Dark Pool Trading

As retail investors and traders, we are largely accustomed to participating in the major exchanges like the NYSE or NASDAQ. However, about 20% to 40% of the transactions happen outside these major exchanges in platforms called Dark Pools. These are privately regulated exchanges that are not available to a retail investor. In existence there must be hundreds if not thousands of these “Dark Pools”, some popular examples are Goldman Sach’s Sigma X, Citibank’s Citi Match, and Morgan Stanley’s MS Pool. 

When big institutions buy or sell an asset, they do it in large block orders. These orders can be anywhere from five to a couple hundred Million Dollars. If you went out on the normal trading floor with a $125MM order to buy Snapchat for example, that’s 6.25MM shares at $20!!! It would be really difficult to get this order filled, either you’d drive the average price down substantially, it will probably take many days or even weeks to fill, and cause crazy speculation, to name a few. 

In order to avoid these complications, “Dark Pools” were invented. They allow for big blocks of shares to be traded without affecting the retail price on major exchanges. One key element that Dark Pools share between them, is the lack of transparency; they do not have a visible ledger like in the regular exchanges (where you press level II and see the order book). Only after the transaction has been filled, can the investors see the details. Important to mention that they will be very closely correlated or the same as the retail price.

While the vast majority of traders are unaware of the existence of these dark pools; there are a handful of them that use this data as one of the pillars to their trading and investment strategies. At the very least, for most of us, it is a very good place for idea generation. The thesis is that if you can understand how the big hedge funds are behaving, then you can position yourself accordingly in order to profit. (Please make sure to do full due diligence before making a trade), so as the same with options, we not only look at Dark Pool Activity, its Unusual Dark Pool Activity!

When we find a big transaction in the Dark Pool scanners, we need to build a picture of the sentiment of the transaction, meaning if it was bullish with high conviction from the buyer, or bearish with high conviction from the seller. Normally in an options flow we would use the bid and ask, but dark pool scanners don’t show this information (at least that I’m aware, please let me know in the comments if it’s different).

In order to build the complete picture of the sentiment we need to couple this data with existing news, options flow, technical indicators and overall market trends. This will allow us to determine if the institutions are bullish or bearish, and therefore give us the context to place our trades.

Lets use a real life example (Aug 7, 2020)

Two block orders for $28MM and $6.4MM came through for SNAP at around 3pm. I started to look at the options flow for the day and found that the general sentiment of the options bought at the ask or above were CALLS with the orders ranging from $10k to $50k in different strike prices and expiration dates. I interpreted this as general bullish sentiment in the options flow, and therefore assigned a bullish sentiment to the Dark Pool transaction in my analysis. Next, I looked at the news, what I found was Snapchat adding new features to make itself more a competition to TikTok, and Trump’s war on Chinese apps, I took it than anything could happen. Finally, I looked at the chart (this is my favorite part) what I find is an overall bullish trend with a two week pullback which seems to have found a support (this is my interpretation), had a small gap down, rejection of lower prices, and now sideways consolidation for 3-4 days.

My conclusion of all this… Options are cheap cause IV is low (trading sideways), bullish sentiment in the options flow, bullish sentiment with the hedge funds, lots of news and movement, I am betting that the stock will move higher. Therefore, as a short-term trade I have bought the AUG 21 $22.5 CALLS @ $0.65. I’ll be looking for a 50% to 100% on this. As long as it closes above $20 the play is valid. Lets’ go!

Thoughts of a Psycho Trader…

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