Many traders are probably familiar with Wall Street lingo ”smart money” (commercial traders) and ”dumb money” (non-commercial traders). What might be less clear is the reason for the dichotomy and why it matters.
Traders often want to know where the smart money is flowing into or out of. The reason is ostensibly because professional traders tend to know the right time to enter or exit stocks while the novices are much less adept at the game.
In other words, professional traders in general are pros at buying low and selling high compared to the rest of the market players.
That might sound a bit condescending, but it’s actually backed by years of solid market data. Studies have shown that there’s a negative correlation between the Dow Jones movement and the number of short positions opened by commercial traders.
The DJIA usually falls when commercial traders increase their short positions and rises when they cut down their short positions:
Non-commercial traders, on the other hand, have the unfortunate tendency to buy high and sell low:
Level II Explained
If the smart money wins more often than not, it only makes sense to try and gain insight into what these professionals are buying and what they are selling. And that’s where Level II comes into play.
Level II is a subscription-based service that provides real-time access to order books for stocks in the tech-heavy Nasdaq exchange. Level II provides insights into a stock’s price action and tells the trader which traders are buying or selling which stocks and also gives a good feel of the open interest in a given stock.
Level II displays the demand and supply price levels for different stocks well beyond the National Best Bid Offer (NBBO). A trader can use this information to determine entry and exit points and also to check liquidity levels.
In contrast, Level I offers less in-depth information since only inside, best bid and ask prices are provided.
A Level II quote looks like the image below:
The quote tells us that UBS Securities has bought 5,000 shares @ $102.50. Note that the actual number of shares is arrived at by multiplying by a factor of 100.
Understanding the Market Participants
There are three types of players that operate in the stock markets:
- Market makers–these types of players play a special role by providing liquidity in the marketplace. They accomplish this by buying when nobody is buying and selling when nobody is selling.
- Electronic Communication Networks (ECN)–these are computerized order placement systems. Anybody, including large institutional players, can use ECNs.
- Wholesalers (order flow firms)–online brokers are mostly retail traders. Many brokers sell their order flows to wholesalers instead of doing it directly.
Level II market participants are identified by the four-letter ID at the beginning of the quote. Examples of popular market players include:
- UBSW–UBS Securities
- DBAB–Deutsche Bank Alex Brown
- FBCO–Credit Suisse First Boston
- GSCO–Goldman Sachs
- NMRA–Nomura Securities
Although there might be several market makers in action at any given time, the most important to watch out for is the ax. The ax is the market maker who dominates the price action. You can get a good idea who the ax is by observing the market for a couple of days. Many day traders trade with an ax so as to increase their chances of success.
Level II Benefits for Day Traders
Level II quotes provide a wealth of benefits for day traders. These include:
- The trader can discern when the big boys are in action because professional traders and large institutional players use different market makers than retail traders.
- Scouring through ECN order sizes for irregularities can give you a clue as to whether there are large buyers trying to use a smokescreen for their buying activity (suggesting the stock is in favor).
- Identifying an ax and trading with them can significantly enhance your odds of making a successful trade.
- Large traders frequently make trades between the bid and ask and take a small loss as a result whenever they need to get out of a stock in time before everything goes south. A high frequency of such trades can act as a warning to the trader that a strong trend is about to come to an end.
The Various Nuances of Level II Quotes
As with everything else in the stock markets, there are plenty of tricks and deceptions in Level II trading. Here are the most common:
- Hiding the size of the order
Many ECNs offer market makers the ability to hide the size of their orders so as to avoid moving the prices too much. These orders can take the form of reserve orders or hidden orders. This is common with big players who need to fill large orders.
For example, assume a trader wants to sell 500,000 shares. Displaying such a large order is likely to lead the bidders to thinking the seller is desperate and thus adjust their prices lower. The traders might therefore opt to display a reserve order for just 10,000 shares to give the perception of limited supply. The trader then fills the entire order in increments of 10,000 shares.
The converse applies when a trader wants to buy a large batch of shares.
Hidden orders work the same way as reserve orders but are invisible on Level 2, thus allowing for more discretion. A trader can determine whether an order is reserved or hidden by checking time and sale of particular orders at indicated prices.
- Baiting the shorts
Market makers sometimes try to deceive other traders using other tricks such as baiting the shorts. A market maker might place a large buy order in a bid to rope in short-sellers and force them to cover their shorts. The market maker then proceeds to pull the order and place a large bid.
- Hiding the trail
Large market makers sometimes use ECNs to hide their identity since it’s difficult to unravel who’s behind the trade i.e. either retail or institutional traders.
The bottom Line
Level II quotes can give the trader unique insights into a stock’s price action. It’s however strongly recommended that the trader supplement Level II data with other forms of analysis to avoid getting ensnared by the cache of tricks that are commonly employed by market makers.