General Stock Market Questions - Level 2

Q. How does Level 2 work?

A: Level 2 displays continuously updating data from the LSE (London Stock Exchange) displaying such information as individual orders, trades, volumes and the present state of the 'order book'. The shares quoted under this system fall under three different categories: Market driven, Order driven and MMSETS which is really a mixture of both. The Market driven stock (also referred to as SEAQ) was the original system before the introduction of SETS (the order driven system) and is used for smaller caps. In the Market driven stock system, prices are established exclusively by Market Makers.

All the pending buy orders for the stock are listed on the left of the Level 2 screen and the sell orders on the right with orders being sorted on a price/time input basis. Let's take an example of how the order book looks; in the picture below you can see a snapshot of the order book of Leisure & Gaming PLC, LNG; this being a small company listed on AIM (Alternative Investment Market).

The yellow strip displays the current best bid and offer prices which are the highest bid of all the market makers and the cheapest offer of all the makers which taken together make the present bid-offer spread. The names of the market makers are displayed to the left with the best bid at 165p and the cheapest offer at 175p.

This means that you would get 165p (per share) if you were to sell and it would cost you 175p (per share) if you wanted to buy into this share. The other thing to consider is the dealing size. Market Makers by exchange rules have to display a price and size at which they must deal and this is displayed on the right of the price by each market maker.

Market Maker Driven Stocks - SEAQ

Market Maker Driven Stocks - SEAQ.

The size is displayed as 2 x 2 which really means that the bid price is in 2000 shares and the offer price is in 2000 shares (there is also one market maker with 2.5 X 2.5 implying 2500 X 2500 size). This means that if you were a seller or a buyer of any amount up to 2000 shares the market maker must fulfill your order at the displayed price although for bigger orders prices will be different. Of course the price does not necessarily have to be 165-175; the last trades appear on the middle left hand side and can be anything between those bid/ask prices - in this example the last trade was at 173 (and since this is closer to 175 than 165 it is probably a buy).

Order Driven Systems - SETS

Order Driven Systems - SETS.

This is only part of the story; as you also need to look at the order book statistics for an idea of how the market is positioned. Note that in the Vodafone Grp. Sets stock illustrated above there buy orders totalling 4,8 million versus nearly 22.4 million sell orders.

One of the favourite tricks that market makers like to pull is to put large orders well away from the touch price to give the impression of a lopsided order book, when they want the market to go the other way.

Note that VWAP is a trading acronym for Volume-Weighted Average Price, the ratio of the value traded to total volume traded over a particular time horizon or for a particular number of shares.

Q. Why is Level 2 useful? Do I really need it?

A: Well, to start with, Level 2 data will give you a good idea of the general demand for a particular share. I find Level 2 particularly useful for several things 1) Examining the strength behind a bid 2) Looking at the order book 3) Examining the "real" bid/offer spread.

One can deduce (perhaps simplistically) that a larger number of sell orders on a share than buy orders is a negative sign i.e. MM's are more keen to sell you stock than buy it. The opposite can be regarded as a bullish sign. But there is much more that can be understood from Level 2 to help us with the timing of our trading.

For myself, before I buy I find it useful to double check the range of prices offered by the Market Makers and the number offering at each price. Normally, the more Market Makers at a specific price the more chance of that price holding. Secondly, a high number of buy orders building up just beneath the market can be a good indication of strong demand at or just below current price levels while a large number of sell orders sitting just above present market levels suggests that the share is likely to meet considerable short-term resistance on the upside. I'll often check the order book to see if there are any large sells waiting. I find that they can dampen enthusiasm for buying. Obviously you need to be wary as this is often used as a strategy to control the price by fake orders being placed.

The offer/bid price on a share can look quite small but may be the results of a range of prices offered by the MMs. If all the MMs start offering the same prices that spread can suddenly look awfully large.

I suppose I look at many other factors when examining Level 2, but most are just variations of the above 3 things. I find that the closer I get to FTSE 100 companies the more tricks are played by MMs and the more my inexperience begins to show, but I am learning...

I think Level 2 has to be learnt in two stages. Stage one is getting to grips with the mechanics of it. Stage two is the much harder interpreting motives.

Level 2 serves each type of stock in a different way. The way in which it is useful does vary. Below I mention four different stock classificatons. The way one might utilize Level 2 is different in each of those different situations. There is no shortage of basic L2 education on the web - but it's the stuff beyond the basics that's probably most useful.

A good way for anyone viewing Level 2 anew, and who only has a single free day in which to do so, is to focus on just four stocks. A fast moving SETS stock, a slower moving SETS stock, a SETS/Market Makers hybrid, and a SEAQ (i.e. Market Makers only) stock. But don't study them in that order.

The first stock should be a sets-only stock from somewhere in the upper half of the FTSE 250 (or bottom end of FTSE100), where the action is frequent enough to tell you something, but slow enough to make sense of.

The second stock should be a hybrid sets/mm stock, so you get a chance to see how the MMs and the non-MM players interact. Again it needs to be one where the action is brisk enough to be meaningful but slow enough to take onboard. (JPR is one I'm currently watching - but something a little brisker would be better).

The third stock should be a sets-only one from the upper end of the FTSE 100, where the action is too fast to learn much from, but gives a useful indication of how rapidly volumes swing around between the buy side and the sell side, and the way in which that ties in with imminent price directions.

The fourth should be a SEAQ stock (i.e. MMs only). Again this needs to be one that is busy enough to be almost constantly active. In that case the aim is to see how MM price changes trigger trades, and how trades in turn trigger MM price changes.

Level 2 becomes even more useful when you trade with a broker that provides Direct Market Access such as IG Markets as this will allow you to place buy and sell orders on the central order book of the exchange. This means that you will be able to set bid and offer orders on SETS and SETSmm stocks and compete directly with other traders and market makers as opposed to having to accept a market maker's spread which is especially useful when dealing in larger size.


How the Stock Market Works

It was autumn, and the American Indians on the remote reservation asked their New Chief if the winter was going to be cold or mild. Since he was an American Indian chief in a modern society, he couldn't tell what the weather was going to be. Nevertheless, to be on the safe side, he told his tribe that the winter was indeed going to be cold and that the members of the village should collect wood to be prepared.

But, also being a practical leader, after several days he got an idea. He went to the phone booth, called the National Weather Service and asked, "Is the coming winter going to be cold?"

"It looks like this winter is going to be quite cold indeed," the meteorologist at the weather service responded.

So the Chief went back to his people and told them to collect even more wood.

A week later, he called the National Weather Service again. "Is it going to be a very cold winter?"

"Yes," the man at National Weather Service again replied, "It's definitely going to be a very cold winter." The Chief again went back to his people and ordered them to collect every scrap of wood they could find. Two weeks later, he called the National Weather Service again. "Are you absolutely sure that the winter is going to be very cold?"

"Absolutely," the man replied. "It's going to be one of the coldest winters ever."

"How can you be so sure?" the Chief asked.

The weatherman replied, "The American Indians are collecting wood like crazy."

This is how the stock market works!


Q. Does the Level 2 order book give me some indication of what direction things might go in the coming hours or days (or even longer?).

Is there anything I can glean from the order books that would give me some indication of what direction things might go in the coming hours or days (or even longer?). Obviously nothing is concrete, but what things should I be looking out for?

A: Level 2 is of no great use to a medium/long term investor - other than in timing the opening deal within the day it's done, and likewise the best moment to exit on the day you sell. You might pick up some indications for the following day from orders stacked just before the market closes - or with particular stocks you might sense a pattern of behaviour that might continue over further days (example, the way a particular order book behaves ahead of regular scheduled market/government statement timings, or with Investment Trusts that routinely declare a midday revaluation).

With SEAQ stocks (market maker controlled) or SEAQ/SETS hybrids (where market maker prices are listed but are maybe positioned away from the best price) you can often spot movement of prices among market makers several minutes (or even an hour or so) ahead of it influencing the bid/offer price. (example; with say five market makers involved, you might see the middle threesome shifting prices in the same direction before either of the two lead market makers move theirs).

EDIT: The way you view L2 on SETS stocks (with no market maker stocks, so down to assessing order book behaviour) will differ from how you view market maker stocks. They are different beasts.

Q. What are SETS/SETSmm/SETSqx?

A: SETS is the LSE's proprietory electronic order book, trading FTSE 100, FTSE 250 and the FTSE Small Cap Index shares as well as other liquid shares. In the United Kingdom the most liquid stocks consisting of all FTSE 100 shares and a number of FTSE 250 shares are traded on SETS (SETS stands for Stock Exchange Trading System). This system works by matching buy and sell orders electronically.

In practice for traders, SETS means that the order book is open to the public. You can put an order on the book using a direct market access (DMA) share account (eg iDealing or Interactive Brokers or IG Markets). For shares with a large spread like GCM or CHAR it means you can save a few % on a trade which gives a bit of leeway if you don't pick the bottom (who does?!?!).

Another system, referred to as SETSmm is used for the lesser mid-cap companies and FTSE Small Cap constitutents as well as some of the bigger AIM stocks. This is basically a hybrid of the SETS market, and market-maker style trading which helps to keep spreads tight. SETSqx is one other system designed for the less liquid shares on the main markets (including AIM) and works by merging an electronic accumulation of orders with individual bids and offers of market makers.

Finally there is SEAQ which is the London Stock Exchange's non-electronically executable quotation service that allows market makers to quote prices in AIM securities (not traded on SETS or SETSqx) as well as a number of fixed interest shares. Market Makers can manipulate the share price more easily on SEAQ (especially by widening the spread).

All trades are cleared by Euroclear UK who are the owners of CRESTco. Settlement for UK share dealing is T+3, which means that the trades are settled 3 business days after the actual trade has taken place. There's still many shares that are SEAQ on AIM that means you have to buy from market makers.

Note 1: Most of the London market is SETS these days. Only the lower end of AIM is solely SEAQ (ie Market Maker driven). The higher levels of AIM tend to be SETSmm (ie halfway house between MMs and Automatic).

Note 2: SETS is a direct electronic trading platform (order book) where buyers/sellers directly deal. MMs are not in the loop although they can deal directly on the order book themselves and will also handle orders from clients without DMA (direct market access). The 'AT' trades are all automatic trades (i.e. a matched buy and sell order). The 'O' trades are those still being handled by Market Makers.

Q. What is the Yellow Strip?

A: The Yellow Strip refers to a term used by market makers denoting the highest bid price/lowest offer price in Level 2. It is commonly used as a reference point for best execution and you would hope that a stock broker is competent enough to get you the best price, after all you are paying them a commission for each trade. Thus a stockbroker beating the Yellow Strip should be considered a positive point.

Q. Could I ask whether you know where I might find volume data feed for the indices or markets? Also would you know anything about level 2 data and whether it would help trading commodities and currencies?

A: You can generally get in depth data from anyone of the data look...etc. But it is not 'cheap'. There may be delayed data you can access for free, I would suggest that you look around the threads on T2W or advfn. I am sure that there will be extensive discussion over this very subject.

Level II data is often used by momentum traders in less liquid stocks but much activity is now hidden by traders (as they do not want others to know what they are doing until they do it). Currency level II would be pretty useless as there is generally huge volume both sides (except over economic figure releases).

Q. Could you enlighten me on the colour changes on Level 2? I can understand Blue = change up and Red = change down. But why change to Black?

I'm pretty new to Level 2, having only subscribed recently. Could you enlighten me on the colour changes? I can understand Blue = change up and Red = change down. But why change to black? Or is it just my computer screen?

A: Colour changes are only used on Level 2 for SEAQ (i.e. market-maker only) stocks. On SETS/MM (i.e. hybrid market-maker/order book) stocks and pure SETS stocks, black is always used. (Except on old Level 2, where unchanged prices on SEAQ and SETS/MM stocks are in green - much better contrast IMO, which is why I always use old Level 2).

In other words you only get what you're seeing with SETS (and SETS/MM) traded stocks for some reason. If you look at purely MM-driven stocks you only see the red/blue changes. Most of my trading is in MM-only-driven stocks so not sure why they use black elsewhere!

Hope this helps.

Q. On Friday i was trading avz and bought nearly 25000 at around 414p. Even though there were more buyers than sellers price dropped to nearly 400p then picked up.

Any explanation to this? By the way i sold most of them at around 430, nice profit, but even at that time buyer/seller ratio was 5 to 1!!!

A: What's happened here is you have bought into a share that's traded on SETS and without a look at the order books you have traded blindly by buying the stock. You might have seen...say a spread of 413-414p but there might have been very thin support below this 413p and thus if the buy orders were filled the price dropped quickly because of a lack of buy support on the books above 400p.

With SETS you have to instantly see what prices the big orders are at both sides of the book, this is what's called support and resistance whenever you read those words, unfortunately SETS can be manipulated very easily with orders placed and removed at will.

Q. If one puts in an electronic sell or buy at best and then cancels, do you think that this information is factored into the market?

If one puts in an electronic sell or buy at best and then cancels, do you think that this information is factored into the market? Presumably it gets to the MM's since someone comes back with an offer. Maybe we could test it by putting in a massive simultaneous buy at best one day when we are bored?
Little Miss Marketmaker - A bit like our old friend Mr. Treeshake, in fact...

A: I have it on good authority (from more than one dealer at Selftrade) that every single potential trade, including those "dummy" trades that many people such as myself make of, say, only 100 shares for the purpose of attempting to gauge the demand for a stock at any one time, can be seen by the market makers.

Furthermore, I have noticed on many occasions that when I test the market in this way - particularly when putting in a larger quantity of, say, a few thousand shares - Level 2 often changes straightaway; in particular, WINS may go up or down (depending on whether the dummy trade is a buy or a sell). Also, the dealing quantities are likely to change, seemingly as a result, so whereas the system might have accepted 5000 shares before, it will now only accept 1000 or even fewer.

Now, of course, it is impossible to prove that this isn't all down to coincidence. It's just that it has happened so many times that I think it is not. And furthermore, the price/dealing size nearly always change in a disadvantageous way - e.g. if I'm thinking about buying, and thus put in a dummy buy trade, the price goes up and/or Level 2 strengthens, and the buying quantity/improvement on offer price shrinks!

Which is why I now tend to be pretty cautious about putting in too many dummy trades for a share which I am very likely to want to buy or sell; and tend only to put in those small 100-share quantities as a test, as this is less likely to lead to the MMs changing their prices/cutting online dealing sizes in response.

This is what I've been told by dealers who I respect and trust; they visit market makers' offices from time to time, so I have no reason to doubt them. I suspect that MMs only watch dummy trades on shares that happen to be "active" at a particular time. A bit like our old friend Mr. Treeshake, in fact - MMs are not going to expend effort on shares that aren't moving/being traded much.

Q. Barclays - Market Makers will try to shake a few PI's into releasing their holdings sometime tomorrow before the share price moves above £1

A: Barclays is a SETs stock. There are no market makers. The price is determined by supply and demand in the order book.

Q. So how do Market Makers work? If I fill their 2000 or so order will they push the offer up?

Say they are offering 2k of stock @ 233 on the bid (sell order) side - if that goes the price drops to 230 ok? Equally a 2.5k purchase would push the offer price to 238 right? So is the bias towards the price dropping as there is less volume supporting it than the volume resiting the advance to 238? Does that make sense?

A: No, that's just the amount the Market Maker will sell you at the price...forget the amount of stock on Market Maker shares, it has no bearing. Watch the trades...if people buy then the price will go up but we don't know how many tranches of 2.5k the Market Maker has to offer so we don't know when.

 ...Continues here - Stock Market Workings

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