Level II Quotes – Learn About Market Depth [Videos]

Level II Quotes

The Level II quote window provides data for pending orders in the market. [1]

It displays the size of the best bid and offers with their respective depths. Day traders use Level II to gauge the direction of the stock market over the short-term. When I say short-term, I mean seconds to minutes.

In this article, I will discuss the working parts of the level II within Tradingsim (currently in the final stages of testing).

Level II Window Structure

The Level II window structure is comprised of three key components: (1)  bid/ask window, (2) size of orders, and (3) depth.

Bid/Ask Prices

The bid/ask data contains the current bid/ask prices for the security across various exchanges.

The data is displayed in rows of what is known as the order flow. This order flow is also referred to as market depth and displays the best bids.

Market Depth

Market Depth

As you can see the spread or distance between the bid and ask are closer near the top of the order book.

Size of the Orders

The next key element is the size of the order which is displayed directly after the bid and the ask prices. This provides you with an idea of where traders are placing their orders which gives you some indication of their intent.

In the above image, the level 0 depth which is the first row, has 500 buy orders at 189.38 and 2300 sell orders at 189.39.

This means there are more traders looking to sell at higher prices. If you see the sell orders being gobbled up and the price is moving higher, this flow tells you that the longs are in control and are able to push the stock higher.

Depth Chart

The depth chart is the visual representation of the orders and their respective size. The color of the graph in the depth chart will match the color of the bid/ask data.

In Tradingsim the depth is represented with histograms within the Level 2 window. This provides you a clear view of the order size without having to review the numbers of the Level 2 table.

It's just much easier to see the red and green charts to gauge which way the market is moving.

Depth Histogram

Depth Histogram

Speed of Order Flow

At this point, we have discussed the structure of the Level 2 window, but now it's time to see it in action. In the below video I have taken a one-minute snapshot view of the order flow for the QQQ.

The QQQ is a popular security for day traders, so this will give you a good feel for the speed of the tape (a.k.a. Level 2).

When to Read the Tape

If you stare at Level 2 screens all day, you are going to get a headache. However, the best time to use L2 is at critical price levels. [2]

For example, if you are looking to buy a stock on a breakout, you can look at Level 2 to see the quality of the order flow to determine if a breakout has legs.

Now a key point to remember is a stock can show a sign of strength for a brief moment, but ultimately fail.

This is where you have to really watch the order flow to begin to "feel" the market. This, my friend, takes time and is not something that you can just pick up after watching the market for a few days.

Breakout Example

Check out this video of a breakout as a stock approaches a key resistance level. The video is short, but you can see that the order flow at the resistance level picks up and the asking price continues to spike higher as sellers look for higher prices to execute trades.

In the video, you will notice how the order flow accelerates at the breakout level and most importantly the price is able to hold this key level.

So, what was the result of this positive tape action at the breakout point, you guessed it, higher prices.

Follow Through on Breakout

Follow Through on Breakout

Now please do not look at this and assume all trades will work in this fashion. The key point from observing Level 2 is to gauge if the move is sustainable.

There is no exact method for making this observation. Anyone telling you that is oversimplifying the process of trading with L2. You will need to put in the hard work of observing market depth to assess signals from this off-chart indicator.

Where Level 2 Gets Tricky

Level 2 can prove challenging for the untrained eye. You see the orders flying, time and sales streaming and green and red histogram bars sliding in and out.

It's honestly a lot.

The other thing is large institutions are now using AI to send buy and sell orders. [3]

This can make it tricky to know if the orders in the depth are "real". This practice of placing fake orders is spoofing and is illegal. Here is a link from the CFTC that highlights a case where a firm was found guilty of spoofing. These regulations have helped, but there still is a bit of grey area around orders.

How to Combat the Robots

Let me first say there is nothing you can do to stop these fake orders. The best thing you can do is to not solely rely on the tape for your trading strategy.

Check out this great piece from tradingshools.org which touches on this subject of spoofing.

Order Flow with Thinly Traded Stocks

L2 is an awesome tool for stocks that trade with volume. However, stocks with light volume or wide spreads inform you little of where a stock is likely to trend.

This is because the L2 window will have little to no order flow. So, it becomes extremely difficult to use L2 as an effective forecasting tool.

How Can Tradingsim Help?

Tradingsim will begin offering and add-on for Level 2 data shortly. This will allow you to develop the muscle memory to master order flow to improve your trading results.

External References

  1. Jepsen, Lance. (2013). Level II Trading: Using Level II Quotes For Maximum Profit.
  2. What is Level 2 Trading? bullishbears.com
  3. Thomas, Mike. (2019).How AI Trading Technology Is Making Stock Market Investors Smarter — And Richer. builtin.com

Al Hill Administrator
Co-Founder Tradingsim
Al Hill is one of the co-founders of Tradingsim. He has over 18 years of day trading experience in both the U.S. and Nikkei markets. On a daily basis Al applies his deep skills in systems integration and design strategy to develop features to help retail traders become profitable. When Al is not working on Tradingsim, he can be found spending time with family and friends.
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  • I am trying to understand the intergration between level II quotes, time and sales box, and market depth and how all these interface with identifying market imbalances at the end of the day and how i can use all this information to improve my stock trading profitability

    is there any literature or real life examples you can recommend that can help with my questions. I am a a novice investor just started digging into info on the web and library november 2018. Is there also any relevance to knowing the amount and timing of block trades identified in the “dark pools”

    Reply

    • Hello – so there really isn’t a go-to piece of literature on the subject because it combines so many disciplines. You can watch youtube videos to get an idea of how it all ties together. I would recommend you start watching and recording the tape.

      While you can read about these concepts via blog posts, you really need to see the tape in action to develop a sixth sense of the action.

      Reply

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