We are proud to welcome our first full-time contributor, Gilbert “GMan” Mendez. GMan is the Head Trader at world-class proprietary trading firm SMB Capital. Reading the Tape is a trading skill too many developing traders lack. This skill helps professional intraday traders gain an edge over their competition. So, at Wall St. Cheat Sheet we want to give you an inside look at how a proprietary trading desk uses this skill to improve their trading. GMan will be our guide. GMan’s column, “Reading the Tape,” will be featured at Wall St. Cheat Sheet every other Friday.
In addition to High Frequency Trading, Dark Pools are another issue du jour in the trading world. I caught up with Gilbert “G-man” Mendez to ask him how Dark Pools affect traders and what steps we can take to adjust to them.
Damien Hoffman: First, G-man, can you explain what are Dark Pools?
G-man: Dark Pools are sources of liquidity available to institutional and some, but not many, big day traders. It is a way for big orders to be traded amongst institutions as an alternative to filling a big order — think 30,000+ shares — in the open market.
Damien: Most people assume Dark Pool orders are kept off the order books. Is this accurate?
G-man: It is not that they are kept off the order books all together. These orders are just kept in a special order book available to only those who have deep pockets and need to trade large [share] blocks. I like calling Dark Pools the big money ECN [Electronic Communications Network].
Damien: How does this maintain a fair and transparent auction?
G-man: Just as any other ECN per se, it maintains a fair and transparent auction to those who have access to it. For the rest of us it is just a small inconvenience. Dark Pools just suck up some of the liquidity available to us active traders — that’s why they are inconvenient, not because I can’t tell where the big liquidity resides.
I won’t deny it, a very small part of my game is to get in front of these orders to make the “spread” — literally making a few cents on the trade. But since it is such a small part of my gains — less than 5% — then I don’t lose any sleep because I can’t see those orders. To me the big money is made identifying strong or weak stocks and going for the big move. When I can sense a large order coming into the market from reading the tape, I am going to get long whether the volume is coming in from easily accessible ECNs, Dark Pools, or both.
Damien: Can you further elaborate how individual traders should deal with Dark Pools?
G-man: I am a trader. My job is to find patterns from which to profit. I have developed superior trading skills over the years. Programs, Dark Pools, piker algorithmic programs, etc. just require some trading adjustments. I will still find a way to make money. I am glad that some of the above will be eliminated, but if they kept it all I would still be a consistently profitable trader.
Traders should embrace Dark Pools and find a way to trade with them. The reality is they are not going anywhere. As a trader I could endlessly argue about the field not being level. But I don’t take money from the markets by complaining or enumerating all of its disadvantages. I take money from the markets by adapting to it and finding patterns from which to profit.
When it comes to Dark Pools I just use the large volume traded on these liquidity pools as an indicator or hint that some big institutional fellas are pushing around size. These prices where the transactions take place tend to become quite important.
Damien: Can you give an example?
G-man: Let me tell you about this scenario I have seen happening a lot. I like to call it “The Trapped Program”. It happens often in stocks that are very in-play, meaning huge volatility, nice volume, tight spreads, and big traders pushing around size.
Let’s suppose I am trading the stock as it approaches support at $11 and it looks awful on all time frames in the charts. As the stock gets to support I spot a $11.03 ARCA [an all-electronic trading platform] offer holding — a repeating seller at the same price — for a little bit of size. This indicates weakness. Now imagine a large bid at $11 is hit aggressively. The bid drops and now ARCA steps down to sell at $11, thus making the stock look very weak. A couple of minutes go by and suddenly a large white print for 100,000 shares goes off at $10.99. Not shockingly, there are no more ARCA orders at $11 or $11.03. The stock explodes to the upside. This $11 support now becomes significant and a great entry point for a long position the next time the stock comes down [to this level].
So, in plain English, the stock comes down to places where there is buying interest. An aggressive seller thinks the stock ought to trade lower so he comes down to sell very close to support. He gets others to believe the same, and they wipe out a large buyer at support. Convinced that the stock could now start going down, the seller steps lower and sells a lot at the previous support price. Then out of nowhere — meaning, a Dark Pool — another institutional player puts out a print for huge size right below the support. The ARCA seller realizes that there is still buying interest right around that $11 level so he lifts. And the stock goes up very fast from that support level.
Clearly, as a trader it would be nice to see the big offer appear on the book so we could add to a short position. But as a tape reader I have learned to consider all the different possibilities on how the stock may trade based on what you see on the Level II. A sizeable print right below where we see an active seller makes me uncomfortable about my short. It makes me think the seller is holding up the stock while he gets his print on the Dark Pool.
Damien: G-man, thanks for this introductory lesson about Dark Pools! We are excited to have you contributing to our site and to continue making Wall St. Cheat Sheet a valuable place for traders and investors.
G-man: Thanks for the opportunity. The team at SMB is excited too!
We are proud to have hand-selected SMB Capital as a partner to offer our audience products and services to become better traders. If you are interested in learning more about SMB Capital’s world-class trader training or trader tools, please click here.