Understanding Level 2 and Market Makers

Market data includes various pricing information (such as the most recently traded price), and various volume information (such as the number of contracts that were most recently traded). Market data is available in two different levels, with level 1 providing the basic trading information, and level 2 providing some additional trading information.

Level 1 Market Data

Level 1 market data provides all of the trading information that most day traders need, including the following :

• Bid Price - The highest price that a trader is willing to pay to buy a contract (or share). This is the price that will be received for any market orders to sell a contract.
• Bid Size - The number of contracts (or shares) that are available at the bid price. When this number of contracts have been traded, the bid price will move down to the next highest price.
• Ask Price - The lowest price that a trader is willing to accept to sell a contract (or share). This is the price that will be received for any market orders to buy a contract.
• Ask Size - The number of contracts (or shares) that are available at the ask price. When this number of contracts have been traded, the ask price will move up to the next lowest price.
• Last Price - The most recently traded price. This is also known as the closing price, if it is the last price traded in the trading session (i.e. trading day).
• Last Size - The number of contracts (or shares) that were most recently traded.

Level 2 Market Data

Level 2 market data provides some additional trading information that is used with trading systems that follow the order flow, such as scalping trading systems or advanced volume based trading systems. The additional trading information includes the following :

• Highest Bid Prices - The highest five prices that traders are willing to pay to buy a contract (or share).
• Bid Sizes - The number of contracts (or shares) that are available at each of the bid prices. When each of these number of contracts have been traded, the current bid price (included with level 1) will move down to the next level 2 bid price.
• Lowest Ask Prices - The lowest five prices that traders are willing to accept to sell a contract (or share).
• Ask Sizes - The number of contracts (or shares) that are available at each of the ask prices. When this number of contracts have been traded, the current ask price (included with level 1) will move up to the next level 2 ask price.

Level 2 market data is also known as the order book. When orders are placed, they are placed through many different market makers and other market participants. Level 2 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, including the market depth. Knowing exactly who has an interest in a stock can be extremely useful, especially if you are day trading.

This is what a level 2 quote looks like:



This tell us that NSDQ has a bid of 20,500 shares of stock at a price of $5.49 and the right side tells us that NSDQ wants to sell 14,385 shares at a price of $5.50.

Now let's take a look at the market participants.

The Players

There are three different types of players in the marketplace:

• 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. In other words, the Market Maker buys and sells the stock to brokerage firms.
• Electronic Communication Networks (ECN) - It is an electronic system that brings buyers and sellers together for the electronic execution of trades. It disseminates information to interested parties about the orders entered into the network and allows these orders to be executed. 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).

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. The ax isn't always trading the stock in one direction or another. Sometime he is keeping it in a tight range and sometimes he is not there at all and another ax may step forward. Note that there are times where there is no ax present. The point is the ax is the one to watch closer than all other parties or MMs. Many day traders make sure to trade with the ax because it typically results in a higher probability of success. Note that the ax is not static. On any given day any party can be an ax, there may be one ax in the morning and another in the afternoon. If a big order comes onto the trading desk of a firm that doesn't do big volume in a certain name, the ax will take care of it and command the action. An ax can easily use an ECN to hide much of their action. They can and will use fake outs. Keeping an eye on Level 2 will reveal the ax.

Each market participant is recognized by the four-letter ID that appears on level II quotes. Here are some of the most popular ones: NITE, ETRD, SCHB, TDCM & ARCA.

NITE - wholesaler
SCHB - wholesaler
TDCM - retailer
ETRD - retail ECN
ARCA - an ECN

NITE : This is the king MM of the OTCBB. He intimides traders and other MMs use that to their advantage knowing that he scares them. That's why NITE is the shaker on most stock runs; he is the most common ax. NITE could be on the ask all the time, he could be leading a dip scaring sellers to SCHB and TDCM on the bid.

Other ECNs : ARCA, BRUT, BTRD, INCA, INTL, ISLD, REDI

Wholesalers : ETRD, HRZG, MASH, NITE, SHWB

Big Shorters : JIMK, POND, GNET or ARCA (anyone can use GNET, even other MMs because it's an ECN).

TDCM - retailer MM.

Top Retail Dilutors : ACAP, AGIS, BAMM, BMIC, CHIG, CLYP, FANC, FRAN, JIMK, MAYF, NATL, PERT, SACM, UCAP, VERT, VFIN

Biggest OTCBB ECNs : GNET, TRAC & DATA

• NASDAQ Market Maker List here
• OTC Bulletin Board Market Maker List here
• TSX Market Makers List here

Level 2 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 the level 2 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. It’s not easy to tell when these methods are applicable and when there is no real pattern:

• 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.
• Market makers also occasionally try to deceive other traders using their order sizes and timing. These types of orders are called NITBB or NITSO (No Intention to Buy Bid or No Intention to Sell Offer). When using this technique, the market participant displays a huge size greatly exceeding all others seen on Level 2. Most often it’s done in order to provoke traders to move in the opposite direction, as they are trying to undercut this big size or to get in or out “front running” this size.
  Example: If some player wants to accumulate shares at $5.90 while the market is at $5.98 x 10, he can try and display a huge size at $6.02, spooking traders into selling. Meanwhile our player places a bid for small shares at $5.90 with a reserve order for the amount of shares he needs, thus absorbing the selling. When he is done buying, he cancels his sell order. Of course this technique could now be used to propel the stock up. If a quick profit was the original intention of our player, he can do just that by selling his accumulated shares at a higher price. More often, this technique is used simply to accumulate shares when building big position. Needless to say, this can be done only on thinly traded issues – an attempt to do something like this on AAPL will be doomed. This also carries a certain risk – there could be someone attracted by big size to initiate or liquidate his position, and if that happens, our player will be stuck with big position against his original intention.A trader can try and use this situation for a scalp in the opposite direction, buying when the accumulation is done and big intimidating size disappears.A variation of this technique would be to drive a stock to a certain price level by following it with a bid or an offer which stays slightly away from the inside market and chases it as a price moves. If a stock trades at $5.98 x 10 and our player wants it at, say $6.20 to start unloading his position or for whatever reason, he displays big size at $5.93 for instance, and trails it higher as a stock moves higher but stays behind the best bid all the time.In both cases such a “fake” order is usually easy to spot given two signs. Firstly, such an order most often stays slightly away from the inside market. Secondly, if some trades are executed against this order, it usually disappears immediately.
• Using big order size for attraction is a directly opposite scenario. When a player has a big position to sell and he senses some buyers are looking for a size to buy, he can try and display big size in order to attract a buyer by opportunity to build his position in a single hit. This involves differentiation between this situation and the one we described earlier, when appearance of a big size will spook traders. An experienced trader working big orders usually possesses such skill (although he won’t be guarantied from mistakes of course).A trader can use this situation as an indication of some institutional interest in a stock. Considering that big institutional firms use a much longer time frame, there is no guarantee that a stock is going to move right away, but it’s worth keeping an eye on for signs of movement starting.
• There are cases when a big player interested in a stock, builds his position as a stock moves. There is already interest in a stock aside from his interest, maybe as a result of some news event. Trying to get as much shares as possible at more favorable prices, our player can apply combinations of methods described above. The player will show big sizes trying to cap the movement and provoke pullback which he will be using to accumulate more shares. The player will have to be very careful to avoid being “steamrolled’ by hot buying. As he maneuvers, his movements sometimes can be read. This is dangerous and fast game, for our player as well as for a trader that tries to utilize his moves. If he is using ECNs to mask his identity, this becomes even more of an art. Used in conjunction with chart reading, these observations can provide additional clues for timely entry and exit.
• 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.

Level 2 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 2 alone. Rather, he or she should use it in conjunction with other forms of analysis when determining whether to buy or sell a stock.