When looking at a bid/ask quote during trading, you are looking at Level 1.
To take things a step further, you may sign up for Level 2 quotes, which give you access to the NASDAQ order book, which provides price quotations for each price level and the amount of each order, and which market maker is holding it.
The window above is a Level 2 of the SPY, with bid and ask prices on the left and right, respectively.
You'll see that each size includes the market maker, bid price, order size, and order time.
Retail investors often accept Level 2 trade data as a crystal ball. Unfortunately, this is not the case.
Furthermore, Level 2 is often misinterpreted, resulting in traders acting on incorrect information and significant losses.
This post aims to explain how Level 2 works and how you can utilize it to improve your trading. Before selecting to add Level 2 to a trading strategy, we must first comprehend what it is and what it accomplishes.
What Exactly Is Level 2?
The electronic order book for listed stocks, known as Level 2 (or Level II), is available to traders and investors through subscription-based services. Level 2 displays a sorted list of the best bid and ask prices and orders and order sizes from all market makers and market participants.
What Does Level 2 Entail?
Level 2 gives a stock market depth by allowing us to observe all of the available orders in the market for that stock, which determines the price level. This lists prices on the bid and asks at their most competitive levels and order sizes.
The asking price will display a list of the most competitive sell orders in decreasing value, while the bid price will show the best offer in a list of the most competitive purchase orders in descending buy.
It operates by aggregating all market orders and showing them on a single Level 2 screen, allowing traders and investors to see the market in real-time.
The current bid/ask share price will be shown on the touch - the strip above all of the orders that indicate the number of shares in both the bid and ask.
Level 2 has boosted liquidity in the stock market by making it more transparent for all market participants. However, it used to be prohibitively costly, making it only a viable alternative for buyers and sellers in major markets.
With so many low-cost Level 2 data packages available, you should consider if Level 2 will provide you with a competitive edge in your trade.
Is It Necessary to Utilize Level 2?
Many traders believe that Level 2 access provides them with a crystal ball and the capacity to forecast short-term price fluctuations.
If so, I'd have retired to my Caribbean island, where, after years of looking at Level 2 displays, I now spend my days drinking pink gin and tonics.
Level 2 is required for aggressive traders and intraday traders (day traders). It'd be the equivalent of driving with your eyes closed.
Day trading depends significantly on volatility, intraday price movement, and the market in real-time; therefore, trading without Level 2 market data would be difficult. To make trading judgments, it is required.
In this part, we'll look at the advantages and disadvantages of using Level 2 data.
Advantages
Level 2 depicts the market as it is, and if you want to obtain or work a better entrance into a trade or direct your order to a particular market maker, you will find Level 2 advantageous.
It's also helpful to view the live prints since we can see what's going on.
If the prints are below the bid, for example, we may conclude that a seller is in a hurry to sell or that the market makers aren't making a large online request (or both).
We may deduce that there is plenty of stock available to purchase since the purchasing prints are nothing near the full ask, indicating that the market makers are content to sell the stock.
You may also route your orders to a market maker if you engage with a telephone broker. This is helpful because when dealing with market makers over the phone, they must honor Level 2 quotations.
When negotiating and trading with an online broker, this is not the case.
Disadvantages
Level 2 data, in my view, has no disadvantages other than the possibility of reading too much into it. This, however, is a problem for the trader, not the instrument.
Investors may not find Level 2 helpful since they are more concerned with the stock's fundamentals and long-term buying and selling.
Even investors, however, want to achieve the most excellent price for their purchases and sales.
What is the best way to read Level 2 data?
In the United Kingdom, Level 2 data is provided on the London Stock Exchange trading platforms, and there are two sorts of Level 2 displays for the two trading platforms.
SETTINGS (Stock Exchange Electronic Trading System)
SETSqx (Stock Exchange Electronic Trading System Quotes and Crosses)
The SETS of Level 2
The London Stock Exchange's primary electronic order book, SETS (Stock Exchange Trading System), is used for trading FTSE 100, FTSE 250, and FTSE Small Cap Index components. SETS may also be used to trade other London-listed securities.
SETS is a liquid and electronic order book that allows for a broad range of transactions.
Direct market access and making trades straight into the order book at your selected price are available with SETS stocks. This permits us to act as a market maker by bidding on other people's shares and putting our stock on the market.
SETS' flexibility enables a wide range of buy and sell orders to be made.
Level 2 depicts the market in real-time. We can view a variety of information in this window, including:
The firm name, EPIC code (GRG), and previous closing price are shown at the top of the window.
The strip, often known as the 'touch,' is the yellow line. The highest bid and ask prices (1,637 – 1,641) are shown on the touch.
The numerals "6" and "423" may be seen on the left side of 1,637.
These figures represent the number of bidders at the price of 1,637 and the market depth of bidders at that price.
The touch indicates that there are six bidders in this case, with 423 shares being bid at 1,637p.
On the opposite side of the touch, there is just one selling in a size of 80 shares at 1,641.
You may be asking why there are so many orders below with a lower selling price than the one shown on the screen. These orders are orange, indicating that they were being erased at the screenshot.
On the Level 2 pane, several orders are green, indicating that they were added lately when the print screen was captured.
The whole market depth may be seen underneath the bid and ask sides. It displays the most competitive offers in decreasing order with prices and sizes, and the most competitive requests in higher prices are shown on the right.
This information may be used to determine the market depth and place our own orders on the order book. I demonstrate how to achieve this in my free ebooks, which are accessible below.
One benefit of utilizing Level 2 on SETS is that we can see the current price and utilize the iceberg capability to work a huge order at a specified price.
An iceberg order has been divided into tranches and reloaded using automated software. Icebergs are essential in stock trading because massive charges for buying or selling may affect the price of a company.
Short-sellers may benefit from icebergs because they absorb the offer and continue to be the highest price when each tranche is reloaded (until someone outbids them – remember, the top bidder pays the highest price).
This is not available to all stockbrokers; I use it with IG Index.
Level 2's Trades Column
An additional column on the right-hand side of the Level 2 screen displays a list of red and blueprints. The sales are printed in red, while the buys are printed in blue.
The time is written on the left-hand side of the order, and a list of previous transactions and their market values.
A two-letter code, either AT or OB, may be seen on the right-hand side of the print. These are referred to as "trade codes."
There are several trade codes that we may learn to recognize.
AT stands for "Automatic Trade."
Trades automatically matched on the SETS electronic order book are known as automated trades.
If someone had 10,000 shares on sale at 600p and I acquired them via direct market access, the transaction would print as a buy with an AT trade code in the market.
Even if the deal was also a sale, the stock is printed as a purchase if the offer is hit and as a sell if the bid is beaten.
OB stands for Off-Book Trade.
A deal that hasn't been electronically matched on SETS and is done by market makers on the RSP is known as an off-book trade.
Level 2 of SETSqx
SETSqx (Stock Exchange Trading System with Quotes and Crosses) combines a market maker-driven methodology with a daily electronic auction book.
Because we can only access the order book at particular periods of the day, this system is mainly driven by market makers.
SETSqx also conducts an opening auction, during which market makers registered to trade in the securities are required to submit solid prices to buy and sell the stock from 08:00 to 16:30. With a Level 2 membership, you may see SETSqx live data again.
Liquidity is sometimes lower in shares that solely allow market maker trading and no direct market access other than the auction. This is because all trading is done via market makers, and we must buy and sell at the prices they set.
Example of SETSqx Level 2
Below is a Level 2 screen from a SETSqx stock.
You'll note that there's a lot less information here than elsewhere, and this is because we must trade SETSqx equities via market makers.
Market makers are organizations that take on market risk in order to supply liquidity to us by delivering two-way pricing.
They make the spread on stocks in exchange for that risk. The spread is defined as the difference between the purchase and sell prices. The spread in this situation is 10p since the bid is 270p and the ask is 280p.
Instead of the orders displayed on SETS, we might see codes when we touch the screen. These are the mnemonics for market makers.
We may observe the following on this Level 2 screen:
On other Level 2 screens you may see:
On Level 2 screens, all of these market makers give two-way pricing on the equities they cover.
The Normal Market Size, or NMS, is a term used with the market maker mnemonic (it is now officially called Exchange Market Size or EMS, but everyone still uses NMS).
When dealing with market makers over the phone, they must sell on this scale.
The market makers would be obliged to handle up to 1,500 shares at a price stated on the Level 2 screen if we used our phone broker to purchase or sell Eagle Eye shares.
When dealing with an online execution broker, market makers are not required to trade-in NMS.
This is a significant distinction between dealing on the internet and dealing over the phone.
Market makers are aware that most traders and investors do not do business over the phone, and they may take advantage of this fact.
Markets will position themselves on Level 2 at a price that is lower than what they are providing on the Retail Service Provider (RSP). The RSP is a service that links us with market makers so that we may trade.
Shake The Market Maker Tree
Market makers are there to offer liquidity for market takers, but it's important to remember that they're also there to create a market for themselves. We know they profit from the spread because market-creating is not a philanthropic endeavor.
As a result, market makers might be enticed to encourage individuals to trade to profit from each transaction — purchasing from one person for less and selling to another with a markup.
Marking the stock lower and generating a reduction in the mid-price is one of the finest strategies to entice people to trade. This may frighten individual investors, who incorrectly feel the stock is dropping for a cause and sell their stock to market makers.
The stock will be run back up to its original price after the market makers have had their fill.
A tree shake is a name for this strategy. Market makers also know where many retail traders would set their stops, so they will jiggle the price to activate them.
Understanding Data At the Level2
Level 2 data provide a comprehensive picture of the order book, allowing you to examine market depth underneath the stock's bid and offer price. It also enables us to observe market maker quotes for that particular stock.
As a result, when paired with RSP quotations, Level 2 gives us a better understanding of stock and may help us make more informed purchasing and selling decisions.
Level 2 gives us real-time access to the market. This may help us place wiser orders on the order book since we can put our trades directly on the market in SETS stocks instead of getting a quote from the market makers.
On one side of the Level 2 screen, we become market makers since we are either bidding in the market for stock or giving a price to sell our shares to new purchasers.
Conclusion
We've seen how Level 2 may benefit traders and what benefits it provides.
We must, however, be wary of information overload. Although it might be easy to interpret too much into short-term data, Level 2 can help you obtain better entry and exits.
We can avoid being caught off guard by market maker techniques like tree shakes if we understand the market dynamics between Level 2 and the RSP.
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