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Level II

This article is an abstract of the book:
The Complete Guide to Daytrading

Market Depth
The market maker box, also called Level II, gives you a picture of the market depth in a stock. All market makers and ECNs are listed, together with price and size information. On the left side of the screen you can see all the market participants willing to buy (Bid), and on the right side you can see those who want to sell (Ask). Share size is usually displayed in hundreds, so if you see "NITE 61 1/8 10" on the left side of the screen, it means that the market maker with the identifier NITE wants to buy 1,000 shares of the stock at 61 1/8. INCA 61 3/16 75 on the right side (Ask) means that the ECN INCA wants to sell 7,500 shares of the stock.


click here to enlarge

The top level represents the best Bid and the best Ask, the so-called "inside market." The difference between the Bid and the Ask is called the spread. One level lower is the second best Bid/Ask and so on. If there are few market makers and ECNs, the market depth is low. This puts traders at a higher risk because there are fewer buyers and sellers, besides which the spread may also be larger. Stocks with low depth tend to drop faster than those with greater depth. You can see the market depth only with a Level II window.

Level II changes dynamically and in real-time. If a market maker joins the Bid or Ask, the Level II shows this immediately. You can see the share size that a market maker or an ECN is willing to buy or sell, too, although it doesn't mean that these are all the shares that are available. It may indicate only a small part of a much larger order.

True Size
Only ECNs show "true" share sizes. If an ECN shows that there are 1,000 shares for sale, then there are exactly 1,000 shares available. A market maker, however, is not obliged to post the full share size he wants to trade, so you can never tell how much a market maker has to buy or sell. INCA is an ECN but it doesn't show true size either.

No hierarchy
If you join the Bid or Ask and you are the first one in on Level II at a certain price, or if you see your order at the top of the Level II window ahead of other market participants, it doesn't mean that you are going to be the first one to get a fill (unless you are using SOES which queues incoming orders). You only get a fill if someone prefers you and takes your order out.
There may even be fills at a worse price than yours while your order remains unfilled. This is because traders are not obliged to execute their trades against the prices shown in the inside market. For instance, you can buy a point above the best Ask price if you want to, providing somebody is selling at that price and is willing to execute the order, or you can enter a buy order point below the best and wait for somebody to hit you. These types of trades are perfectly legal.

No trade information
You can't see the pace of trades or those which have been executed in Level II because it only shows the price at which the market participants want to buy and sell. It doesn't show the price at which trades are actually executed. You can see this only in the Time & Sales window. You could surmise that trades have been executed when the share size decreases, however this is not a true indication because traders may have canceled orders or market makers may have automatically refreshed their quotes. The Level II screen might not change at all while thousands of shares are being traded. On the other hand, Level II can change dramatically even though no single trade has been executed.

Everybody gets the same information
Everybody with a Level II window gets the same information. Although Market makers use Level III, this doesn't mean that they have access to more information on the market. Level III is merely Level II with enhanced order execution functions.

Most traders overestimate the importance of Level II. It is often very misleading, especially for short term trading. Certainly, Level II provides some valuable information but you must also know whether the information is accurate for your trade or not. Level II is only useful under certain conditions; if you use it extensively for your entry and exit decisions you might not achieve much success. This chapter will show you how to use Level II, where the pitfalls are, and whether or not it gives you information that is really valuable.

Level II is always being acclaimed as a tool that allows you to see behind the scenes, so you can identify every market participant and how many shares he wants to buy and sell. That's just not true. Level II is an important tool and you should have access to it, but it is crucial that you know what it really shows and how you should use the information it displays.

First of all, let us dispel a few myths: you can NOT see every market participant on Level II, and you can NOT see how many shares are really available for buying or selling. So what does Level II show? That's a good question. It shows most of the supply and demand most of the time, however you must read between the lines to figure out what it is not showing.

Be sure to do the following training so you can use Level II competently before you start trading. Our training will show you how to read Level II and what to pay attention to. You must have a good command of Level II as it changes in real-time and it's important for your order entry. You must be able to analyze Level II in real-time so that you can make the right decisions quickly and competently.

Read more about Level II with many samples and Level II training in the book The Complete Guide to Daytrading

 
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