Level II Quotes – Learn About Market Depth [Videos]
Level II Quotes
The Level II quote window provides data for pending orders in the market.
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.
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.
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.
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.
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.
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.
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.
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.
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.