Introduction to Level II Quotes

Level II can provide enormous insight into a stock's price action. It can tell you what type of traders are buying or selling a stock, where the stock is likely to head in the near term, and much more. Below, we'll explain what Level II is, how it works, and how it can help you better understand open interest in a given stock.

What Is Level II?

Level II is essentially the order book for Nasdaq stocks. When orders are placed, they are placed through many different market makers and other market participants.

Level II will show you a ranked list of the best bid and ask prices from each of these participants, giving you detailed insight into the price action. Knowing exactly who has an interest in a stock can be extremely useful, especially if you are day trading. 

Here is what a level II quote looks like:

This tells us that UBS Securities is buying 5,000 shares of stock at a price of 102.5. Notably, the number of shares is in hundreds (x100). Now let's take a look at the market participants.

The Players

There are three different types of players in the marketplace: market makers, electronic communication networks, and wholesalers.

Market Makers (MM)

These are the players who provide liquidity in the marketplace. This means that they are required to buy when nobody else is buying and sell when nobody else is selling. They make the market.

Electronic Communication Networks (ECN)

Electronic communication networks are computerized order placement systems. It is important to note that anyone can trade through ECNs, even large institutional traders.

Wholesalers (Order Flow Firms)

Many online brokers sell their order flow to wholesalers. These order flow firms then execute orders on behalf of online brokers (usually retail traders).

Each market participant is recognized by the four-letter ID that appears on level II quotes. Below are some of the more well-known ones.

The Ax

The most important market maker to look for is called the ax. This is the market maker that controls the price action in a given stock. You can find out which market maker this is by watching the level II action for a few days. The market maker who consistently dominates the price action is the ax. Many day traders make sure to trade with the ax because it typically results in a higher probability of success.

Why Use Level II?

Level II quotes can tell you a lot about what is happening with a given stock:

• You can tell what kind of buying is taking place—retail or institutional—by looking at the type of market participants involved. Large institutions do not use the same market makers as retail traders.
• If you look at ECN order sizes for irregularities, you can tell when institutional players are trying to keep the buying quiet (which can mean a buyout or accumulation is taking place). We'll take a look at how you can detect similar irregularities below.
• By trading with the ax when the price is trending, you can greatly increase your odds of a successful trade. Remember, the ax provides liquidity, but its traders are out there to make a profit just like anyone else.
• By looking for trades that take place in between the bid and ask, you can tell when a strong trend is about to come to an end. This is because these trades are often placed by large traders who take a small loss in order to make sure that they get out of the stock in time.

Tricks and Deception

Although watching Level II can tell you a lot about what is happening, there is also a lot of deception. Here are a few of the most common tricks played by market makers.

Hiding Order Size

Market makers can hide their order sizes by placing small orders and updating them whenever they get a fill. They do this in order to unload or pick up a large order without tipping off other traders and scaring them away. After all, nobody is going to attempt to push through a 500,000 share resistance, but if a persistent 10,000 share resistance is there, traders may still think it is a beatable barrier.

Order Sizes and Timing

Market makers also occasionally try to deceive other traders using their order sizes and timing. For example, JPMS may place a large offer to get short sellers on board, only to pull the order and place a large bid. This will force the new shorts to cover as day traders react to the large bid.

Trading Through ECNs

Market makers can also hide their actions by trading through ECNs. Remember, ECNs can be used by anyone, so it is often difficult to tell whether large ECN orders are retail or institutional.

The Bottom Line

Level II can give you unique insight into a stock's price action, but there are also a lot of things that market makers can do to disguise their true intentions. Therefore, the average trader cannot rely on level II alone. Rather, they should use it in conjunction with other forms of analysis when determining whether to buy or sell a stock.