Author: Lee TG | Publish date: Wed, 26 Jan 14:18 | >> Read article in Blog website
Open any classic text book on economics and you are sure to find that the explanation for pricing comes down to supply and demand. The idea that supply and demand is the sole factor on the determination of prices is as familiar as Newtonian gravity. If there is more demand than supply then prices will rise; if there are more sellers than buyers, then prices will fall.
This is a simple market model and looking at pure Level 1 real time prices gives no indication on what is going on beyond the moves of the Bid (demand) and Ask (supply). This information is limited and thus difficult to read. In the old days of the ticker reading, acute or perhaps deluded, speculators could divine the next price move from the sequence before. But those were the days when there could be minutes between ticks. This is as far from modern trading as the pony express is from email.
Chartists can point at tick charts and try to understand and predict the movement of the markets from them, but what you see is a two dimensional representation of the past action. What you need is a three dimensional representation and one that contains information that makes up the future.
While the buy-and-hold investor sails calmly over the sea of volatility unshakable in his resolve to ride economic progress to nirvana, the trader is looking to jump onto the volatility and time his entry and exit. He plans to get paid for providing liquidity by capturing the noise of random swings that are the markets tick-by-tick volatility.
To do this he must have as much information as possible, and Level 2 is the view of the inner workings of the market. Level 2 is the leading edge of market data. Happily, it is a multidimensional data stream, and information contained in it does give information about the future--or at least a very strong indication of this.
Market Depth in Level 2
The Level 2 information covers not only the Bid and Ask for a stock, but also the "market depth". Level 2, as the name suggests, is the next step up in market information. Level 1 shows the Bid and Ask (the buy and sell price of a stock), whereas Level 2 includes so called "market depth." The "market depth" is the whole spectrum of buy and sell orders at different volumes and different prices. Buy orders are on the Bid side and sell orders on the Ask side. Different markets have different flavors of Level 2, so that the Nasdaq flavor, called TotalView, is a bit different from NYSE's Open Book. However the basic principles are the same. The order book for a stock on Level 2 is like a pile of orders. The bid orders are buyers offering to buy quantities of stock at price levels at the current bid and at lower prices. If you want to sell, you 'hit' the bid price of the best bid. The opposite is the case for ask orders.
You could place a buy order on the bid by entering an order at the bid price or lower. For example, you could place an order for MSFT at $2 below the current bid, and if the price fell that far, you would get your order at that price. If you placed a buy order at the bid, you would be added to the end of the bid queue at that particular bid price. This would be the last order filled at that price before the market moves onto the near Bid price level. Level 2 is a queue, and it is the way in which everyone lines up with their orders that makes the market.
While the orders that you see are real, they can be entered and removed by the trader at any time if these were not met. This means that an order to buy can disappear and new orders to buy and sell can appear at any time and at any price level. This makes the Level 2 a fluid environment with orders coming and going when they are filled, or just merely cancelled before they are met.
Orders can be placed on the Level 2 book for reasons other than buying or selling. Bid orders might be an artificial show of strength to suggest support for a price, but this support might melt away if a significant seller appears. Conversely, a large buyer will not put all his orders into the market at once and will instead break up his order into smaller pieces in order to conceal his intent. All markets tend towards game play and the games certainly come thick and fast on Level 2.
Level 2 and the Ax Force
Participants on the Level 2 book are named and, in many instances, there is a party whose order or general interest is the dominant factor in the action of that stock. The order or the participant interest and hence the participant themselves, is known as the 'Ax'.
Many traders make their living simply by judging the direction of the market and its participants and following along behind them. Like the Remoras swimming under the shark, they do not try to guess the market; they try to guess what the big guys with the big orders are doing. A market maker, who makes his money from the spread with a huge buy order, will drive the price up and, likewise, a market maker with a big position to dump will push the price down. Many simple traders watch for the tell tale sign that there is a big order being filled before going with the flow. This flow will be the 'Ax', and likely to be a market maker working an order flow to try and get the best price.
Simply riding on the coat tails of the 'Ax' makes these traders their money. These 'Axes' will be trading with computers, so working out what is going on in a Level 2 book is as much of an art as any kind of trading
You can imagine that every stock is a miniature market, in which a group of players bargain to set the price. The 'Ax' is the main player with the big position who will set the pace and scope of the play.
For example a market maker may have an order to buy 10 million shares of a stock. As no one else has a big position to buy or sell, his actions will dominate the market while he has this position to fill.
He will not simply put a 10,000,000 share order in at a price. That order would be liable to drive the price higher. So the 'Ax' will put a 50,000 stock order in, at say $50 a share, which is the current bid and wait. As the 50K order is filled he will put in a new order at $50 and so on to fill his big order. This may well be executed by his computers, which would be connected to the market by what is known as a 'program trade.'
The system will try and hide the fact that there is a buyer at $50 a share by varying the price, timing and size of the broken up order. This disguises what is going on. Only a small part of the whole order will be placed as an order into the market book, yet the 'Ax' will have, in effect, put a level of support on the price by his buying action. If the order has a price range it may well drive the price higher. In any event, the floor on the price will mean that while the market is very unlikely to go below this $50 level, the upside is open to the turn of events. This, in a way, is a one way bet.
Sadly it is not often that a single 'Ax' will stay in place for very long periods of time and the 'Ax' will pass between players. Yet this understanding of what is going on in a stock market is only to be had via a Level 2 screen.
Conversely if an Ax has been holding a price down all day or is driving the market upward, it is obvious that, at some point, he will get a complete fill. When his play is finished, it is a fair bet that the price of that stock will move in the opposite position for a while. The markets are always reverting to a mean, and as players enter and exit, so the noise of their actions jerks the price away from a smooth transition. In the intense day trader environment, this translates into the constant vibration of price, and a trader is trying to catch the extremities of this shaking to capture a profit.
Conclusion: Level 2 as an Advanced Tool
From a Level 2 perspective, the market is an enormous poker game. With real orders waiting to be filled, iceberg orders with larger volume stealthily preloaded and phantom orders designed to spook out other traders, this is no simple map for the uninitiated. This doesn't make the Level 2 world a simple one, but it is the actual state of play and without Level 2 you may as well trade from the prices in the morning papers.
What is clear (or clear for some) is the flow of trades. When a stock like Cisco starts to trade fast, it can go from 30 trades a minute to 500. To the naked eye it is hard to pick out what exactly is happening except that trading has got very fast.
Level 2 is an arms race just like Level 1 was before it. Without the most advanced tools-unless the angels are on your side-you may as well stay away from the markets.
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