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fyi: Introduction to Level II (level 2, L2,
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Sunday, December 31, 2006 2:14:01 PM
fyi: Introduction to Level II (level 2, L2, L II, Lii)
From StockJock-e's excellent post on Hot Stock Market:
You have probably heard of Level 2 quotes and are wondering what they are, how to use them and how to get them. Good news! All your questions will now be answered.
When you get a normal stock quote, you see the price of the last trade, the volume and the change from the previous price, this can be called a Level 1 quote.
Level 2 (L2, LII) is an essential tool that any serious trader requires. L2 lets you look behind the scenes at what is going on beyond the current bid and ask of a stock and gives you a clear snapshot of how much demand and supply there is at that precise moment in time.
The most basic and fundamental rule of the markets is that there are only two things which make any stock move, supply and demand.
- If there is a lot of demand for a stock, the price will go up.
- If there is a lot of supply, a stock will go down.
- If demand matches supply, the stock will go sideways.
Congratulations, you now know the secret of the stock markets!
Understanding Level II
To begin understanding level II you must understand how an open market works.
Let us use an example of your neighbor Frank who is selling his car for $5000.
You friend Lisa wants to buy his car, but lowballs the offer at $4800. Your other friend John also wants to buy the car, and since he knows that Lisa offered $4800, he has to offer a better price to get it, so he comes in at $4900.
As it turns out, your other neighbor Bob has the exact same car for sale, he heard that Frank is selling his for $5000, but Bob wants to get rid of his car fast, so he prices it at $4950.
What we have here is a market of two buyers and two sellers. If this car sale had a level II quote, it would look like this:
Buyers ----------- Sellers
JOHN $4900 | BOB $4950
LISA $4800 | FRANK $5000
Does this look like something you have seen somewhere before? (hint: image above)
You can clearly see that John is the highest bidder and Bob is the lowest seller. Odds are if John wanted to grab the car now, he would just meet Bobs price of $4950 (aka hitting the ask), or if Bob wanted to get rid of his car quickly, he could just sell at the highest bid (hitting the bid).
Now imagine this scenario playing out hundreds of times every minute with hundreds of buyers and sellers and now you understand level II.
Level II is essentially an order book for Nasdaq stocks, OTCBB and Pinks also have level II, but you will not find NYSE showing level II.
Instead of John, Bob, Lisa and Frank showing up as buyers and sellers, we have what are called Market Makers or MM’s. When you place an order with your broker, he will route your order through an MM. The MM acts on your brokers behalf, placing the bid or matching the trade for you, in effect, you contol the MM. These MM’s your online broker is using are most likely not people sitting at a desk punching away at their keyboards, but rather, an ECN (electronic communications networks), examples of ECNs are NITE, ISLD and ARCA.
There are basically three different types of players on the level II screen, they are:
Market Makers (MM)
– With most stocks and specifically penny stocks, the MM’s are firms that provide liquidity in the market. They have an inventory of shares and will match orders for other firms and trade for themselves, profiting off the spread (difference between the bid and the ask). In essence, they make the market, this the name.
Electronic Communication Networks (ECN)
- Electronic communication networks are automated systems designed to match buyers and sellers. Anybody from a large financial institutions to small traders like you and me can trade through ECN’s.
Wholesalers (Order flow firms)
– Your online broker will have a relationship with a Market Maker, or several MM’s depending on how much business they do. Brokers who handle large orders may choose to sell this order flow to a wholesaler who will execute them on their behalf. If for example you had a really large order to sell stock in thinly traded WXYZ, your broker does not have the time to sit there all day and make sure you get the best price, he will pass it on to the wholesaler who will take care of it for them.
Examples of useful info you get from Level II
By watching L2 you can see what retail or institutional traders are doing at the moment in time. For example, if you see a large firm like MLCO (Merrill Lynch) repeatedly buying heavily, that could be considered a positive for your stock as opposed to seeing MLCO on the sell side.
Watching a realtime chart in conjunction with L2, you may notice things like each time your stock hits a specific price, a certain MM comes in and supports it, but only when it drops to that price. This could be seen as quiet accumulation or support for the stock, which is a good sign.
Entries and Exits:
To get the most out of your level II quotes, you need to be able to spot entry and exits using technical analysis. You can find my TA tutorial here:
Combining TA with L2 will yield some important results. If you can use TA to find a favorable entry, watch your L2 screen as the important pivot points are met. You will note that retail MM’s start coming into the stock at specific points, these are most likely other traders who are using the same signals. Being aware of the support levels and jumping in ahead of other traders will give you an advantage. The same can be said for exit levels.
Let us say you have done your technical analysis and think INTC is a good buy at $32.50 but you see on your charts that there is a resistance level at $33. Check you level II screen... Hmmm.. look at that. Since you are not the only trader on the planet who uses technical analysis, it seems that there are bunch of other traders who also feel that $33 is a good place to sell, but rather than be so obvious, they have come in below the technical level and are trying to sell at $32.62. This information, combined with your TA is a clear signal that you should not be buying INTC in this area, if anything, you should be going short.
Let us say for example that you are Bill Gates and you want to buy 10M shares INTC. Would you a) put in an order for 10M shares or b) put in an order for 100,000 shares and try buy it in small amounts?
Answer ‘b’ is correct. If you simply waltz into the market and put up a huge bid, other traders watching L2 will take this as a signal of strong demand for INTC and start bidding it up, thus causing it to go higher. Accumulating it quietly in small blocks would be the more logical approach if you want to get in at a low price.
You are still Bill Gates, you own 10M shares of INTC that you accumulated quietly, but now you want to sell it as high as possible. Do you a) sell it in small blocks as to not attract attention, or b) flash a huge bid for 10M shares (place the bid well below market, then retract the bid), thus make traders thing there is demand and make them run the stock?
Because Bill is sneaky, he will most likely choose ‘b’, and run the stock, and sell into the fake demand he created. Keep in mind that these tactics are used on both the buy and sell side, so shorters can flash a huge ask, scare people into selling and play the opposite side.
There are plenty of other scenarios will become aware of as you watch what MM’s do during the trading day.
Here we see Merrill Lynch flashing a big bid of 30,000 shares at $32.55, when traders see this kind of thing we think "holy cow! somebody at Merrill wants a boat load of shares, Im going to jump infront of him and he will have to buy them higher up, thus causing the stock to rise!" But hang on! There is MLCO on the sell side with 1000 shares, it could be that MLCO will pull that bid once he gets to sell his shares at $32.59... Keep an eye open for these things
Getting Level II Quotes
Your current broker will most likely offer you level II quotes with your account if you are an active trader. If you broker does not offer it, you can always get level II from Microcapfeed which is our partner site for level II and screeners.
Level II is an essential tool in your trading arsenal. If you are an active trader or just looking for the best entry and exits on your trades, you need to understand both technical analysis and level II.
From here, I suggest you go read RGhonaims 'Exploring Level 2' tutorial:
If you take anything I say as advice, you're crazier than I am.
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