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Level Two Basics




MTrader Class (C) copyright MTrader 

August 15, 2003
by Matt and Mike from Shoreline Trading

[09:29] <KenWolff>  today we are priveleged to have matt consent to doing a class on executions..
[09:30] <KenWolff>  welcome Matt from shoreline trading... take it away!!
[09:30] <whale> clapclapclap
[09:30] <shoreline-matt> ok..away we go..This class is a precurser to Whales class about what he looks for when trading.
[09:30] <shoreline-matt> this is the class on Level 2.
[09:30] <whale> huh?
[09:30] <whale> lol
[09:31] <shoreline-matt> It will tell you the very basics of the level 2, why and how it works. 
[09:31] <shoreline-matt> As I am sure many of you know, the Level 2 is basically an in depth view of all the quotes for OTC stocks.  And slowly it is incorporating listed stocks as well.
[09:31] <shoreline-matt> The Level 1 quote is basically just the bid and offer for a stock and the size of the bid and offer.  It might look like:
[09:31] <shoreline-matt> MOT  35.30 - 35.32  200x300
[09:32] <shoreline-matt> The level 2 is entirely different. 
[09:32] <shoreline-matt> The reason for the difference is that the Level 2 was created to show the market for OTC stocks. 
[09:32] <shoreline-matt> The Level 1 quote was created to show the market for listed stocks
[09:33] <shoreline-matt> Because listed stocks trade or actually traded (before the creation of ECNs) in one centralized location, you always knew that it was the specialist showing the market
[09:33] <shoreline-matt> Meaning, if MOT was bid 35.30, you knew that you had to go to the NYSE specialist to sell it at 35.30.  He was "the man."  If you wanted to trade MOT you had to go to the MOT specialist.
[09:34] <shoreline-matt> The OTC market works differently
[09:34] <shoreline-matt> It does not have a centralized location with a specialist.  Instead it has Market Makers and ECNS. 
[09:35] <shoreline-matt> These MMs and ECNs create a "virtual market"  This means that it is a combination of many bids and offers that make up the market. 
[09:36] <shoreline-matt> OK..So to explain this, maybe Goldman Sachs (GSCO on the level 2)has a bid of 51.50 for INTC but their offer is 51.60. Andů
[09:36] <shoreline-matt> Bear Stearns (BEST on the level 2) has a bid of 51.45 for INTC but their offer is 51.55.
[09:37] <shoreline-matt>  Looking at these two quotes, if we want to Sell INTC all we care about is the highest bid. 
[09:37] <shoreline-matt> Obviously if you want to sell something you want to find the person who is willing to pay the most for it.  This is GSCO who is bidding 51.50
[09:37] <shoreline-matt> Got that?
[09:38] <shoreline-matt> Makes sense right?
[09:38] <KenWolff>  yep
[09:38] <shoreline-matt> If we want to buy INTC all we care about is the lowest offer.
[09:38] <Gimmie>  (OTC = over the counter stocks.. or over the computer. Stocks listed on exchanges like the New York Stock Exchange are traded face to face, in "trading pits. All others are OTC stocks, like the Nasdaq stocks.... case anyone was wondering what he meant)
[09:38] <Eubac> or post it at the ask
[09:38] <shoreline-matt> Obviously, if you want to buy something, you want to find the person selling it for the least amount. This is BEST who is offering INTC at 51.55
[09:38] <shoreline-matt> Thanks Gim
[09:38] <Gimmie>  :-)
[09:39] <_dan> question...
[09:39] <shoreline-matt> Go ahead Dan.
[09:39] <_dan> goldman had a bid and offer??
[09:39] <shoreline-matt> Yes...All MMs have both a Bid and an Offer
[09:40] <_dan> ok
[09:40] <shoreline-matt> But his offer was too high for us so we dont care about that.  All we care about is his bid
[09:40] <shoreline-matt> Therefore the "inside" market is 51.50 (GSCO) - 51.55 (BEST)
[09:41] <shoreline-matt>  As you can see, we want to use the "inside" market to get the best fills possible.
[09:42] <shoreline-matt> Now imagine instead of 2 MMs there are 50 along with 7 ECNs.  It would make finding the National Best Bid and Offer (NBBO) very difficult. 
[09:42] <shoreline-matt> NBBO = inside market
[09:42] <shoreline-matt> That is what the level two does. 
[09:42] <shoreline-matt> It compiles all the quotes form various MMs and ECNs and puts it into a form that Is easily and quickly understood.
[09:43] <shoreline-matt> OK.  So looking at a level two, you might not be able to see how all the information I just gave you fits into those lovely colors there. 
[09:43] <shoreline-matt> The first thing you  see is that somewhere on the level 2 should be the level one quote.  Remember that is just the "inside" bid and offer and the size for each. 
[09:44] <shoreline-matt> On REDI Plus this is found at the top of the Level 2.  Along with some other info such as volume, high, low, change and percentage move. 
[09:44] <shoreline-matt> As you can see, the level 2 portion of this box is split into 2 sides.  The bid side and offer side
[09:45] <shoreline-matt> The bid side is on the left and the offer side is on the right.  The best (highest) bid is on the top of the left side.  And the best (lowest) offer is on the top of the left side.
[09:45] <shoreline-matt> Each color is a different level.
[09:45] <shoreline-matt> Meaning...One color will be all the .32 bids.
[09:46] <shoreline-matt> The next color willbe .31 bids.
[09:46] <shoreline-matt> and so on.
[09:46] <shoreline-matt> Generally the same color will be used for the best bid/offer.
[09:46] <shoreline-matt> Then another color for the next best bid/offer.
[09:47] <shoreline-matt> I said the best (lowest) offer is non the rop left..but it is on the top right.
[09:48] <shoreline-matt> So.  as you can see..the top line of the Level two matches the level one quote
[09:48] <shoreline-matt> Moving down the left side, we see that the bids get lower and lower. (outside market). 
[09:48] <shoreline-matt> Moving down the right side, we see that the offers get higher and higher
[09:49] <shoreline-matt> You might think that there is no reason to show this but many traders feel that this is very important.
[09:49] <shoreline-matt> Why you ask?
[09:49] <shoreline-mike> yes, why?
[09:49] <shoreline-matt> Thanks
[09:49] <KenWolff>  why?
[09:49] <Gimmie>  why ?
[09:50] <_dan> where
[09:50] <shoreline-matt> Well, I don't want to step on Whales toes because I know he is going to talk about what he looks for in the level 2 but...
[09:50] <shoreline-matt> for many traders the level 2 is important because it shows a possible direction in the market and it gives a decent picture of where some support and resistance is. 
[09:51] <shoreline-matt> For instance, if you are looking at the level 1 quote and see INTC 34.20 - 34.22 200x300.
[09:51] <shoreline-matt> You see that there is 20K bid for at 34.20 and 30K offered at 34.22
[09:51] <shoreline-matt> Looking at the level 2 you see INCA bidding 34.19 for 240K shares behind the best bid of 34.20. And ISLD offering 10K shares at 34.24 behind the best offer of 34.22. 
[09:52] <shoreline-matt> Notice that the next best bid is for 240K shares and is only 1 cent behind the best bid
[09:52] <shoreline-matt> The next best offer is for only 10K shares and it is 2 cents behind the best offer
[09:52] <shoreline-matt> This would indicate to many traders that there is strong support and not too much resistance at these levels.  It might help you choose and entry or exit point. 
[09:53] <shoreline-matt> Unfortunately, with the introduction of hidden orders or display orders, many times it is hard to get the full picture of support/resistance and who is where on the level 2.
[09:53] <shoreline-matt> It also lets you see who the bid or offer is.  Many traders place more emphasis on a particular ECN or MM.  This is something that might not have as much value as it used to but it is still a valuable tool.
[09:54] <shoreline-mike> the ECNs enable traders to enter "hidden" orders
[09:55] <shoreline-mike> so if you have 5,000 shares to buy..but only want to show can so you don't show strength
[09:56] <shoreline-matt> Also, with the advent of direct access trading you are able to direct your trade top a particular ECN or MM.  The level 2 helps because now you know exactly where to send your trade. 
[09:56] <shoreline-matt> Of course you would not want to send an order to GSCO when ISLD was the best price.
[09:56] <shoreline-matt> With the level 2 you know where to send your orders.  This increases the speed and productivity of your executions
[09:57] <shoreline-matt> REDI Plus utilizes a new order routing system called SIGMA
[09:57] <shoreline-matt> This system automatically routes the order directly to the best bid or offer so you don't have to make the decision. 
[09:57] <shoreline-matt> It uses the information from the level 2 to decide where to send the order
[09:58] <shoreline-matt>  So if INCA is the best offer and you are buying the stock at the market, SIGMA will send the order direct to INCA.  If the best offer is GSCO, SIGMA will supersoes GSCO. 
[09:58] <shoreline-matt> So that is the basics about Level 2. 
[09:58] <shoreline-matt> Does anyone have any questions
[09:58] <shoreline-mike> how about limit orders?
[09:59] <shoreline-matt> Good question Mike.
[09:59] <Eubac> I think you should say where all those bids and offers come from
[09:59] <shoreline-matt> With limit orders, the Level 2 enables you to post a bid or an offer and let the whole level 2 world know about it.
[10:00] <shoreline-matt> This means unline the days of old when you would give your order to a broker and he would fill it where and when he wanted you can post your bid or offer to the world and let individuals make a decision about whether or not to fill your order
[10:01] <shoreline-matt> Eubac.  All the bids and orders come from several places.
[10:01] <Eubac> I think you're answewring, they come from limit posts
[10:02] <shoreline-matt> If it is a MM bidding, then that bid could come from one of the traders for the market maker or from a customer order that the MM holds.
[10:02] <shoreline-matt> On an ECN, that order most likely comes from a clinet of a Brokerage Firm that has access to that particular ECN.
[10:03] <shoreline-matt> OK...Any other questions?
[10:04] <kflaig> matt, do you have any idea of why big traders often use INCA, BTRD and BRUT when their commissions are higher than ARCA's
[10:04] <shoreline-matt> INCA had a head start because they were the first real ECN.
[10:04] <kflaig> do they get a better deal than we do?
[10:04] <shoreline-matt> As you know, it is hard to get traders to stop using something they know and like.
[10:05] <shoreline-matt> No Most likely they do not get a better deal.  Some brokers might get a better deal if they direct their orders to a particular ECN.
[10:05] <shoreline-mike> also depends on the stock they are trading kfliag..maybe they feel a certian stock has more liquidity on a certain ecn
[10:05] <shoreline-mike> i've seen that before
[10:06] <spar> Is there a difference in cost to you when you post a Limit order or if you directly get a bid/ask already on L2...?
[10:06] <shoreline-mike> and inca and brut just lowered their you'll see the $ difference disappear
[10:06] <kflaig> yes, getting hit is cheaper than hitting
[10:06] <shoreline-mike> correct kflaig
[10:07] <Eubac> how so?
[10:07] <kflaig> no ecn fees when adding to liquidity for ARCA at least
[10:07] <shoreline-matt> Spar.  The cost difference comes when you execute whether or not you are viewing hte level two.  Remember the level two is just a quote monitor it is not an execution tool  although in some software like REDI Plus you can execute from the level 2 for speed.
[10:07] <shoreline-mike> some ecn's, a rebate for adding a limit order to their ecn
[10:08] <Eubac> thx
[10:08] <shoreline-matt> They do this to promote use of their ECN.
[10:08] <shoreline-mike> the rebate, kflaig, is another reason why certain ecn's are used over others
[10:08] <kflaig> makes sense, thanks
[10:09] <spar> thx guys
[10:09] <shoreline-matt> Anything else?
[10:09] <shoreline-matt> I will be around for the class that Whale gives if any questions pop up there as well.
[10:09] <spar> awesome, appreciate it matt & mike....
[10:09] <whale> thanks guys
[10:10] <Eubac> is whale today
[10:10] <jerry> thanks matt and mike
[10:10] <shoreline-matt> Monday..right whale?
[10:10] <shoreline-matt> You are welcome guys.
[10:10] <_dan> thanks guys
[10:10] <whale> i think so...or tuesday
[10:10] <Eubac> thx, shoreline
[10:11] <mks> thanks! matt
[10:11] <shoreline-matt> Good Trading guys and gals.
[10:11] <shoreline-mike> we're always in the room if anyone needs further info
[10:12] <Gimmie>  Thank you Matt !!!!
[10:12] <KenWolff>  thanks Matt!!!!
[10:12] <Gimmie>  great class !!!!!!!
[10:12] <kflaig> thanks Matt
[10:12] <jbeever> taa matt
[10:12] <KenWolff>  excellentaaaa
[10:14] <_dan> one question
[10:15] <shoreline-mike> hey dan
[10:15] <_dan> want to be sure i have this right. looking at L2. with reguards to pressure...
[10:15] <shoreline-mike> ok..what symbol
[10:15] <_dan> more concerned with the overall or just more on inside bid or ask?
[10:16] <_dan> L2 =level 2
[10:16] <shoreline-mike> ok
[10:18] <shoreline-mike> "overall or just more on inside bid or ask"...depends....
[10:18] <shoreline-mike> if you view the might see large size bids, for example..which you might see as strenght
[10:19] <shoreline-mike> the same is is tru for large size offers..which you might see as weakness
[10:19] <shoreline-mike> but
[10:19] <shoreline-mike> remember what i said about hidden orders
[10:20] <_dan> yep
[10:20] <shoreline-mike> there cab be larger bids and offers out there that you don't see..which would distort the concept
[10:21] <shoreline-mike> block traders might not want to tip there hand
[10:21] <_dan> so do you realy look at that guys.  is that what whale is gonna speak on?
[10:22] <shoreline-mike> looking at L2 is just one part of the overall puzzle....
[10:22] <whale> yeah Dan...over time you start to get a feel for hidden orders
[10:22] <_dan> ok
[10:23] <_gunsmoke> yeah like sometimes you see an order go through that you did not see on level 2? or..
[10:23] <_gunsmoke> was not between the bid/ask spread (inclusive)
[10:23] <shoreline-mike> correct gun..and a reason for that can be...
[10:24] <shoreline-mike> orders can be completely show no quote at all..but have the system always keep it just above the bid (for example)
[10:24] <shoreline-mike> until you are filled
[10:25] <shoreline-mike> now keep in mind when looking at Time of Sale and L2..they might not always be insync, because.....
[10:26] <shoreline-mike> brokers have 90 seconds to report trades to the tape
[10:26] <shoreline-mike> now...most brokers report instanatneous
[10:26] <shoreline-mike> some might not
[10:27] <_gunsmoke> this gives them an advantage or is this just a technology vacuum?
[10:27] <shoreline-mike> so if you see fills going off Time of Sales at...35,35,35,35 and then 30...the 30 might very well be a late report (or a bad fill)
[10:27] <_gunsmoke> the not reporting for 90 I mean
[10:28] <_gunsmoke> so time of sales is more os apre-post market tool?
[10:28] <shoreline-mike> actually gun more has to do with the broker and how he reports them..we are electronic so it's quick..others might be hand done
[10:28] <shoreline-mike> not necssarily, gun
[10:28] <_gunsmoke> sounds like it's not reliable for real-time trading
[10:28] <shoreline-mike> no agian
[10:28] <shoreline-mike> it's very valuable for real-time
[10:29] <shoreline-mike> these late reports are more the exception then the norm
[10:29] <shoreline-mike> you just need to be aware of them
[10:29] <_gunsmoke> gotcha - so a reasonble picture can be consructed
[10:29] <_gunsmoke> from TOS
[10:29] <shoreline-mike> correct
[10:29] <shoreline-mike> yes
[10:30] <shoreline-mike> L2..just another part of the puzzle
[10:30] <_gunsmoke> I'm sorry I was not here - are all the pieces of the puzzle discussed in this transcript?
[10:30] <shoreline-mike> we just went over L2
[10:31] <_gunsmoke> I'm referring to a trading screen
[10:31] <whale> hmm
[10:31] <_gunsmoke> I guess I'd like to know the ideal componenet I should have in view at all times when trdg
[10:31] <_gunsmoke> components
[10:32] <shoreline-mike> have charts, news..even the comments made in the chatroom..all parts of the puzzle..tough to have an "ideal"'s going to take time to develop one
[10:32] <whale> the idea to be as well informed as possible
[10:32] <_gunsmoke> but there are core pieces that everyone has
[10:32] <whale> information is you want as much as you can personally process...
[10:32] <_gunsmoke> and there is consensus that it is not ...
[10:32] <_gunsmoke> wise to trade w/o
[10:32] <whale> everyone is different...but level 2 is rudamentary
[10:33] <whale> cant trade like this without level 2
[10:33] <_gunsmoke> totally agree
[10:33] <whale> its just too have to see whats going on
[10:33] <_gunsmoke> something like charts though - real -time or offline tool
[10:33] <_gunsmoke> those are the questions I have
[10:33] <_gunsmoke> types of questions'
[10:33] <whale> for some..its too complicated....but they should be more interesed in learning it..than shutting it off
[10:34] <whale> real time EVERYTHING
[10:34] <whale> would you go to war with a handgun and a grenade?
[10:34] <whale> you want the best tools available
[10:35] <_gunsmoke> no -gimme the heavy artillery
[10:35] <whale> very smart people are using these tools...and they want your money
[10:35] <_gunsmoke> just need to knwo what it all is
[10:35] <whale> so arm your prepared for the learning ...and go




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