If you want to take your trading strategies to the next level, it’s time to dive headfirst into Level 2 market data.
For traders who want better insights into what’s happening behind the scenes of a stock’s price action, Level 2 data is a great addition to your tool kit. It can tell you who’s buying and selling a stock, where the price will move in the short-term, and at what price.
Though Level 2 market data is often an undervalued subset of technical analysis, it can be a powerful tool when incorporated into your trading strategies. In this article, we’ll cover the basics of Level 1 and Level 2 data, how they work, and how they can help you make informed and educated decisions.
Key Takeaways
- For most investors, Level 1 data will be adequate for their needs. However, for active traders and investors, Level 2 data will provide greater market depth and insights.
- Level 2 allows users to see the supply and demand of various securities, including volume, liquidity, and order sizes.
- There are three key market participants to pay attention to – market makers, electronic communication networks, and wholesalers.
What is Level 1 Market Data?
Generally, there are two subscription tiers for market data – Level 1 market data and Level 2 market data. Level 1 is typically free for users, while Level 2 requires a monthly fee paid to the platform you are accessing the information from. For example, Level 2 data currently costs $2.99 per month on Webull (as of December 2022). Level 1 data provides the trading information necessary to display charts of the price actions of different securities and the time and sales, or market trading information, of a market.
Level 1 data includes:
- Bid price: The highest price that an investor is willing to buy a security for.
- Bid size: The total quantity of a security that investors can purchase at the bid price, including the number of shares (for stocks), contracts (for futures), or lots (for forex).
- Ask price (aka offer price): The lowest price that an investor is willing to sell a security at.
- Ask size: The total quantity of a security that investors can sell at the bid price, including the number of shares, contracts, or lots.
- Last price: The price that the most recent transaction for a security was completed at.
- Last size: The number of shares, contracts, or lots traded in the most recent transaction for a security.
What is Level II Market Data?
While Level 1 will provide adequate information for most investors, Level 2 adds market depth and additional insights for active traders. Level 2 was first introduced as the Nasdaq Quotation Dissemination Service (NQDS) in 1983 and provides real-time pricing information from market makers.
With Level 2, you can see the supply and demand of various securities live, which gives you a visual representation of the price ranges and liquidity at each available price point. The supplemental information allows you to execute complex trading setups, including finding the best entry and exit points for different positions.
Note that Level 2 market data does not always accurately reflect price movement. It is simply a way to display the available price and liquidity of the market, or in other words, market momentum. Larger firms, such as Virtu Financial, Two Sigma Securities, or DRW, typically use high-frequency trading (HFT) programs to make investment decisions. These programs rely on complex models and algorithms to execute orders quickly, which can impact the bid and ask prices displayed on Level 2.
Level 2 data includes:
- Multiple bid prices: With Level 2, you can see the highest prices where investors have placed buy orders, meaning you can see the current bid and bids below it. In heavily traded securities, that allows you to see the bids for individual price increments, such as bids every $0.01 for large-cap stocks like Apple or Amazon. For securities with less volume or larger bid/ask spreads, you can see the gaps between each bid in real-time.
- Bid sizes: For each bid price, you can see the number of shares, futures, or lots that market participants want to buy. The higher the bid size, the greater the demand on the buyers’ side.
- Multiple ask prices: Similar to multiple bid prices, you can see the highest prices where investors have placed sell orders, meaning you can see the current ask and asks below it. Heavily traded assets will have smaller price increments for their asks, such as every $0.01 above the current offer. The gaps between the asks will be spaced farther apart for illiquid or low-volume securities.
- Ask sizes: For each ask price, you can see the number of shares, future, or lots that market participants want to sell. The higher the ask size, the greater the supply on the sellers’ side.
Most brokerage firms will give their users access to Level 2 at a low monthly fee. Currently, I have a free Level 2 Advance subscription with Webull from referrals and promotions. Since learning about Level 2, I’ve been much more invested in my stock portfolio as I can now easily see the supply and demand of different stocks and identify investing opportunities.
When you read a Level 2 quote, you may see four-letter IDs, which are codes for various market participants. For example, you may see MLCO (Merrill Lynch), MSCO (Morgan Stanley), GTSZ (GTS Securities), or UBSS (UBS Securities).
There are three main types of market participants, though their roles are not always cut and dry:
Market Makers (MM)
As their name indicates, market makers make the market. They are key players who provide liquidity. When nobody else is buying or selling in the market, market makers will step in to buy or sell the securities.
The most valuable market maker to watch out for is the ax, which controls the price action of any given stock. If you pay close attention to the Level 2 data for a specific stock, you can figure out who the ax is as they will consistently influence its price action. To increase their likelihood of success, most day traders tend to follow the behaviors of the ax.
Electronic Communication Networks (ECN)
Electronic communication networks are computerized systems that match buyers and sellers from different geographic areas who want to trade securities without involving a third party. With ECNs, investors get additional privacy and can execute orders outside of the traditional market trading hours. If there’s breaking news before or after hours, investors can quickly react to them via ECNs.
An example of an ECN is the Nasdaq market, which is a network of securities where traders can directly trade without needing to go to a physical location like the New York Stock Exchange on Wall Street. To trade with an ECN, you would need to subscribe to an ECN broker or open an account with one that provides direct access trading.
There are two fee tiers:
- Classic structure – The ECN charges a small fee ranging from $0 to $0.0015 to all market participants.
- Credit (or rebate) structure – The ECN pays liquidity providers a credit ranging from $0.002 to $0.00295 per share and charges a liquidity provider a debit ranging from $0.0025 to $0.003 per share.
Without ECNs, buyers and sellers would have a much harder time getting matched with each other, which increases the costs and risks of trading and makes it more difficult to time entries and exits for positions. However, ECNs are not free – they charge access fees and commissions. Additionally, anyone can trade through ECNs, including large institutional traders, who can hide their actions to make it harder for outsiders to anticipate their next move.
Wholesalers (Order Flow Firms)
Many brokerage firms, such as TD Ameritrade and Robinhood, sell their order flow to wholesalers (alternatively known as market makers) such as Citadel Securities and Virtu, in a controversial practice known as payment for order flow (PFOF). Under this system, these wholesalers will then execute orders on the online brokers’ behalf.
With payment for order flow, brokerage firms get compensated for routing orders to market makers like Citadel. Generally, they will make fractions of a penny per share as compensation, which adds up to billions of dollars in revenue annually. Since the GameStop saga in January 2021, PFOF has been largely criticized by many retail investors and traders who argue that this practice creates unfair disadvantages that prevent them from receiving the best executions for orders.
Why Use Level 2?
Level 2 market data gives you access to valuable information that can get leveraged to make profits. For example, you can identify trends and anticipate price movements by looking at the highest bid and ask orders. You can gauge institutional interest by looking at order sizes for a stock.
With Level 2, you can find out a lot about a given security:
- You can figure out what type of buying is taking place by looking at the type of market participants involved. Typically, large institutions and retailers do not use the same market makers, and one would be dominant over the other.
- Sometimes institutional players will try to hide their activity, so you can detect irregularities by looking at ECN order sizes. For example, if there is a buyout in process or accumulation taking place, institutional investors may try to keep their buying activity hidden from the rest of us through ECNs.
- Use the ax for reference when the price is trending. Though the ax’s goal is to provide liquidity to the market, they also have to make a profit. By using their movements as guidance, you can increase your chances of profiting alongside them.
- Look for opportunities between the bid and ask. When a strong trend is about to end, large traders will typically place orders in between the bid and ask to minimize potential losses.
3 Things to Look Out For
When using Level 2 market data, there are a few tricks to look out for from market makers.
1. Hiding Order Size
Market makers can hide their order sizes to prevent other traders and investors from getting scared off or finding out their next moves. When they want to unload or pick up a large order, they can split them up into smaller orders instead and update them as they get filled. For example, if a large trader wants to sell 600,000 shares of a stock, splitting them up into groups of 10,000 shares will prevent people from sounding the alarms and selling off their shares.
2. Order Sizes and Timing
Market makers can sometimes use their order sizes and timing to trick other traders. For example, they can strategically place a substantial offer for a security to bait short sellers to jump in, only to cancel their order and place a large bid instead. Short-sellers borrow shares from their broker to try to profit off of the price of an asset falling. So, this move will force shorts to cover, thus benefiting the market makers at their expense.
3. Trading Through ECNs
As we mentioned earlier, market makers can hide their trades, such as the actual size of their order, using ECNs. Because anyone can access ECNs, it can be hard to determine whether the orders are from retail or institutional investors and traders.
The Bottom Line
If you don’t plan on putting a lot of time and effort into investing, Level 1 market data will suffice. With Level 2 market data, it’s easy to get overwhelmed by all the information available, especially if you are a beginner. Additionally, most brokerage firms will charge a monthly subscription fee, which may not be worth it if you can’t take advantage of all the data.
However, if you plan on devising complex trading strategies, such as day trading or scalping, then Level 2 will be perfect for you. Make sure to incorporate the available information into your trading setups rather than using it in isolation. The key is to leverage this data to your advantage so you can make money and build wealth.
