Join our community of smart investors

On the level

Full-time trader Michael Taylor explains how investors can navigate the inner workings of the Level 2 market information system
November 21, 2019

Level 2 is often lauded as extremely insightful on social media and bulletin boards. The reality is that, quite simply, it isn’t always the useful piece of magic it’s hyped up to be. People will type things like “WINS have moved off the offer” as though this means that Winterflood Securities, a leading market maker, has stopped selling. Well, if it was that easy – why do most retail traders lose money and why did Winterflood only have two losing days in the whole of 2018? 

The whole of Level 2 on SETSqx (Stock Exchange Trading System Quotes and Crosses) is a game of poker. Prices aren’t real, and Level 2 doesn’t tell anybody anything about market depth. The market makers are obliged to deal in the normal market size (NMS) at the price and size as displayed online when dealt with over the telephone, but online they can charge what prices and size they want. This is the true price of cheap online commissions. When dealing over the phone market makers will often deal in several times NMS as they want to maintain a reputation for doing business and keep favour with brokers. If a market maker doesn’t execute, the broker will go to someone who can and will fill. 

If we think about Level 2 as a market stall, we see the prices as displayed as the prices labelled on the shelf. It’s only when we barter that we find the real price. Market makers lay their prices out differently for two reasons:

1) By shifting the price up and down they can trigger stops and encourage people to deal, thereby increasing the amount of turns where they make money.

2) Because they can – they know they are highly unlikely to be obliged to deal at the online price. 

One common bluff played out on Level 2 is where a market maker will prop up the bid and pretend to be bidding for stock, but by checking the RSP (retail service provider, available on IG Level 2 dealer) we can see that very same market maker is nowhere near the bid price and is actually there in size on the ask. They’ll often get away with being priced at a price they don’t want to deal at because most people don’t deal via the telephone.

Many traders believe that if there are three market makers on the bid (left side) and only one on the ask or offer (right side) then that means that the stock is supported. That is not the case, as only by testing liquidity and/or the RSP can one truly know what is going on.

We can see in the screenshot above that there are three market markers priced at 0.06p, and only one at 0.07p. The NMS is listed at 500,000 shares. But a quick dummy quote may reveal that we can’t sell in size above the bid, and we may be able to buy plenty of stock within the spread. This would tell us that the market makers aren’t keen on buying stock, but are happy to let us buy and get rid of it from their book. It’s impossible to tell from Level 2 alone – the only way is to check both sell side and buy side liquidity.

There are two ways to check what the market is really like – by using test quotes, or dummy quotes, and by checking the RSP. I rarely use the RSP, because it offers a snapshot of the market at a single point in time. In just a few seconds that can change, so I use dummy quotes to buy and sell to test the market’s depth of liquidity and pricing. Generally, if it’s difficult to buy or sell much stock then the price is likely to rise or fall. However, with Level 2 on SETSqx we don’t get to see the full order book – only market makers. For example, there may be only 20,000 shares left at 8p, and if we clear this out assuming the ask to buy might rise, we might be disappointed if another 20,000 is then reloaded onto the ask. This is called an iceberg (see box). Nobody knows what is up another’s sleeve.

Testing for liquidity comes in useful when there is disorder in the market and there is an emotionally charged liquidity event. Profit warnings, spikes, or anything that moves the price a significant amount on large volume, means that often a price will overextend and then revert to the mean. A profit warning will always have a bounce (the dead cat bounce), and a spike will always pull back at some point. These are both trading opportunities that offer good risk/reward ratios with the right entry price. 

 

Trading the bounce 

When something goes wrong in a small-cap stock, it’s very often a rush for a crowded exit. Everyone wants to sell, and they want to sell quickly, which means the price can rapidly fall within minutes. The market makers will open up the price down, and selling pressure pushes this down further until the point comes where buyers start to first trickle in and then surge in. No doubt many readers will have been in the position where they are trying to buy, but cannot, yet experience the frustration of seeing trades go through at their desired price. When this happens, a quick call to your broker or a spread bet position will do the job. 

When we are trading the bounce, we want to be continuously dummy testing liquidity. When the price is falling, the market makers won’t want to be acquiring stock, and so they won’t be bidding in size for it and maybe not even at the price quoted online. What we want to see here is the bid strengthen – when the market makers are now bidding in size at a high price for stock, we know they are now positioned long on the stock. Quickly checking the buy limits by placing a few dummy quotes should show that it’s difficult to buy in size and preferably not available at the price quoted online. When this situation occurs, it’s time to pull the trigger. Once we have our position, we want to still be continuously testing liquidity because we want to dump our position as soon as the stock’s bounce appears to be exhausted. 

In the chart below we can see the price gap down and fall from 6p to 4.5p in the first minute of trading. The stock was reacting to the largest shareholder notifying that he had disposed of most and soon to be all of his entire position. Selling began in the pre-market, and people rushed to sell on the bell, with leveraged accounts hitting stop-losses and positions closed due to margin calls. 

As we can see from the chart, the stock moved back up before putting in what would become the daily high, and continued the trend downwards. 

 

What doesLevel 2 show? 

Level 2 shows the market as it is happening. What a trader needs from Level 2 is to be able to see what is going on at that moment if we are scalping in and out intraday, and also to see where to place our trades directly onto the exchange.

We mentioned the three market makers on the bid and one on the offer situation earlier – while the market makers don’t have to honour these prices, if we can see that we can only buy at a price higher in the equity market then a simple spread bet will mean we can get exposure to the stock at a price not available to buy from the market makers online. When the market makers are offering stock above their quoted ask, or bidding for stock below their quoted bid, this will often result in the market makers ticking up their quote online on Level 2 or ticking it down.

 

Direct market access

SETS is the London Stock Exchange’s flagship electronic order book and is used to trade FTSE 100, FTSE 250 and FTSE SmallCap constituents and other London-listed securities. The key difference between SETS and SETSqx is that, unlike the market-maker-driven stocks, SETS collects all of the market makers’ displayed prices and quantities to buy and sell, as well as other market participants’ order prices and sizes that they have submitted to the stock market.

SETS offers a wide discretion of trades to be placed such as limit orders and is a liquid and electronic order book. Stocks that trade on SETS allow direct market access and the ability to place trades directly onto the order book at our desired price. This allows us to take the place of a market maker as we can bid to buy others’ stock as well as placing our own stock on offer too. The versatility of SETS allows various buy and sell orders to be placed into the market. We can use Level 2 to assess market depth to consider where to place our limit order. 

In this example, we can see there are 9,197 shares available within 1p of the best bid price available in the market, and only 2,803 shares within 1p of the best ask price offered. In this moment in time there is clearly more demand for stock at the current levels than there is supply – but that can easily change. Market makers can move up and down, and the orders without a code can be from anyone – private investors or proprietary desks.

It could also be the case that some of these orders are ‘spoofs’ – orders, sometimes algorithmic, used to tempt bidders onto the order book, only for the bid order to be deleted and stock dumped into those who were duped into believing the stock was well bid. So-called ‘layering’ is not illegal – if we wish to buy a stock at several levels and place these orders onto the bid before leaving the house and seeing if we are filled later on, we are well within our rights to do so. 

Level 2 gives us an advantage that we can see optimum positions to place our limit order. Being able to see market depth and where others are priced can mean we can get good entries. For example, if we are ahead of many bidders in the market, and a large sell order is dumped into the bid, we will be filled, but also the price may not move as much because the market depth is liquid enough to absorb the sell. 

Here is another Level 2 window, from SETS stock Vodafone – a very liquid stock. We can see that the spread at the time this screenshot was taken is 159.94p to 160p – a spread of 0.0375 per cent.

In stocks with high volume there will be several trades a second and trying to gain a short-term edge is difficult, but there are many SETS stocks where being familiar with the order book can pay off. You can spot buyers in the market if the stock is continuously well bid up to a certain level, and sellers if the price goes above a certain point and sells begin to appear. Again, those buyers and sellers can easily disappear, but being aware can help you make astute decisions. If we know that every time a stock advances through 80p it is met with heavy selling pressure, we might consider waiting until we are sure that supply has cleared before taking a long position.