Ep 16: What Are Dark Pools, PFOF and Market Makers?

Have you heard about payment for order flow, dark pools, and market makers, but didn't understand what any of it actually is or what it means? We're going to explain it all to you today!

We've delved into the stock market's inner workings, uncovering how prices are set, the role of market players like market makers, and the concept of dark pools. It's like a financial puzzle where supply, demand, and rules come together to keep things fair and efficient. Think of it as a dynamic dance, adapting to changes in technology and market trends while ensuring fairness in the financial world.

Episode Equity

Before understanding payment for order flow, dark pools and the function of market makers, you need to understand how a stock is quoted -- or in other words, how a stock is priced.

Reading a stock quote and understanding stock price

When you land on your brokerage firm's website and type in that stock symbol, you're immediately bombarded with a wealth of data. It's all vital information for determining the fair price of a stock and figuring out what you can buy or sell it for at this very moment. What can I buy and sell the stock at right now? How are stocks priced? Let's break it down, step by step.

Your initial term and complex phrase: NBBO - National Best Bid and OfferThe National Best Bid and Offer is simply the best price for buying and selling a stock. It's determined by looking at the highest price someone is willing to pay (the bid) and the lowest price someone is asking for (the offer). I know this might sound confusing, so let's simplify it.

Historical AAPL Stock Quote

Last price: This is the most recent price at which a stock was traded, reflecting what happened in the past. The "change" tells us how much the stock's price has gone up or down compared to the closing price from the previous trading day. Usually, these price updates occur during regular market hours, which are from 9:30 am to 4:00 pm Eastern Time (ET).

For instance, let's take Apple stock as an example. If it last traded at $176.58 per share, and this price is $2.14 lower than the closing price from the previous day, it means Apple's stock price went down.

The bid and ask are forward looking

Ask price: If you're an everyday investor like most people reading this, you buy at the Ask price. This is the best price at which you can purchase a stock, and it represents the lowest price at which someone is willing to sell you that stock. The "size" tells you how many shares are available for purchase at that specific price, and these are typically listed in round lots, which means groups of 100 shares each.

In our example, the quote says there are 1100 shares available to buy at $176.59 per share, it means that's the lowest price someone is willing to sell their shares for at that moment. The lowest ask is displayed.

Bid price: If you thought this is the price we use to sell, you're absolutely right! For everyday investors like us, we sell our stocks at the Bid price. The Bid price is the best price available for us to sell our stocks, and it represents the highest price at which someone is willing to buy those stocks from us.

For instance, in this AAPL quote example, you see there are 500 shares available for purchase at a price of $176.58 per share, that's the highest price someone is willing to pay to buy those shares at that moment. The highest bid price is displayed.

Together, the Bid and Ask prices make up the National Best Bid and Offer (NBBO), also known as the top quote.

When the stock market is open, these prices are in constant flux. In this specific example, we're observing Apple Stock, which is a highly traded stock. To give you an idea of its popularity, it was traded a whopping 46.8 million times today - that's what we call "volume."

Now, notice how the price at which you can buy (the ask) is higher than the price at which you can sell (the bid). The difference between these two numbers is called the "spread." In the case of AAPL, the spread is very narrow, with just a $0.01 difference.

Generally, stocks with high trading activity or volume tend to have a tight spread, meaning the difference between the bid and ask prices is very small, as seen here with AAPL. On the other hand, if a stock doesn't see much trading activity or has low volume, the spread tends to be wider, with a more significant difference between the bid and ask prices.

What are level 2 quotes? 

You can actually delve even deeper into understanding stock prices by using something called "Level II quotes." These are typically available on your brokerage firm's active trader platform. With Level II quotes, you can get a clear view of what's happening behind the top quote.

Here's how to interpret it: In Level II quotes, you'll notice that the ask price is made up of the lowest sell prices available, which is the best price for you to buy the stock at. Conversely, the bid price is composed of the highest purchase prices available, which is the best price for you to sell the stock at.

To help you understand the data more easily, similar colors in the quotes indicate the same price, and the brighter the color, the higher it ranks in the quote. Additionally, the red and green bars show the size associated with the stock price. This visual representation allows you to see at a glance the larger orders or the number of orders at the same price, as well as which order has the most shares available. It's a useful tool for traders who want a more detailed view of market activity.

Real Historical AAPL Level II Quote

Understanding how stock prices move throughout the day is quite simple. It all boils down to the fundamental principles of supply and demand in the market.

Imagine a scenario where a particular stock is in high demand, similar to when a popular product like the Charlotte Tilbury contour wand goes viral on TikTok, and everyone wants it. You might remember times when you couldn't find it in stores, but you could buy it on eBay or another secondary market at a greatly inflated price. Well, the stock market functions somewhat like this secondary market – it's where trading happens secondhand.

Now, let's consider an extreme example where we freeze a stock quote in time. If there's an overwhelming number of buyers for that stock, their buy orders will keep pushing the ask price higher and higher. This surge in demand, with more buyers than sellers, causes the stock's price to rise.

Conversely, when there are more sellers than buyers, it results in an excess of supply, which pushes the stock's price down. This concept can be easily grasped by looking at a Level II quote. In essence, stock prices are determined by the forces of supply and demand. When demand exceeds supply, prices go up, and when supply outweighs demand, prices go down.

What do Market Makers do? 

As retail investors, we typically buy at the ask price and sell at the bid price. Market makers, on the other hand, do the opposite: they buy at the bid price and sell at the ask price. This difference between the bid and ask prices, in this case, $0.01, is what market makers capture as profit.

What's interesting is that market makers aren't concerned about whether the stock price goes up or down. They have what's known as a "delta neutral portfolio," meaning their portfolio doesn't benefit from price rallies or declines. Instead, their main goal is to attract orders. They openly display prices and are willing to take the other side of the trade, essentially creating a market for the stock.

Think of a market as a place where both buyers and sellers come together. When you want to buy or sell a stock, the market maker steps in to take the other side of the trade at the displayed price, ensuring liquidity and facilitating trading.

It's important to note that there are many market makers in the market, not just a few. They compete with each other to execute your orders, creating an auction-like process where you can get the best possible execution for your trades

What is payment for order flow (PFOF)? 

Guess who receives a lot of orders? Your brokerage firm! They have a multitude of orders from customers like you. Now, "payment for order flow" is a pre-arranged agreement. Market makers make these offers to attract orders from brokerage firms.

In simpler terms, payment for order flow is like a pre-set deal between the brokerage firm and a market maker. It specifies that the brokerage firm will route its orders to that particular market maker. Typically, this involves multiple market makers. Essentially, it's a way for market makers to get access to a steady stream of orders from the brokerage firms, and in return, they may provide some compensation to the brokerage for sending those orders their way.

Is payment for order flow good or bad?

Let's unpack the concerns surrounding payment for order flow.

Some worry that brokerage firms might prioritize selling orders to the highest bidder rather than focusing on the best execution quality for their customers. However, it's crucial to recognize that the financial industry is heavily regulated, even more so than healthcare, with rules governing almost every aspect of its operations. For instance, you can explore FINRA rule 5310, which covers best execution and interpositioning.

In a nutshell, this rule requires brokerage firms to consistently review and ensure that they direct order flow to markets offering the most favorable terms for their customers' orders. In other words, it mandates that your execution quality is a top priority, and it's enforceable under FINRA rules.

Payment for order flow plays a significant role in allowing commissions to be reduced to zero. If payment for order flow were eliminated, it's possible that trade commissions could make a comeback. This would create barriers, particularly for retail traders, especially those with limited investment capital. Imagine the potential impact on commissions for fractional shares – would they rise above the $4.99 mark? Such increased costs could be burdensome for retail traders and make it harder for newcomers to enter the market and start building their wealth.

How do dark pools work? 

As we've discussed, the bid and ask prices reflect the best available prices for buying and selling stocks. When a large buy order enters the market, it can push up the lowest sell price (the ask), causing the stock's price to rise rapidly. Institutions often engage in large trades, especially in the creation and redemption of ETFs and mutual funds, which involves significant buying and selling of assets. These substantial transactions have the potential to influence and manipulate the broader market.

To prevent such market manipulation, these large orders are taken out of the regular price discovery process and conducted in a more discreet manner. This is where dark pools come into play. Dark pools are designed to safeguard against market manipulation by keeping these large orders "in the dark."

The primary intention behind dark pools is to maintain market integrity and prevent large orders from significantly impacting stock prices. However, dark pools have faced criticism for potentially reducing transparency in the market. Critics argue that this lack of transparency can provide certain market participants with unfair advantages and, in extreme cases, enable market manipulation.

Nevertheless, it's worth noting that there is a substantial amount of regulation in place to prevent abuse in dark pools. Regulators continually work to enhance transparency while maintaining an anonymous trading system, striking a delicate balance between protecting against manipulation and ensuring fairness in the market. It's an ongoing effort to address these complexities.

Understanding the stock market's mechanics, from bid-ask prices and market makers to the role of dark pools, reveals the intricate dance of supply, demand, and regulation that shapes financial markets. While market dynamics can be complex, they ultimately aim to maintain fairness and efficiency, even as they evolve in response to changing technology and market forces.

Jessie's Questions

  • Q: What is the NBBO in stock trading?
  • A: NBBO stands for "National Best Bid and Offer." It represents the best available prices at which you can buy (the bid) and sell (the ask) a stock. The bid is the highest price someone is willing to pay, and the ask is the lowest price someone is willing to sell at.
  • Q: What is the spread in stock trading?
  • A: The spread is the difference between the bid (buying price) and ask (selling price) for a stock. It is typically a few cents wide, but it can vary depending on the stock's trading volume. The higher the volume the tighter the spread generally.
  • Q: What is a market maker?
  • A market maker is a participant in the stock market who helps maintain liquidity by providing buy and sell quotes for a particular stock. They facilitate trades by matching buyers and sellers and make money by profiting from the spread. They buy on the bid and sell on the ask. Which means they want orders and is the reason why stocks with less volume have wider spreads.
  • Q: What is payment for order flow (PFOF) in stock trading?
  • A: Payment for order flow is a practice where brokerage firms receive compensation from market makers or wholesalers for directing customer orders to them. Market makers pay for the opportunity to execute these orders and make money from the spread.
  • Q: What are dark pools and what are they intended for?
  • A: Dark pools are private, off-exchange trading platforms where large institutional investors can execute large orders without affecting the stock's price in the open market. They are designed to provide confidentiality and prevent market manipulation.
  • Q: How are orders routed in stock trading?
  • A: Orders can be routed to various destinations, including internal inventories, dark pools, market makers, and stock exchanges. The routing process depends on the brokerage's algorithms and the specific order details. Your order is required to be executed at the NBBO or better.
  • Q: How can I check the transparency of my brokerage's order routing practices?
  • A: You can usually find information about your brokerage's order routing practices, payment for order flow, and execution quality on their website or by contacting their customer support. They are required to provide this information to investors.

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Episode Transcript

Jessie: A listener slash friend of mine sent me that John Stewart episode on the problem with stocks and he was talking about payment for order flow and dark pools and I realized I don't know what any of those things are or how they work. And I think you told me that part of your job in the past was educating clients on those sort of things, right?

Jess: You know how we talked about zero commissions back on episode one? technological progressions in like cost cutting to be able to have operating efficiencies really within the market and the way that works. So we need to talk about what happens to your order, what a market maker is, what a wholesaler is and how dark pools work. Let's talk about that. That'd be fun. Jessie: Greetings, money mermaids, merthems, and mermen. You are listening to Market MakeHer, the self-directed investor education podcast breaking down complex stock market topics from ‘her’ perspective. We're your host. I'm Jessica Inskip, the resident finance expert with 15 years of industry experience here to explain all of those complex topics.

Jessie: And I'm Jessie DeNuit, your siren guide on this financial empowerment adventure. asking all the questions you were thinking, so you don't have to.

Jess: Yes, and if you didn't notice, it's October special Halloween themed fancy dress episode. Jessie: Were we dressing up today? I didn't even think about that. Sorry, I'm just kidding.

Jess: We are also so thrilled and wanna thank every single one of our listeners, our community and for your support. We won gold for the Signal Awards.

Jessie: Yes. And we were the only finance podcast to do that, right?

Jess: Yeah, we were. And actually everybody in the best emerging podcast category got gold, so we're all winners. But I went through everyone that I saw in finance and no one got a gold award. So yeah, yay us.