A passive order, or if the order is transacted a passive fill, happens when you add liquidity to the market. This happens when a trader enters a bid below the offer price, or enters an offer above the bid price. The advantage of entering passive orders is that the trader is not giving up the spread in price. Over time, or with large enough shares, saving the spread can lead to a huge difference in net profits for a trader.
The drawback of entering passive orders is the lower likelihood of having the order actually filled. This is true on both LIT and dark markets. If you use an aggressive order to enter a position, meaning you remove liquidity posted to the order book or in the dark pools, you are guaranteed that your order will transact. If you are putting an order in passively there is no guarantee that even part of your order will be filled.
There is also a high probability in most cases that if the order is actually filled, most likely the price will move and the order could be transacted at a better price anyway in the near future. This is known as the adverse selection of fills. This is also true on both dark and LIT markets. There are ways that a trader can avoid this to some extent, and it is understanding the nature of how different ECN and dark markets fill during different situations.
For instance, a stock may have a very thick ECN book with lots of share size on both the bid and the offer. Sometimes an institution may be buying or selling a large quantity of shares, and may be willing to give up the spread, but does not want to move the share price. An alert trader may be watching the tape print, and the markets that offer traders rebates to remove liquidity may be transacting very quickly on the bid or offer, as the institution seeks to slowly enter or exit their position. At the same time the more expensive markets may not be printing at all, and the trader can be reasonably confident that the price is not about to move in the near future. The trader can enter the position passively and be reasonably assured that they have a good price.
Understanding how different dark pools transact can also be critical to a trader’s ability to have the highest probability of seeking the best priced liquidity. There are dozens of dark pools in which traders can execute orders, and each one fills differently. Some are managed routes, meaning the dark pool maintains their own inventory of shares, and as they balance their share holding quantity their traders or algorithm may be willing to execute a trader passively, even if the LIT markets would not offer the same fill. Other dark pools indicate a large buyer or seller may be moving the share price in the near future, and a passive fill will typically be a strong sign that the price is about to move against the trader.
With large enough size understanding how to be filled passively can be a huge advantage for a trader. Even taking a one penny spread with 10,000 shares is a $100 profit for a trader. For this reason a trader must always watch how different ECN markets and dark pool markets are filling.