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Why you need Level 2 Market Information

by Clem Chambers MD of ADVFN

Level 2 market information is as close as you can get to the stock market's inner workings. When prices move, there is market action. Level 2 pulls back the veil so that the components of a price move are revealed. Apart from being fascinating in its own right, it is hard to imagine how anyone could perform short term trades without this information, especially when you consider this extra depth of data is enjoyed by market professionals on their Reuters' and Bloomberg terminals and private investors through web services like ADVFN

Clearly without Level 2, a trader is trading at a disadvantage. Even a long term investor can benefit from the insights that Level 2 can offer when it comes to entering or exiting the market.

What follows is a brief exposition of London Stock Exchange Level 2 which covers the basics.

The London Stock Exchange is the central collection point for share pricing in the UK. Whenever a bargain is struck with for a share, the price and trade is relayed to the LSE, as the London Stock Exchange is called, collated and retransmitted to all parties connected directly or indirectly to the LSE.

There are two main levels of price information currently transmitted by the LSE. Level 1 and Level 2. Within these levels are contained different types of information. Level 1 contains the price, bid and offer, volume and trade information. From this a receiver of Level 1 information can see trades that have been made and know what the current price of a share is in the market. If the stock market were a Play, Level 1 is the view from the audience.

Level 2 on the other hand is different, it shows the behind the scenes state of the market. While Level 1 information such as price can be extracted from Level 2 information, Level 2 actually shows what is going on in the market itself. This state of the market is shown by what is called the order book in SETS and the Market Maker quotes for SEAQ. SETS and SEAQ make up Level 2.

SETS and SEAQ are two different subsystem of the LSE system. Broadly speaking SETS is for Big company stocks with high volumes of trade in their shares, while SEAQ is for smaller stocks which trade less regularly.

SEAQ is a modern form of the old 'jobber' system, where stocks and shares would be bought through a wholesaler who stood on the stock market floor and held a 'book.' A broker would go between jobbers and ask for their prices. SEAQ in effect saves the legwork.

This 'jobber,' now know as a market maker, makes his money on the Spread. This spread is the difference between BID and OFFER and represents a margin between what he buys at and what he sells at. Just like a wholesaler, he buys low and sells high. In theory he is just a simple facilitator of the market, but as we will see later there is a lot more to Market Making than meets the eye.

When you buy a share your broker will contact a market maker by either calling him up or entering an order on an automated system like BESTWINS a computerised market making system run by leading market maker Winterflood Securities. In effect the Market Maker is acting as a small LSE. However there are other Market Makers competing for the Bid Offer profit margin. All the Market Makers are linked together by the stock exchange electronically and therefore compete as they once did on the floor of the LSE itself.

The LSE is the marketplace containing Market Maker markets and it is the umbrella of the stock market that bring them all together into a single environment.

SEAQ is the electronic summary of the state of all Bids and Offers available on a stock made by the Market Makers on a particular stock. Some shares have a dozen market makers, some microcaps have only one.

On Level 2, the Bid and Offer for each market maker is shown, as well as the size he will buy or sell in. Every company as a NORMAL MARKET SIZE, which is an amount set by the LSE and applied for by market makers, that sets a level of a trade above which they can refuse to deal at the quoted price. For a big SEAQ quoted company this can represent an order of £30,000 pounds of stock or in a very small company a mere £100. However normally the size a Market Maker will deal in is set above this so called NMS, but in times of sharp price movements the NORMAL MARKET SIZE can be invoked.

Looking at a SEAQ screen with several market makers on it you can see that not all MM's are what is called 'ON THE BID' or 'ON THE OFFER'. This means they are either quoting to buy a stock at a lower price than other market makers or willing to sell the stock more expensively than other market makers. If they are 'off the BID or OFFER' it means in effect they do not want 'to deal,' i.e. want to trade, the share at this current price. When an investor wants to buy a SEAQ stock, his broker calls a market maker and sells or buys the stock from him. The details of the transaction are then send to the LSE, which are then registered as a trade. As an order is executed a Market Maker may the want to move his BID and OFFER price, with other Market Maker following suit or not as the case maybe.

It is the state of the positions of market makers and their changes, that help traders and investors discern the overall state of the market in a SEAQ stock.

SETS is an automated market maker run by the stock exchange. It is the market for big stocks in the UK. While there are human market makers in SETS stock, they are in effect trading in the SETS market rather than providing their own sub market. SETS is an evolution from the old system of 'jobbers,' who stood and the floor of the stock exchange and served brokers who served clients. While SEAQ can be visualised as bringing the jobbers together on one screen, SETS can be imagined as one of their ledgers where everyone is free to enter bids and offers, which are matched if possible. The operation of SETS is automated and as such more efficient. Unlike a market maker it can not be negotiated with.

The old system of participants on a trading floor was seen as restricted by physical space and a cause of inefficiencies. A move to electronically disembody the stock exchange pushed the operation out of the exchange itself and used communications to collect up the information at the LSE, from where it redistributes it back out to the market, which was now decentralised. The floor of the LSE has long since gone.

This and particularly the introduction of SETS was aimed to increase efficiency and drive down transaction costs such as the size of the spread. An automated market needs a lot of trading interest, known as liquidity, passing through it, to work effectively, so only the biggest stocks are included as SETS stocks.

SETS stocks are shown by Level 2 as an order book. This electronic book has two columns. Sell orders and buy orders. These orders are Bids to buy and Offers to sell. Rather than 4 market makers making 4 bids and 4 offers, the order book represents registered offers and bids at a selection of prices from who ever has access and a desire to transact. It is as if there were scores and scores of market makers operating. Orders are placed in the book or removed, buys and sells transacted, by brokers, market makers, traders and private individuals directly. As a transaction is executed, it becomes a trade.

It is the overall balance of the SETS book and the flow of trades, that provides the investor a close up view of the equilibrium state of the market. This detailed pictures shows what is going on behind the scene of a market in a share and helps form a picture of the balance of supply and demand for a stock. This in turn offers an insight to how the price will move in the short term. As SETS represents a plethora of participants trading a stock the complexity of the ongoing action can be staggering. However we can be sure that without it we would be operating blindly.

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