Chapter 11. Level 2 Quotes
Level 2 (also called Level II)
Warning: Serious "Game Playing With Your Head" Potential Here
Level 2 trading is not for wimps and should not be attempted without first taking a serious training session from a professional or talking to a few successful investors and making sure they don't think its insane for you to participate. Level 2 is a fast moving game, based on momentum, a few indicators, a will of iron, not to mention a cast iron stomach, and a large cash position.
You can get killed very easily even if you know what you are doing. It’s a gambling game full of head fakes, sucker bets, fool's gambits, just the kinds of things you see at a Poker game in Las Vegas. Take our advice, watch people do it for a while before you jump in. See what the stakes are, and don't put up your kid’s college fund for collateral just because you think you are a great gambler. This is quicksand with a funnel to hell.
Trading Level 2 is not like buying a good stock and holding. It’s more like jumping the rapids and riding without crashing into anything or turning over.
When trading Level 2 you must become incredibly sensitive to the ebb and flow of a security's shares, what's called the supply and demand. Level 2 is like a Time and Sales sheet injected with an adrenaline cocktail. You will be watching huge numbers of shares of a stock move as fast as lightening, as large trading houses, exchanges, ECNs, and brokers as well as individual traders make bids and offers and move large and small blocks of securities. While Level 2 shows the same information as the T&S, (the bid and ask), it also shows which Market Maker is offering or bidding, and how many shares they are putting on the line, and at what price. We'll explain what this means later, first let’s see how the mechanics work.
If you want a good book on Level 2, we suggest Toni Turner's A Beginner's Guide to Day Trading Online, Adams Media Corp, 2000, 285 pages. We think this book has one of the best descriptions of Level 2 trading I have read. We like the entire book and its approach to day trading, as well.
What Is the Level 2 Display?
The Level 2 display is a special window into the NASDAQ Market Makers. A Market Maker is a person or company controlling a large inventory of shares of one or more stocks. On the NYSE this same person is called a specialist and they can only have inventory in one stock. But with the NASADQ a MM need only have a ton of shares to play the game, and thus they are playing a lot of stocks at the same time.
In order to use the Level 2 sheet you need to subscribe to a Level 2 feed or service, which we will assume you have (ErlangerQuote supports Level 2 data from Quote.com, currently). If you do not have a Level 2 feed you may still see some activity in a Level 2 window, however it will only be a small part of the overall picture (such as the Island book).
The figure below shows a Level 2 sheet for HGSI. There are two sides to the Level 2 sheet, the bid side on the left and the ask side on the right. A divider line that you can move to the right or left separates them. Note: you CANNOT add any additional columns to the Level 2 sheet, they are not like Quote sheets in that regard. When looking at the Level 2, remember the phrase, ‘Bid to buy and Ask to sell.’ In other words, buyers want to buy on the bid, and sellers are offering to sell their shares at the ask (the asking price or offering price, sometimes just called the offer, too).
Following the Level 2 is vitally important because it can help you determine the fastest route for executing your trade. We are not going to discuss order routing techniques because it is too complex, but there are several excellent books that discuss this. The other reason for following the Level 2 is to become familiar with the rhythm of your stocks before you trade them and also to identify who the Ax market makers are before you get in their way and get trampled.
Figure 1 A Level 2
display showing bids on the left and asks on the right
Market Makers
What this display is showing is the "Market Makers" and what they are selling and buying at any instant in time. There are hundreds of Market Makers or trading houses like Merrill Lynch and Goldman Sachs. They are also made up of electronic exchange networks or ECNs that are trading on the Nasdaq exchange, such as Island and Instinet. The ECNs are exchanges that represent the buying public, though any market maker can access and use them also. They can aggregate their trader’s orders and try to gain the strength of a large Market Maker.
Market Makers and ECNs are indicated by the four letter ID code (MMID), Merrill Lynch is MLCO, Goldman Sachs is GSCO, Island is ISLD, and so on. You will find a more complete list below. When we talk about the Market Makers we will be referring to the ones that are the "inside" bid or ask. These are the guys in the yellow band who have landed at the top of the bid chart as highest bid, or the top of the ask chart as lowest ask. If you buy at the ask, you are buying from the MM at the top of the Ask sheet and if you sell at the bid you are selling to the guy at the head of the bid side.
|
MARKET MAKERS |
Market Maker
ID |
AX |
|
Bear Stearns |
BEST |
|
|
B.T. Alex Brown |
BTSC |
|
|
Cantor Fitzgerald |
CANT |
|
|
Donaldson, Lufkin
& Jenrette |
DLJP |
|
|
Gruntal & Co. |
GRUN |
|
|
Goldman Sachs |
GSCO |
Lead gorilla |
|
Hembrecht &
Quist |
HMQT |
|
|
Herzog, Heine,
Geduld |
HRZG |
|
|
J.P. Morgan
Securities |
JPMS |
|
|
Knight/Trimark |
NITE |
|
|
Lehman Brothers |
LEHM |
|
|
Mayer &
Schweitzer |
MASH |
|
|
Merrill Lynch |
MLCO |
|
|
Montgomery
Securities |
MONT |
|
|
Morgan Stanley |
MSCO |
|
|
Paine Webber |
PWJC |
|
|
Prudential
Securities |
PRUS |
|
|
Salomon Smith
Barney |
SBSH |
|
|
Spear, Leeds, &
Kellogg |
SLKC |
|
|
Troster Singer Corp |
TSCO |
|
|
ECNs |
|
|
|
Bloomberg |
BTRD |
|
|
Instinet |
INCA |
|
|
Island Corp |
ISLD |
|
|
Spear, Leeds &
Kellogg |
REDI |
|
|
Terra Nova Trading
LLC |
TNTO |
|
|
Attain |
ATTN |
|
|
Brass Utility LLC |
BRUT |
|
Table 1 Market
Maker/ECNs Names and Codes
The AX
The column in the Marker Maker List called AX is the name of the Market Maker who has the most influence in controlling the direction of the stock. Here the word AX means to swing the tool that does the most damage or good depending on your perspective. The AX probably has gained a reputation of being able to get great prices for his clients, and wields a very large sword when it comes to influencing the stock. We say influene because in spite of the forces placed on stocks by external market conditions, since the AX may be sitting on millions of shares, the AX can fight that tide and control it, and even turn it around. Are you beginning to get the idea of the kind of game you will be playing? Now we can get to the purpose of the colors in the rows, and the horizontal meter above the sheet. The colors represent the top four tiers of prices that buyers and sellers are bidding or offering for the stock. In other words the highest, 2nd highest, 3rd highest and 4th highest bids are colored in tiers. If there are multiple market makers at the same price level, then the rows are all colored the same. Precedence within tier levels is first determined by shares (highest number of shares bid will be first), then time of bid (most recent bid will be highest). The tiers on the ask are the same except that the lowest asking price will take precedence, then size, followed by the most recent time of offer.
1st Bid Ask Yellow Best
Inside Bid (Highest) and Inside Ask (Lowest)
2nd Bid Ask Green
3rd Bid Ask Cyan
4th Bid Ask Red Worse
If you examine the previous Level 2 sheet you can see that ISLD (Island) and INCA (Instinet) share the best bid and HRZG (Herzog, Heine, Geduld) claim the best ask. Right under Island is INCA (Instinet) at the same bid and both are in yellow. Why is Island on top? What size of shares do we buy? If they both had 200 shares listed to buy, ISLD would still be on top because the ISLD bid was updated at 16:02:43, 3 seconds later than the INCA bid. If Instinet raises their bid to 164 1/8 they would move above Island. Remember it’s an auction system.
The Level 2 Meter
A Level 2 trader is interested in order flow, which means how many shares and at what price, is moving on the sell side and the buy side of the sheet. They see the movement of shares at specific prices analogous to the ocean and its numerous layers of currents.
One of the rules of trading with Level 2, is that if more shares at higher prices move to the buy side (bid), a trader wants to be on that side of the trade, and if they move to the sell side, they want to be on that side. You can't easily tell what way buying pressure is moving in the normal Level 2 meter because you have to mentally figure out the proportions to see what the shares times volume equals for each Market Maker, which is hard to do. This is the purpose of the Level 2 meter.
The meter takes the top 4 Market Maker bid and ask values, and multiplies them by the number of shares. Then it adds them all up, and creates a bar for each that is proportional to its share of the total sum. Then this bar is displayed horizontally on the top of the Level 2 sheet. Look at the figure below of the L2 meter for the previous Level 2 sheet. You can see that the bulk of the shares that are being traded are, proportionally, on the bid side of the meter.
Figure 2 Level 2
Meter
The way the prices are spread out on the bid and ask side is also revealed in this L2 meter. In our example you can see that the first and second position (yellow and green) are very large, while the blue and red are very small. This means that while there is strength right under the bid, it is not that deep. Of course, that is true on the ask side as well.
To better understand the meter, below is the same HGSI Level II screen a few moments later. There is a Bid Ask chart below it so you can see how the prices look in time (this was at the end of the day). As you can see the 1000 HRZG shares has moved up to be the best bid, but Instinet and Island have each suddenly added 900 shares to be the best ask. This has pulled the meter back to the sell side, and now both sides are more even. How can these guys play both side of the fence? I did warn you that Market Makers mask their true intentions. This could easily be part of a ruse to get rid of a large position. Market Makers jobs are to liquidate large holdings of shares at times. They do this secretly and attempt to quietly pour them into the market and have no one realize that they have a lot of shares to sell. They will fake away the day to manipulate the impression that the market is going up, in order to generate more buy orders so they can dump more shares. Smart guys catch on to this but the unobservant can miss it.
Figure 3 Level 2
display a few minutes later
The charts below show the pricing action corresponding to the Level 2 display above. If you look carefully at the last candle in the 1-minute chart you can see the wide swings in the top wick. The same action can be seen in the bid ask chart below the candlestick. There was a large spread between the bid and the ask in the last few minutes of trading at 15:59 or so, then the spread reduced as the remaining trades filtered in.
Figure 4 Candlestick
chart corresponding to previous Level 2 display
Figure 5 Bid/Ask chart corresponding to previous Level 2 display
Preferences
The Preferences for the Level 2 screen are shown below. You can control the coloring of the row text, background, empty cell, grid and Change color. You can also add new bars to the Level 2 display in this dialog or recolor the existing four. The font can also be changed.
Figure 6 Level 2 Preferences
Tracking
Right clicking on any MMID cell in the Level 2 and selecting Add Tracker will display a function dialog box like the one below. Use this to highlight the market makers and ECN’s that you want to observe, such as MLCO, who is an Ax that you want to be aware of. In the display below the MMID code is ISLD for the Island ECN. Many traders will highlight ISLD because it is usually the fastest way to get executed.
Figure 7 Level 2 Tracking.
As you can see above the name MMID will appear in the box and you can choose any color background and foreground. These colors will be applied to the specified MMID in the Level 2, so as that MMID moves up and down it stands out. You can use this to nail the AX and make it easier to follow his movements.
In the Level 2 below, we have highlighted GSCO – Goldman Sachs, MLCO – Merrill-Lynch. There is also INCA (Instinet), which is frequently used by the market makers to mask their moves. Two ECNs are highlighted in yellow, ISLD, and REDI.
Figure 8 More Level 2 Tracking.