Research’s results on the robustness of information efficiency and liquidity regimes regarding opacity have important regulatory implications for debates on dark trading. Furthermore, opacity appears to increase the profits of informed traders, but only when their private information is of high quality and rapidity.
What is Hidden Liquidity?
Hidden liquidity refers to buy or sell orders that are not immediately visible in the order book, a type of order entry made on crossing networks (dark pools). These can include iceberg orders, where only a portion of the total order is visible, or orders placed on alternative platforms that are not visible in the order book. Although it is difficult to quantify the amount of orders placed in this way, estimates in the U.S. market suggest that about 25% of daily trading volumes are conducted this way. Hidden liquidity can significantly influence trading strategies. …
High-frequency trading (HFT) algorithms are designed to execute thousands of trades per second, exploiting small price variations. Hidden liquidity represents a significant opportunity for these algorithms. Here’s how they operate:
1. Arbitrage: HFT algorithms seek arbitrage opportunities, exploiting price differences across various markets. Hidden liquidity can provide them access to more favorable prices, allowing them to realize quick profits.
2. Market Making: Many HFT algorithms act as market makers, providing liquidity to the market. The presence of hidden liquidity allows them to manage risk more effectively, as they can hedge their positions without having to fully reveal their intentions. 3. Order Entry Strategies: Algorithms can utilize advanced techniques to “hide” large orders, breaking them down into smaller orders to avoid influencing the price.
3. Order Entry Strategies: Algorithms can use advanced techniques to ‘hide’ large orders by breaking them down into smaller orders to avoid influencing the price. This approach allows them to enter and exit the market more efficiently.
In intraday trading, where positions are opened and closed on the same day, hidden liquidity becomes a strategic element. The activity, carried out through limit orders in the book, has intensified over the last five years, presumably due to the increase in hidden liquidity, altering market behavior. The opposition between aggressive and passive activities in the book carried out by high-frequency algorithms, always in search of liquidity, produces volumetric inefficiencies often within the market noise, before it takes a directional trend. Understanding these dynamics can help traders in applying their tactics or operational strategies.
How hidden liquidity from HFT systems is used:
1. Reduced Slippage: For intraday traders, accessing hidden liquidity can reduce slippage, which is the difference between the expected price of a trade and the actual executed price. This is particularly important when large quantities of volume are being submitted.
2. Fast Execution: Hidden liquidity allows intraday traders to execute orders quickly without having to wait for larger orders to be filled, thereby ensuring a more efficient execution of strategies.
3. Volume-Based Strategies: Intraday traders can develop strategies based on the analysis of hidden liquidity, looking for signals that indicate the presence of significant hidden orders to anticipate market movements.
Hidden liquidity will continue to increase if more restrictive regulations do not arrive; consequently, so will the strategies of HFT algorithms, as they operate through tactics that self-adapt based on the presence or absence of liquidity, therefore the implementation of exploratory and passive trading to execute orders will also continue to evolve. Understanding how it works and how it can be exploited is crucial for traders who wish to optimize their performance in the market. A deep knowledge of Order Flow can provide traders with the sensitivity needed to map these changing behaviors. In an increasingly competitive and technologically advanced environment, the ability to navigate hidden liquidity can make the difference between success and failure in trading.