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Shares: Understanding Level 2, market makers & DMA

Created:
23 April 2008
Updated:
24 April 2008
Written by:
Simon Dixon

Having worked as a market maker on the FTSE, Plus Markets and the Alternative Investment Market (Aim), I have witnessed drastic changes in the way that individuals and institutions can trade the UK markets. When I first left the City and the information privileges that went with the territory, it really affected my ability to profit from the markets. In response, I decided to look for ways to bridge the information gap between the institutional trader and the individual trader.

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In recent years, the UK market has moved away from the old quote-driven system and successfully embraced electronic trading. With modern trading platforms that offer live Level 2 data at an affordable cost and direct market access (DMA), the individual now has all the advantages that were previously only available to banks, brokerages and the like. For example, trading in the pre-and post-market auctions is no longer restricted to institutions, giving private investors access to the favourable prices that institutions have enjoyed for years. What's more, the benefit of smaller trade sizes offers individuals an edge over larger institutions.

Having access to cutting-edge technology is all well and good, but if you don't know how to exploit the information now available, it's actually pretty useless. With this in mind, I will guide you through using Level 2 data to interpret price action and show you the advantages that DMA can offer you.

Up until 1997, UK shares operated on a quote-driven system with competing market makers offering different spreads. Since then, larger blue-chip companies have been electronically traded through an order book system, significantly reducing the spreads on UK shares. There are three main trading services for UK shares:

• SEAQ: A quote-driven system, in which market makers advertise a bid-offer spread and brokers engage in telephone execution of orders.

• SETS: An electronic order-book system where anonymous bids and offers are left and matched on a book.

• SETSmm: A hybrid of SEAQ and SETS, in which market makers provide quotes combined with an electronic order book system.

Knowledge of each system is essential if you want to achieve better execution and understand market sentiment.

SEAQ

The majority of Aim stocks and other small- to mid-cap companies trade using the competing market maker system called SEAQ, or Stock Exchange Automated Quotation. The number of market makers competing to make a market in any particular stock vary. The number of market makers will clearly affect the general liquidity of that stock. The fewer the market makers, the more volatile the stock will be in response to a small buy or sell order. The Level 2 screen for SEAQ stock Eros International is shown in Figure 1 below.

Figure 1

The Level 2 for Eros can be seen below the yellow strip. In this example, the bid price – the price at which you can sell stock – consists of two market makers, Winterflood Securities and Evolution. Both are bidding for 3,000 shares at £3.83. The offer price – at which you can buy – consists of the same two market makers offering 3,000 shares each at £3.93.

Each market maker is represented by a mnemonic (EVO is Evolution). Also displayed are the minimum dealing size (3,000 shares here), a two-way price (for buying and selling) and the time at which the quote was last changed.

There are two ways to execute a trade in a SEAQ stock – by telephone or through a network called a Retail Service Provider (RSP). Telephone orders can only be taken from brokers approaching a market maker on the Stock Exchange internal telephone exchange (STX). The RSP allows stockbrokers and internet-based traders to deal with market makers electronically, often at an improved price.

The RSP system was originally developed so that market makers did not have to deal with small orders over the telephone. Since then, RSP orders have come to account for around 90 per cent of all SEAQ trades. For larger trades, it is often necessary to get your broker to speak to the market maker directly.

It is worth noting here that market makers will do anything to hide the fact that they might have an institutional order and often push prices and advertise false signals in order to trick the unprepared trader into thinking that a stock is better bid for or better offered at a given moment in time. For example, if there are four market makers on the bid and only one on the offer, this does not definitely indicate that the stock is better bid and therefore is due a move up. The market maker on the offer on Level 2 may or may not be a decent seller – he is just as likely to be a buyer, holding the stock down. The market maker may only be obliged to sell a small number of shares on the offer, but if he has an institutional buy order it may be a small price to pay. If he does, he will be advertising himself as a seller on Level 2 and bidding for stock with a large improvement on the bid side of the RSP.

The key is to identify what is commonly referred to among institutions as 'the AX': the market maker who is most central to the price action of a specific security. We need to distinguish between the AX and the market makers who falsely push prices up and down in the short term for book-keeping purposes. The broker to the issuing company is often the AX. Each listed company has a broker that acts as corporate adviser to the company and often corporate financier for the flotation, placing or other corporate activity. Such a broker often makes a market in the stock and holds most of the institutional orders and business in the stock. They are distinguishable from other market makers as they often advertise a larger size on Level 2, or offer a narrower spread than other market makers. To download a comprehensive list of market makers and their corresponding codes visit www.benedixinvestments.com and look at the 'downloads' section of the site. The AX often provides the clues to institutional business, which drives stocks up and down.

Figure 2

Brokers and institutions with larger orders than those bid and offered on screen will leave an order with a market maker. Market makers and brokers spend a great deal of time building relationships and market etiquette prevents them from doing the rounds of market makers and splitting the order up into smaller chunks. Often, you will see prices move without a corresponding print on the time and sales screen, as the market maker will be working a larger order for an institution or broker, which will not be printed until the end of the day. Such transactions are marked with a 'T' to represent a protected trade. Figure 2, above, shows 250,000 shares booked out from protection at 390. Look for protected trades at the end of the day as they often signify an institutional order that could create a bias in a stock’s direction. A comprehensive list of trade codes is also available on www.benedixinvestments.com

A stock can fall all day long for no apparent reason. Once the sell order that has been worked all day gets trade-reported, the reason for the fall becomes a lot clearer.

Figure 3

Momentum traders often specialise in trading market-maker challenges. Market makers will often deal among themselves, especially when one appears to be holding a stock up or down against the other market makers' interest. If a market maker is artificially holding a stock up or down and is challenged by another market maker, there is often a short-term momentum play that can dramatically push a price in one direction or the other. When a market maker runs around the market challenging, the trade is reported with an 'M' next to it. It is, however, a trick of the market makers to print 'M' trades in order to attract momentum players' interest to fill their larger institutional orders. An 'M' trade can be seen in Figure 3 above.

SETS

Level 2 provides the trader with an informed image of the supply and demand situation in the market, but must be used in conjunction with other supply and demand factors. When watching Level 2, remember that a market maker has taken the other side of your order and so it is important to watch market-maker behaviour when determining market sentiment. But this is not the case with order-driven systems like SETS, which has proved unpopular with market makers, who are used to having more control over prices. The London Stock Exchange (LSE) has converted more and more stocks to SETSmm.

SETS is a completely electronic system through which buyers and sellers are automatically matched, eliminating the need for market makers. That said, market makers still perform the role of executing the larger institutional orders. Figure 4 below, shows a SETS Level 2 screen for Partygaming.

Figure 4

The yellow strip represents the touch price – the best bid and offer. Full market depth Level 2 can be seen below the yellow strip.

The market depth is made up of limit orders placed on a book giving priority first to price then time.

The biggest advantage of order-driven systems is that individuals can now use DMA to buy on the bid and sell at the offer, eliminating the spread. You can leave limit orders on the book outside of the touch price allowing you to benefit from auctions, volatility and mistaken orders, known in the market as 'fat finger trades'. However, as news hits the screens you can be left on the wrong side of a sharp movement. It is now possible for traders all over the world to make a price rather than just a few market makers.

Although Level 2 has brought much greater insight to the independent trader, there are still tricks available to larger institutions and traders who wish to cover their tracks. For example, the delayed printing of orders often causes larger institutional orders to drive a market before the explaining order is printed for all to see.

Level 2 on SETS is great for better execution but, owing to the nature of the system, traders who are new to Level 2 can waste a lot of time speculating on 'fake' orders. You will frequently see large orders on the book that disappear as soon as they approach the touch price. One common scenario is an institution with a large sell order putting a large order on the bid side of Level 2 slightly lower than the touch price. The inexperienced trader will interpret this as a support level. The institution has spoofed the market into buying the stock he wishes to sell and, if the bid side approaches his large order, it will cancel automatically. This type of behaviour is very common indeed.

On Level 2, you can often spot larger trades by looking out for an iceberg order. Iceberg orders are used to disguise larger orders by an automatic reloading facility. For example, an institution may have an order to sell 1m shares and can leave an iceberg order on the book to sell 10 tranches of 100,000 shares, which will automatically reload every time the offer is lifted until the 1m shares are sold. This reveals the order’s true size and thus prevents panic sellers from causing the price to fall away.

SETSmm

SETSmm was introduced in response to the improved trading conditions that SETS brought about among the larger blue-chip companies, namely lower transaction costs, higher liquidity and tighter spreads. SETSmm is an electronic order book that has additional support from market makers. A SETSmm Level 2 screen can be seen in Figure 5 below.

Figure 5

You will notice market maker quotes alongside anonymous orders on level 2. You can spot the market makers' price by the mnemonic next to their bid and offer. It is worth noting that market makers are also able to leave anonymous orders on the book alongside their quotes. The advantage of SETSmm is that traders can use direct market access to eliminate the spread, at the same time as market makers are providing added liquidity.

Since SETSmm stocks are less liquid than SETS stocks, they are subject to more manipulation by brokers and market makers alike. By watching the touch screen you can place a very small order on the bid or offer and watch computer systems jump in front of you with larger-sized bids and offers automatically generated by program trades.

An old trick often used much to the chagrin of market makers is to add a false bid to the touch price in very small size, pushing the price up temporarily at the same time as selling your order on the RSP at the better price. After the order is filled, the DMA trader will remove the bid after execution.

Another ploy is to post a large buy order near to the touch price. Other traders will try to beat the bid and place orders in front in the belief that there is large size behind the bid. The DMA trader can then flip sides and remove the bid order, hit the stock down to its original level, leaving the buyers on the wrong side of a larger sell order.

The advantages of Level 2 and DMA are clear – indeed, if you trade without them you're subject to larger dealing costs and you'll have a much less informed picture of true supply and demand. Distinguishing between the genuine moves backed by institutional orders and the manipulated moves on the other side of institutional orders is of major importance in shorter term trading. Even the long-term investor can get a lot out of understanding the execution of institutional orders and the benefits of entering and exiting at the correct time and price.

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