By Doc Maher
Level II quotes are often a topic of hot debate among traders. So I am not surprised by the questions I received about it from a recent post regarding order execution. Sometimes the more volatile the market, the more people may gravitate to extra bells, whistles, and other features to bolster their confidence when trading. Are these extra tools really that helpful?
Let’s begin with a definition. Level II quotes are real-time quotes of the bid and ask prices for each individual market maker for a given NASDAQ or OTCBB stock. (See diagram below.) These quotes include bid and ask prices that are away from the current market price. This means that you can see bids that are lower than the current bid price plus offers that are above the current ask price. This is also known as market depth. Some traders feel that market depth provides an advantage when making trading decisions so let’s begin with a few questions.
Can traders make sound trading decisions based on information from Level II quotes?
Does having Level II quotes provide an advantage when trading in the market?
In my estimation, Level II quotes are not very useful because the market makers are able to hide their full intensions from the rest of the public. Market makers have Level III access – that is they post a bid and an offer directly to the system (plus execute orders, etc.). You and I may only affect the bid or ask price by placing an order through our broker.
In order to participate as a market maker, one must post a bid and an ask. However market makers are not obligated to fully disclose the size of the bid or offer. So in order to hide their intensions, they may opt to display only 100 shares on the bid side even though they want to buy 10,000 shares. The reason is obvious - if they display the full amount desired, everyone will know what they plan to do and that information could then be used against them. Simply displaying a large bid size may cause the stock to start moving higher. Therefore market makers are very cautious about how much information they display.
In my opinion, very little edge can be gained from the use of Level II quotes. The reason is that the quantity that the market making firm posts is most likely not accurate. In fact the information they disseminate on Level II may be intended to mislead anyone who sees it. Because the information is incomplete, it is therefore suspect and may lead to misinformed decision making.
Click the image to view more detail.
Let’s revisit the Level II table (image above) that I included for Microsoft in the original post. You can see that some of the bid prices have been there for quite some time. This means several minutes. FBCA has a bid of $55.73 for 100 shares shown at 01:31. The current time was apparently 01:45 or later. There is only one bid higher, INCA $55.74 for 700 shares. At the volume that MSFT trades if there were only 700 shares ahead of FBCO’s bid, there is very little chance that it would have lasted 14 minutes. Most likely what is happening is that the bid of $55.74 is being refreshed constantly because there are more than 700 shares sought at that price. The problem is that the quantities that are listed are not accurate and anything that we try to glean out of them is not going to be helpful.
Having said that I know people that claim that they can read through all that confusion and figure out what’s going on. They claim to be able to detect when big players keeps refreshing their bids or offers and to be able to tell if they are trying to buy a large quantity or sell one. I can’t do this myself and I have never seen anyone actually do it reliably. However I imagine that it could be done.
In the next post I will discuss some differences between the NASDAQ and the NYSE and provide some comments on streaming quotes.
"Income Trader"
Doc's previous posts: Three Factors that affect Execution Price and Understanding the Balance Sheet
Click here for a list of previous TradeKing All-Star blogs.
Nicole Wachs contributed to this post.
Any strategies discussed and examples using actual securities and price data are for educational and illustrative purposes only and do not imply a recommendation or solicitation to buy or sell a particular security or to engage in any particular investment strategy. In reading content in the Community, you may gain ideas about when, where, and how to invest your money. Although you may discover new ideas or rationale that may be compelling, you must ultimately decide whether or not to put your own money at risk. Consider the following when making an investment decision: your financial and tax situation, your risk profile, and transaction costs.
Jonathan F. Maher, PhD has a professional business relationship with TradeKing.
