Market depth charts are often a confusing and misunderstood part of trading. Besides just learning to read stock charts, level 2 quotes and order books are a lot like trying to read the matrix.

Numbers flash on the screen and then disappear quickly, especially during volatile trading moments. Also, it can be hard to tell what order are buy order, and what orders are sell orders. That being said, may seasoned traders use L2 data to predict support and resistance levels and liquidity zones.

In this post, we’ll discuss what level 2 trading is, and how to understand a stock depth chart to aid in your trading.

What is Level 2 Trading?

The Level 2 trading window provides data for pending orders in the market. ^[1]

Level 2 quotes display the size of the best bids and offers with their respective depths. Day traders use Level 2 stock data to gauge the direction of the stock market over the short-term. And, by short-term, we mean seconds to minutes.

How to Read a Level 2 Depth Chart

To read a level 2 depth chart, you need to understand the L2 data window structure. It is comprised of three key components: (1) bid/ask window, (2) size of orders, and (3) depth.

Level 2 Bid/Ask Prices

The bid/ask data contains the current bid and ask prices for the security across various exchanges. These could be from the NASDAQ, ARCA, BATS, or many more exchanges.

The L2 data is displayed in rows of what is known as the order flow. This order flow is also referred to as market depth and displays the best bids.

Here is an example of what this might look like in a professional day trading Level 2 window:

As you can see, the spread or distance between the bid and ask are close or near the top of the order book. You can also see which exchange is facilitating the orders.

Size of the Orders

The next key element is the size of the order which is displayed directly after the bid and the ask prices. This provides you with an idea of where traders are placing their orders,

which gives you some indication of their intent.

In the above image of a TSLA stock depth chart, the level 0 depth which is the first row, has 57595 buy orders at $700 and 100 sell orders at $700.65. That’s for the NSDQ exchange only. As you can see there are 63500 and 5965 shares sitting on the bid at the same price, $700.

This could mean one of two things, depending on the context. One, there are more traders looking to buy at lower prices, or two, there are more traders looking to sell on the bid. If you see the buy orders being gobbled up and the price is moving higher, this flow tells you that the shorts are in control and are able to push the stock lower.

In contrast, the orders are filled and the stock moves higher, it could be a key support level where buyers stepped in to move the price upward. This is benefit of watching level II market data.

Level 2 Depth Chart

The market depth chart is the visual representation of the orders and their respective size. The color of the graph in the market depth chart will match the color of the bid/ask data.

In TradingSim the depth is represented with histograms within the Level 2 window. This provides you a clear view of the order size without having to review the numbers of the Level 2 table.

For many, it’s just much easier to see the red and green charts to gauge which way the market is moving. However, color coding the depth chart allows you to see just how many exchanges have similar bids or offers sitting at a single price.

Notice the blocks we have circled. This gives you an idea of the depth of market in the level 2. This gives you an indication of how many orders may be stacking up at certain levels. This L2 data can then be used to make informed trading decisions based upon key levels.

Speed of Order Flow

At this point, we have discussed the structure of Level 2 data, but now it’s time to see it in action. In the below video we have taken a one-minute snapshot view of the order flow for the QQQ.

The QQQ is a popular security for day traders, so this will give you a good feel for the speed of the tape (a.k.a. Level 2).

Keep in mind that the speed of the order flow may increase during times of volatility, especially near the market open. The best way to study this is to have a replay service like TradingSim to slow things down in case you missed quick orders getting filled.

When to Read the Level 2 Tape

If you stare at Level 2 screens all day, you are going to get a headache. However, the best time to use L2 is at critical price levels. ^[2]

For example, if you are looking to buy a stock on a breakout, you can look at Level 2 to see the quality of the order flow to determine if a breakout has legs.

On that token, a key point to remember is that a stock can show a sign of strength for a brief moment in on a market depth chart, but ultimately fail.

This is where you have to really watch the order flow in the level 2 order book to begin to “feel” the market. This, my friend, takes time and is not something that you can just pick up after watching the market for a few days.

Breakout Example

Check out this video of a breakout as a stock approaches a key resistance level. The video is short, but you can see that the level 2 order flow at the resistance level picks up and the asking price continues to spike higher as sellers look for higher prices to execute trades.

Also, you will notice how the order flow accelerates at the breakout level and most importantly the price is able to hold this key level. Often, it is the price reaction coupled with the level 2 stock data that gives you the best picture.

So, what was the result of this positive level 2 trading action at the breakout point? You guessed it, higher prices.

Do not look at this and assume all trades will work in this fashion. The key point from observing Level 2 is to gauge if the move is sustainable.

There is no exact method for making this observation. Anyone telling you that is oversimplifying the process of trading with L2 data. You will need to put in the hard work of observing market depth to assess signals from this off-chart indicator.

Where Level 2 Gets Tricky

Learning how to use Level 2 market data can prove challenging for the untrained eye. You see the orders flying, time and sales streaming, and green and red histogram bars sliding in and out.

It’s honestly a lot to absorb and make sense of.

The other thing is large institutions are now using AI to send buy and sell orders. ^[3] Not to mention, dark pools and other hidden orders can show up on charts when they don’t show up in the Level 2 data.

This can make it tricky to know if the orders in the depth are “real”. This practice of placing fake orders is spoofing and is illegal. Here is a link from the CFTC that highlights a case where a firm was found guilty of spoofing. These regulations have helped, but there still is a bit of grey area around how to read level 2 market data orders.

How to Combat the Robots

Ultimately, there is nothing you can do to stop these fake orders. The best thing you can do is to not solely rely on the tape for your trading strategy.

As with any strategy, you need to compliment your level 2 trading with chart reading skills. We have a lot of great articles on this site that teaches volume and price action trading.

In addition, check out this great piece from tradingshools.org which touches on this subject of spoofing.

Level II Order Flow with Thinly Traded Stocks

L2 is an awesome tool for stocks that trade with volume. However, stocks with light volume or wide spreads inform you very little about where a stock is likely to trend.

This is because the L2 window will have little to no order flow. So, it becomes extremely difficult to use L2 as an effective forecasting tool.

If you’re inclined to trade thinly traded stocks, keep in mind the issues associated with liquidity and potential liquidity traps. Often it is better look at higher time frame key volume levels rather than focus on the intraday level 2 data.

How Can TradingSim Help?

TradingSim offers a full Level 2 montage as part of it’s trading application. As we mentioned before, there is no better way to learn reading a depth chart by using level 2 data than by recording your screen or watching a replay.

With TradingSim, you don’t have to worry about recording. There is no need to store all that data on your hard drive. Not to mention, there are thousands of stocks in the market. We make it easy to replay every single one of them for up to 3 years worth of intraday data.

This will allow you to develop the muscle memory to master order flow to improve your trading results.

External References

1. Jepsen, Lance. (2013). Level II Trading: Using Level II Quotes For Maximum Profit.
2. What is Level 2 Trading? bullishbears.com
3. Thomas, Mike. (2019).How AI Trading Technology Is Making Stock Market Investors Smarter — And Richer. builtin.com