We have all heard the phrase taken from George Orwell’s Animal Farm: all animals are equal, but some are more equal than others. The same is true in the financial markets, as some traders are definitely more equal than others. No issue best exemplifies this than the issue of pricing in the market.
There are two different types of pricing/quotation of prices in the financial market:
- Level I quotes
- Level II quotes
Level I Quotes
The Level I quotes show the real time bid and ask prices of an underlying asset in the Nasdaq or Over the Counter Bulletin Board (OTCBB) markets. Level I quotes represent the most basic price quotation system that most traders are given by their brokers. Put another way, most retail investors/traders will see the price of the asset they want to trade as a Level I quote.
Very little information is given by the Level I quote. For instance, there is no information as to what quantity of the asset the market maker is buying, which market maker is either offering the asset for sale or purchasing the asset, aside from just knowing the bid/ask, the trader has no access to the information detailing the market depth of the order.
A Level I quote looks like this:
Stock ABC = 120.25/120.29 (bid/ask)
It is all so basic. This puts a limitation on the trader’s ability to know what is going on around him in the market. For instance, if the market maker that is offering the security to the trader has a long position and has placed a particular huge order for this position, it will not be in the trader’s best interest to go against the market maker. Such insight can be the difference between a win or a loss, and this underscores the limitation of the Level I quote.
Level II Quotes
In contrast to Level I quotes, Level II quotes are used by institutional traders or traders operating in an Electronic Communication Network (ECN) environment. The Level II quote provides the entire information in the order book for the asset. The trader gets to know which market maker(s) has an interest in the asset, the quantity the market maker has bought the stock, and the quantity of units purchased. A Level II quote looks like this:
Stock ABC = MLCO/58.5/100
In this quote, we can clearly see that Merrill Lynch has purchased 100 contract units (10,000 shares) of stock ABC at $58.5 per share. Each market participant such as Merrill Lynch above, are connoted with a 4 letter ID on the Level II quote.
Level I and Level II Quotes in the Day Trading Scenario
The difference that a Level I or Level II quote makes in a trader’s career is not very visible if the trader is a long term trader. The difference is seen in day trading, which is by its nature, carries a short term trading outlook. The trader who depends on Level I quotes is basically trading blind. He is purely depending on his own analysis to take him through without getting the whole picture.
The market is dominated by three classes of player. There are the market makers, who provide the liquidity gap by purchasing when there is no trader buying activity, and selling when there are no sellers. The market makers also have trading desks which they use to try to make profits for themselves. Then there are the ECN brokers and wholesalers.
The key variable is identifying the market maker that is responsible for most of the price action of the specific asset under examination. The trader should study the order flows for a few days and the market makers who constantly hold large positions in the market should be tagged. This is the market maker that should be used as the benchmark in deciding the direction of trade. The best outcomes are seen when trading in the direction of the trades of this market maker. It is essential to distinguish trades from his market maker and those from the institutional traders.
Great care must be taken by the trader to avoid being deceived by the market makers. The market makers make their trading money off the uninformed Level 1 quote traders. They know that their profits are only secure when more traders are kept in the dark. Thus they try to throw traders off the trail of the market-moving market makers using a variety of tricks such as hiding their fills, changing their order sizes and masking their orders.
In summary, Level I quotes give a trader only the most basic price information, whereas a Level II quote provides traders with more information about the order to enable them make more informed decisions about their trades. This is part of the reason Level II traders are generally more successful than Level I traders.