STOCKMARKETLEVEL2.COM

author : Clem Chambers

level 2 Articles

by Clem Chembers

CEO of ADVFN Plc.

LEVEL 2 ARTICLES

Level 2: Comparing Level 1 vs. Level 2

You may see in the newspaper or from a site such as ADVFN that a share is 100p. This price is just the tip of the iceberg as there is a lot more information available than the top line figure of a simple share price.

There's the bid and offer representing the price you can buy and sell at, the volume traded so far that day, details of trades that have occurred, the type of trades that made up the trading volume and even values like the average price of the stock over a recent period of trading. In the UK, the London Stock Exchange collects all this information up and makes these details transparent to anyone who is prepared to pay a little for it.

Broadly speaking, there are two levels of price information transmitted by the London Stock Exchange - Level 1 and Level 2 data.

Level 1 contains the price, bid and offer, volume and trade information. This enables a trader to see trades that have been made, ascertain what type of trade it was and know what the current price of a share is in the market. While Level 1 shows the result of trading, Level 2 shows the sentiment. It provides greater transparency and actually shows what is going on in the market itself.

In days gone by, the jobber on the floor of the exchange acted as the wholesaler, the broker acted as an agent/retailer and the investor was the end customer. Investors would instruct their broker, who would then come onto the floor of the exchange and buy from the jobber. The investor was not allowed to interact with the jobber at all. The jobber held a book, which was his account of the amounts of stock he held. This was his "order book" and the collective order books of all the jobbers, was the heart of the market.

Today this order book is an electronic one and is contained inside a computer. Level 2 is the status information of this order book.

Level 2 Order Books

There are three kinds of Level 2 order books: SETS, SETSmm and SEAQ.

SETS holds anonymous orders placed by all participants in the market. SEAQ is an order book where solely Market Makers can place their bids and offers and the new SETSmm system, introduced in November 2003 by the London Stock Exchange, is a hybrid allowing both.

Each book is designed as a trading platform for different sizes of listed company. Generally SETS is for big company stocks with high demand and supply for their shares and SEAQ is for smaller stocks, which trade less actively. SETSmm was introduced for stocks underneath the FTSE 100 in the less active FTSE 250 segment. SEAQ is basically a modern representation of the old 'jobber' system, where stocks and shares would be bought on the floor from a Market Maker.

SEAQ

On a SEAQ screen a number of Market Makers put up their buy and sell prices for the shares they make a market in. The market can then see what each particular Market Maker wants to do on the buy and sell side for each stock. The Market Maker (modern day Jobber) makes his money on the 'spread'.

The spread is the difference between the Bid and Offer price and represents a margin between what he buys a share 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, however there is a lot more to Market Making than immediately 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. In effect the Market Maker is acting as a one man London Stock Exchange (LSE).

However there are other Market Makers competing for his bid/offer profit margin. All the Market Makers are linked together electronically by the stock exchange and therefore compete as they once did on the trading floor. SEAQ is the electronic summary of the state of all Bids and Offers available on a stock made by the Market Makers. Some shares have a dozen Market Makers while some very small companies have only one Market Maker.

Looking at a SEAQ screen with several Market Makers on it, you can see that not all of them 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 will only sell the stock more expensively than other Market Makers. Being "Off the bid" or "Off the offer" means not wanting to trade the share at the current price being offered by other Market Makers.

When an investor wants to buy a SEAQ stock, his/her broker calls a Market Maker and sells or buys the stock from him. The details of the transaction will then will be registered as a trade with the LSE.

It is the state of the bid and offers, put up on the SEAQ Level 2 by the Market Makers, that helps traders and investors discern the state of the market in a SEAQ stock. This is because these positions indicate the appetite of the market for a particular share and hence suggest what might happen next to the price.

SETS

SETS is an automated Market Maker run by the stock exchange. It is the market for the biggest stocks in the UK and is made up of the FTSE 100 constituents and remnants of ex-members of the index.

SETS is an evolution from the old system of 'Market Making' Jobbers and was introduced as the future of the Stock Exchange in the late 90s. The technology facilitated the collection of information generated remotely and enabled it to be centralised at the LSE.

SETS stocks are shown on Level 2 as an "order book." This electronic book has two columns - sell orders and buy orders. These orders are classified as Bids to buy and Offers to sell. Rather than four Market Makers making four bids and four offers, the order book represents registered offers and bids at a selection of prices, as if there were scores and scores of Market Makers at many and varied price levels.

Brokers, Market Makers, traders and private individuals who have a direct connection to the SETS system, place orders in the order book. When someone wants to take up a bid or offer in the book at the stated price, the transaction is executed and it becomes a trade. It is the overall make up of the SETS book that provides the investor with a close up view of the equilibrium of the market. This detailed picture shows what is going on behind the scenes in a share and helps form a further opinion of the balance of supply and demand for a stock. The better the picture you have of the state of the market and the record of the recent history that produced the current price, the easier it is to predict the ensuing outcome.

SETSmm

SETS doesn't show the names of Market Makers and SEAQ does not allow for all comers to put an order into the market. Including features of both SEAQ and SETS; SETSmm attempts to bridge the gap for medium sized companies.

SETSmm allows an order for stock to enter straight into the market at whatever price and allows a participant to behave just like a Market Maker. The idea is that this opportunity will stimulate liquidity and competition and bring down the spreads on these smaller stocks. The Market Maker is still there to guarantee liquidity if the going gets rough and for that matter make a thin spread, but there is an opportunity for anyone to take on the role of supplier of liquidity in any event. Basically, the order book is made up of anonymous orders like SETS but has named Market Maker orders too.

Level 2 Example Scenario

What follows is an example scenario.

There are two Market Makers in a stock. They are both on the bid and offer, which is 9p and 10p respectively.

Market Maker A receives an order at 10p for 100,000 shares. He sells the shares.

He only had 50,000 shares in his book and now has -50000 shares. He marks his Bid/Offer to 9.5/10.5. The overall Bid/Offer is now 9.5/10 so the mid price is 9.75, meaning the price has gone up 0.25.

The next order is a sell of 50,000 shares, which Market Maker A buys and therefore closes the short position. His profit on the 100,000 shares is 50,000 x 1p and 50,000 x 0.5p - that is 750.

Meanwhile another order comes in for 100,000 shares and Market Maker B sells them to the customer. Market Maker B has 120,000 shares in his book and now only has 20,000. The market is on the rise and he doesn't want to be short on a rising market so he moves his Bid/Offer to match Market Maker A's Bid/Offer of 9.5p and 10.5p. The overall Bid has not moved but the Offer has, so the price goes up another 0.25p.

As you can see the spread "went in," became smaller, as the price rose and "went out," got larger again when it rose the second time. ADVFN has a unique tool to watch this process called Quote Changes. It can be accessed from the Level 2 screen at the top highlighted in Blue.

You can see this all unfolding on a Level 2 screen. However this is just the start. There are numerous techniques and strategies employed by market participants. The more information and transparency you have, the stronger position you are in.