of information accounted for, the price should converge at a fair value (or so they say).
But in the example above, the buyer in the dark pool has a unique advantage: He never showed his hand to the market, and so he never let that "information" affect the price.
In a simpler time, that buyer would have had to "take" liquidity from the exchange by buying shares at the asking price. This would push prices up (or at least show up at the ask) and, thus, contribute to our efficient market. In a world with dark liquidity, this information is entirely lost when a trade is made off of the exchange and absorbed (like an amoeba!) by a market-maker.
When this trade format becomes endemic, an imbalance between "is" and "ought" prices can gradually form, and this imbalance (depending on the rate of dispersion of information) can last quite a while.
Betting on imbalances.
Our specialty is in looking for imbalances in individual stocks, but there's no reason we can't aggregate our findings.
And so, using a market-wide algorithm, we compile the Dark Index to gauge pricing disparities in the broader S&P 500 basket of stocks.
The results aren't just interesting, they're usually predictive.
See when the DIX (blue line) gets really high? It usually means that the index is oversold, and that dark pool investors are happy with current prices. Like steering an ocean liner; however, the market doesn't always immediately react to the bullishness expressed by dark liquidity.
The same phenomenon (in reverse) applies to a low DIX, when most dark liquidity is expressing a less sanguine view of the market.
It's that simple.
So why do we make this bold (foolish?) prognostication right now?
We thought it'd be a particularly good time because, frankly, the S&P 500 chart looks awful from a technical standpoint, and the cacophony of "sky-is-falling" punditry feels like it's reached a crescendo.
Meanwhile, the reality of the market suggests that shares are being accumulated. Go figure.
So, will the index go up this week? We don't know, of course, but we're very confident that the odds actually favor it for time-tested and sensible reasons. And what else can a good investor ask for?
SqueezeMetrics thinks that you should stop reading the "news" and starting thinking more seriously about what really drives the market. So join the Dark Side and follow us for more. Name-calling and other disparaging remarks can be found in the comments section below.
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.