Most day traders, new or experienced, incorporate some form of technical analysis into their decision making process. Stock charts are one of the most popular technical analysis tools, as they provide traders with a visualization of a stock’s historical price action. The keyword here is “historical.” Stock charts show how much traders were willing to pay for a stock in the past. While charts can be incredibly helpful for making strategic decisions, there are other data sources that may aid traders in making real-time decisions. One of these tools is known as a “level 2 screen.”
Level 2 screens present traders with real-time data for a given equity. They consist of 3 basic elements:
Market Makers – Market makers are responsible for fulfilling the orders you place and adding liquidity to the mark. Certain brokers allow you to choose the market maker you’d like to route through, while others automatically choose for you. Some market makers have different advantages/disadvantages, but that’s another topic for another day.
Price (Bid/Ask) – The “Bid” is the amount someone is willing to pay for a stock, and the “Ask” is what someone is willing to sell a stock for. When the bid price is equal to the ask price (or vice versa), a transaction occurs.
Number of Shares – Number of shares is pretty straightforward. It’s simply the total number of shares that a particular market maker is looking to buy or sell.
It’s important to note that Level 2 screens are organized by price. The bid side (left side) will show all of the highest prices traders are willing to buy the stock for, while the ask side (right side) will show all of the lowest prices traders are willing to sell the stock for. This type of data can be incredibly powerful when used properly.
Supply and Demand
It’s best to think of level 2 screens as a summarization tool for understanding the real-time supply and demand of a stock. Level 2 screens have 2 sides. One side represents the buyers (demand) while the other represents the sellers (supply). Basic economic principles tell us that when demand exceeds supply, price will go up, and when supply exceeds demand, price will go down. Therefore, level 2 screens are used to gauge levels of supply/demand in order to predict whether a stock’s price will go up or down.
How to Analyze this Data
There are a few important things to keep in mind when analyzing a level 2 screen:
1. Your ultimate goal is to predict future price movement. Although it’s virtually impossible to predict this with 100% certainty, you can still make educated hypotheses. Remember, the level 2 screen is just one tool in your arsenal and you should incorporate it with other strategic tools rather than relying solely on this one data source.
2. You should be analyzing supply and demand with the end goal of determining which one will overpower the other. Ask yourself if buyers or sellers are in charge.
Level 2 screens can be somewhat intimidating if you have never used them before. It can be difficult to analyze all of the moving numbers in real-time. That being said, if you break it down to it’s basic functionality, you can make the decision making process much simpler. Let’s look at a fictional, non-stock related example.
Let’s say John has 20 used phones that he wants to sell at $100 each. Bill wants to buy one phone, but he is only willing to pay $90. A deal cannot go through unless the seller’s price matches the buyer’s price. Who do you think is more likely to concede?
In this case, it’s more likely that John (the seller) will come down in price to sell a phone to Bill. Supply is 20 times higher than the demand, meaning that buyers have more power. Bill is in no rush to offer more money because he knows there are 20 phones available. Had there been 20 buyers at $90 and one seller at $100, the supply/demand would be in the seller’s favor. Of course, we cannot say with 100% certainty that John will concede, as Bill may decide he wants a phone quickly and is willing to pay a higher price. Additionally, more sellers and buyers may enter the market and shift the supply/demand levels.
That being said, the goal is not to account for every possible scenario. Overthinking will make the decision making process much more difficult. Instead, it is better to focus ask one question: “Are the buyers or sellers in charge?” This will help you determine the likelihood of a stock moving up or down in price. Combine the real-time data from a level 2 screen with the historical data from a stock chart and you can begin to formulate a strategic trading plan.
We’ve gone over the basic functionality of level 2 screens. This tool can be incredibly helpful for making strategic, real-time decisions. Just like supply/demand principles in economics, the main concept is relatively simple, however, there are plenty of advanced tactics for better understanding the markets. Factors such as hidden order sizes, institutional/retail buying, and market maker games come into play. More advanced level 2 strategies will be discussed in further articles.