By: Alexander Voigt
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Level 2 Trading Explained for Day Traders

Level 2 data visualizes the full range of open orders in the order book, which makes the data valuable to day traders. Instead of seeing only the best bid and best ask on Level 1, traders get more detailed insights about the overall supply and demand.

Level 2 data can be used for reading the tape and interpreting tick data before chart setups are formed. This guide explains how to use Level 2 data for day trading stocks.

What is Level 2?

Level 2 is an advanced stock data view compared to the Level 1 data which only shows the best bid and best ask. Level 2 data shows the full order book to the trader in full depth.

At the same time, the term full depth is not entirely correct because the order book only shows the visible orders but not those flagged as hidden orders by the trader. Still, the available data is much more comprehensive.

Components of Level 2

Three main components make Level 2 data exceptionally useful, the market maker ID/name of the AXE, ECN or stock exchange, the bid and ask price of the stock at all levels, and the order size on each price level.

Market Maker ID (MMID), Name of the AXE, ECN or stock exchange

Day trading based on Level 2 data comes with a great advantage for traders since it is possible to specifically select an order route for each trade ticket. But what would it be worth if you select an ECN or market maker who does not offer any shares to buy and sell? Not that much!

That’s why the Level 2 data is so helpful. You see all bid and ask prices with their corresponding volume per level for each market maker. The column has the name MMID and is also a synonym for AXE, ECN, institutional trading desk or stock exchange.

The MMID always consists of 4 letters. If you see NASDAQ, then the liquidity is on NASDAQ. If you see BATS, it stands for “Better Alternative Trading System.” If you see ARCA, it’s Archipelago Exchange, etc.

Still, this information is only necessary if you want to use order routing. If you choose SMART routing, your order gets transmitted to the stock exchange with the best bid/ask for your order.

While the tape in the Level 2 order book is exceptionally well filled across multiple market makers, the liquidity can focus on specialized market makers when day trading penny stocks.

Price

On Level 2 you see the bid and ask quotes offered by each market maker. At the top is always the national bid and ask price (NBBO), which reflects Level 1, and below all market makers follow on the price levels where they can offer liquidity.

So, if you have an NBBO of $20.50 in the Bid and $20.51 in the ask, the Level 2 bids are $20.49 and below, and Level 2 asks at $20.52 and higher.

Size

The column size shows the number of shares available on each level. The important thing here is that a multiplier of 100 has to be used to evaluate the number of shares. So, if you see the number 1 undersize, then it means that 100 shares are available, and if you see 10, then 1,000 shares are available at that price.

Therefore, the size data reflects the available number of shares the market maker can offer right now. Still, if you see availability for a second, a second later, the order book might have already changed because orders were executed, canceled or modified.

Color Coding

The color coding differs depending on the direct access platform used, but typically you have 6 different color codes:

  • Quote change without trade execution: Sometimes, market makers change quotes faster than a trade executes.
  • Trades below the inside bid: If a market participant sells high order size and transmits it as a market order, he’s aggressively selling, which can cause the price of the entire execution is below the best visible bid.
  • Trades at the inside bid: If a trader sells an order size that can be matched with the inside bid size, the order gets executed at the bid.
  • Trades between the inside bid/ask: If hidden orders are placed between the visible bid-ask prices, the order can get a better fill price somewhere between the NBBO.
  • Trades at the inside ask: If a trader buys an order size that can be matched with the inside ask size, the order gets executed at the ask.
  • Trades above the inside ask: If a buyer routes an aggressive buy order on a high volume market to the order book, the order can get filled above the previously visible ask price when the order volume of the market maker is not high enough to execute the buy order of the trader.

How Much Does Level 2 Data Cost?

The price of Level 2 data depends on the included exchange data and broker. If you need Level 2 data for U.S. listed stocks, it costs about $10 per month, while NASDAQ Total View, which reflects the most complete order book, costs about $15 (web-based) to $50 (trading platform integrated) extra for retail traders, while institutional traders pay $400 and more for the data per month (for example with NASDAQ Workstation).

The Hidden Order Problem

While Level 2 data and NASDAQ Total View are the most complete order books available, they don’t reflect 100% of all orders.

  • First of all, dark pool orders are not visible in the order book. You can’t trade on dark pool liquidity and don’t see what is traded on dark pools since they are not required to provide information in real-time.
  • In addition, all hidden orders are, as the name suggests, hidden. So, while the liquidity of hidden orders is there and a trade can be executed at the price of a hidden order, you don’t see the market maker ID, price and size of hidden orders.

But even if you can’t see 100% of the market liquidity, you see much more compared to the Level 1 NBBO (national best bid and offer).

How Level 2 Trading Works

Level 2 traders primarily focus on the order flow within the order book. This practice is called tape reading. By watching the tape, Level 2 traders try to identify support and resistance levels only based on price.

Level 2 traders don’t really care about stock charts and news. So, while those things can be combined, they distract from reading the order flow appropriately.

The Level 2 trader mainly uses hotkeys or one-click trading to transmit orders. Orders can be transmitted, modified or canceled with one click of a button. An order book trading platform also has buttons to immediately reverse positions from long to short, or short to long, or to sell partials of existing positions.

The rush and adrenalin are at a high level with order book trading, which reduces the number of people who enjoy trading on Level 2 due to the enormous stress level.

Level 2 Trading Conclusion

Level 2 trading is lightning fast and mainly used for day trading, scalping stocks, and futures contracts. For other financial assets like options and currencies, Level 2 trading does not work, either because of missing quotes or lack of liquidity.

Chart-based trading, automated trading systems and algo trading via software are much more popular than Level 2 trading. Also, these days, the insights a trader can gain by tape reading are less helpful now than 20 years ago.

Technical analysis-based day trading strategies like the opening range breakout, gap and go strategy and the 3 bar play pattern can be greatly combined with level 2 trading patterns and serve as a filter for trades, or to evaluate reasonable stop loss levels.

Alexander Voigt, CEO
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Alexander Voigt is the founder of DayTradingZ, was a regular contributor to Benzinga and has been featured and quoted on leading financial websites such as Investors.com, Capital.com, Business Insider and Forbes.