Notes on Level-2.
Direct access is not possible without having a level-2 screen. The reason is that you wouldn't know how to address the counterparty. I do know of a trader who refused to learn the level-2 box, and who traded only with the SOES keys. So when only non-SOES type market makers were at the bid, he was unable to sell stock. It wasn't pretty.
Direct access allows you to arbitrage stocks. This means selling or buying a stock at a price which is immediately profitable. I have posted a description of how I once bought PGNS at about a $1 arbitrage on this thread, because of some technical features of the ISLD book, for instance.
Arbitrage also becomes possible when stocks have way too large price moves, though it then takes very fast fingers to take advantage of it. Very few traders will be able to do this profitably. (And I don't need you guys taking my trades away from me, so don't even try it.)
On very thinly traded, illiquid stocks, level-2 is very useful for determining who is buying and selling, up to a point. Sometimes the true buyer of a stock hangs back from the bid, but if you preference an order to him near the ask, he will take the shares. I have done this on stocks where a single market maker was running the price up, then letting it go up without him. If that market maker takes your shares when you preference him, it means he still has a way big buy order, and will probably have to keep running the price up. So try hard to pick up shares on pull backs.
But these examples are things that would be most useful to those with direct access.
So here are some uses of level-2 that ought to translate to the internet access crowd.
(1) Level-2 gives you some indication of how much the stock might move in the event that a few market makers pull away from the inside market. This can give you an idea of the risk reward. This is particularly useful when you bring up a stock that you have never traded before, because of a news report.
(2) When a stock is going up, level-2 sometimes tells me that the stock is very strong, and is likely to keep going up. The clue is to watch how quickly and fully the bid prices get filled by market makers. This is sort of similar to the previous paragraph, in that this also gives you an idea of how much support there is at the market.
The way I visualize the mechanics of the market is that the current market price is a ball that moves right when prices increase, and left when they decrease. (If I had the ball moving up and down, gravity would screw up my picture.) The limit orders are air resistance that slows down the ball. The ball has momentum, in and of itself, but air resistance will eventually slow it down. Incoming orders push on the ball, and the ball moves quickly or slowly accordingly as there are lots or few limit orders in the direction of the push.
Under normal conditions, when the ball moves one way, it leaves a partial vacuum behind it, and this tends to pull the ball back. But if you see air particles (i.e. market makers) filling back up that vacuum, this means that the ball is very likely to keep going in that direction for a while longer.
(3) Some market makers are very likely to have a lot more shares for sale than what they show, while others are quite unlikely. ISLD shows its true share size, while GSCO does not, for instance. This information gives you a better idea of how likely you are to buy the last shares available at a given level, if you are giving up the spread.
I should mention that I prefer to get the last shares at a price level, cause then the price is likely to immediately move in my favor.
(4) Some market makers in some stocks are almost amazingly badly traded. When you see those guys offering shares, you can modify your inclination to enter the trade on the other side. Similarly, certain market makers are amazingly good, and should incline you to trade the same way. Note that this behavior is not the same as allowing somebody else to give you trades, it is instead a matter of watching the market and noticing correlations.
Time for me to go to bed, I have to get up early.
Luck to all, lets see how many uses of level-2 we can think of. Oooh! Just thought of a great one! You can use it to impress people who watch you trading!
-- Carl |
