Last Updated on 7 April, 2022 by Samuelsson
So many things happen during the trading process: asset prices can fluctuate in either direction, and it can be more when you trade higher volumes. Sometimes these price changes can affect your trade negatively. You may consider using the block trading technique when you trade high volumes. But what is block trading about?
Block trading is a technique for buying and selling a huge amount of financial assets at a price that is agreed upon by the two parties who are involved in the transaction. That is, the buyer negotiates with the seller to buy the asset at a preset price. This form of trading can be executed through a private purchase agreement.
In this article, we will be looking at everything you need to know about block trading. Here are the things we would cover:
- What is block trading?
- Understanding block trade
- How Does block trade work?
- A block trade example
- How block trading can be beneficial to the market
- Negative effects of block trading
- Block trades and market volatility
What is block trading?
Simply put, block trading is the process of trading high volumes of financial assets without the negative impacts of market prices. This form of trading is carried out at a preset price that is arranged by the parties involved in the trade. The price negotiations in block trading can occur directly between the counterparties or via a broker. However, a block trade would not be privately negotiated if it was transacted on a system or facility that functioned like a trading venue or central limit order book.
Furthermore, the parties involved in block trading can use communication technologies to request block quotes from one or more participants directly and to conduct subsequent privately negotiated block trades. As an alternative, the parties can use technologies that are supported by third parties, which allow for the electronic posting of indicative block markets displayed to multiple market participants.
Block trading is relatively common as many brokers offer block trading services to their institutional clients.
Understanding block trade
Block trades usually comprise a large volume of an asset traded at an arranged price between two parties. This arrangement can be done outside the open markets to mitigate the negative impacts of market prices on the traded assets.
Usually, a block trade can involve up to 10,000 shares of stock, for example, not including penny stocks, or $200,000 worth of bonds.
Considering the enormous size of block trades, it is not usually common for individual investors to make use of block trades. So, in most cases, block trades are used by hedge funds and institutional investors, and they normally execute such trades through investment banks and other intermediaries.
Whenever huge trades occur in the open market, it is expected that the open market volume would fluctuate, which could affect the prices of the assets being traded. As a result, block trades are usually conducted through an intermediary, rather than the hedge fund or investment bank purchasing the securities normally, as they would for smaller amounts.
Therefore, to avoid triggering a volatile rise or fall in the prices of a financial instrument, the block trading intermediaries or blockhouses always take caution while carrying out large trades. Blockhouse staff traders have experience managing trades of this size. Staffers provide a blockhouse with special relationships with other traders and other firms that allow the company to trade these large amounts more easily.
When a large institution decides to initiate a block trade, it will reach out to the staff of a blockhouse, trusting they will collectively help obtain the best deal. Once an order is placed, brokers at a blockhouse contact other brokers specializing in the specific type of securities being traded. Expert securities traders fill large orders through several sellers. This often involves iceberg orders that mask the actual volume of stock being moved.
How blockhouse work
Block trades are generally carried out through blockhouses, which are third-party intermediary firms that specialize in facilitating large trades in ways that don’t accidentally trigger fluctuations in security prices. They often have a staff of traders who are well acquainted with the act of managing large trades. It is always best to go through blockhouses when carrying block trading as their staffers have good relationships with other traders and brokerage firms, greasing the wheels of potentially large and unwieldy transactions. While the sizes of trades can vary, it is against the rules of block trading in blockhouses to aggregate multiple separate orders to bring them up to the 10,000 share minimum requirement.
Institutional investors who are looking to engage in block trading will always rely on blockhouse staffers to help them get the deal that is best for them. Block trades involve a large number of trades, and as such, investors prefer to leave them in the care of blockhouses to ensure proper handling of the trades. Interestingly, since the public does not see these trades, they are protected from the large fluctuations going on in the market. However, this does not mean that block trades do not affect the markets.
For instance, a hedge fund holds a large position in Company X and would like to sell it completely. If this were put into the market as a large sell order, the price would sharply drop. This is because the stake was large enough to affect supply and demand, causing a market impact. To avoid this ugly scenario in the market, the fund manager can initiate a block trade with another company through an investment bank. This will benefit both parties since the selling fund gets a more attractive purchase price, while the purchasing company can negotiate a discount on market rates. Unlike large public offerings, which often take months to prepare the necessary documentation, block trades are usually carried out at short notice and closed quickly.
A block trade example
At this point, let us examine a more illustrative example to help us understand the concept of block trading.
Let us assume that a hedge fund wants to sell 100,000 shares of a small-cap company around the current market price of $10. Going by the figures, this is obviously a high volume trade, but the company carrying out the trade is only worth about a few hundred million in total; the implication is that the sale is more likely to push down the price significantly if entered as a single market order. Moreover, the size of the order means it would be executed at progressively worse prices as the market making took place. So the hedge fund would see slippage on the order, and the other market participants might pile on, shorting the stock based on the price action, forcing the stock down further.
There can only be one to mitigate this: contact a reputable blockhouse for trade. When you do, the staffers at the blockhouse will break up the large trade into manageable chunks. That is to say that they might make 50 smaller blocks of 2,000 shares at $10 a share. Each one of the blocks will be initiated with a separate broker, thus keeping market volatility low.
Another way to carry out the above trade is to involve an online trading broker-dealer. In this case, the broker can step in and arrange for a buyer willing to take all 100,000 shares through a purchase agreement arranged outside the open market with another institutional investor due to the large amount of capital involved. However, it is important to note that block trades can be more difficult than other trades and often expose the broker-dealer to more risk. Since the broker-dealer is committing to a price for a large number of securities, any adverse market movement can saddle the broker-dealer with a large loss if the position has not been sold. As such, engaging in block trading can tie up a broker-dealer’s capital.
How block trading can be beneficial to the market
- Efficiency: This is one of the most exciting benefits of block trading. With block trading, smaller underlying investors of the investment manager are able to realize the same price benefits that a large institutional trader would by pooling their assets together. For example, instead of a seller looking to sell $5 million worth of an investment, the seller can use 100 clients with $5,000 each to collectively make the purchase, whereas an individual could not.
- Saves costs: When you purchase a large number of shares in a block trade, you pay for a one-trade execution with a single fee instead of paying a fee per purchase and per client. For example, the 100 clients we mentioned above would have paid individual commissions to the broker-dealer if the trades were carried out individually. But with the bock trading strategy, they only get to pay commission fees once.
- Increased flexibility: One of the exciting benefits of block trading is the enhanced trading flexibility it offers. For instance, if an advisory firm purchases a block of securities early in the day and the price improves, it can add to its earlier position throughout the day. All its clients, combined as one group, will receive the same average price.
- Makes the trading process simpler: Block trading can be invaluable, especially for investment advisor firms with a smaller staff. The ability to allocate one trade to 100 clients instead of executing 100 separate trades is far less cumbersome.
Negative effects of block trading
It is not all rosy with block trading; it comes with a number of negative effects, including the following:
- They do not take place in the public market, which often gives block traders an unfair advantage over retail traders.
- There is a lack of transparency, and many traders have raised eyebrows regarding the way that block trades are handled. These trades that are placed outside of the public question their transparency greatly, giving the possibility of a double standard when it comes to capital markets. Some believe that dark pools are less scrutinized and anonymous. This can lead to potential fraud and illegal trading practices by the associates of the dark pools or private markets.
Block trades and market volatility
If you take a deep look at block trading from the market perspective, you will notice that block trades seemingly promote instability in the market. This is because large movements in a given asset can cause sudden price swings. This is bad enough when it promotes volatility in the market. It is far worse given that the price movement may be unrelated to that security’s value.
Let us imagine a situation where a fund manager is willing to sell one million shares. It’s possible that the fund might simply want to diversify its portfolio and has chosen that stock to sell in favor of another. However, the open market would see 1 million shares go up for sale all at once. That could force the stock’s price down as the market takes this for weakness in the underlying stock.
That would promote volatility in the market and inaccurate pricing in the stock. Also, it could cause the hedge fund to get progressively worse prices for its lots of shares. This last phenomenon is known as “slippage.” If the hedge fund posts 1 million shares for sale, someone might buy the first 10,000 at their initial price. Then the price might fall before the hedge fund can sell its next set of 10,000 shares and fall further before it sells the following set. As the sale goes on, the price only gets lower.
This is why major financial markets have rules specifically addressing the issue.
Putting it all together, a block trade is a transaction involving a large number of securities. Two parties trade a vast number of equities or bonds at an arranged price.
Block trades often occur outside of open markets to decrease volatility and stabilize the price of the security. Generally, block trades require more than 10,000 shares of stock or $200,000 worth of bonds. In truth, block trades are typically far larger than 10,000 shares.