Fool's Eye View

[ September 29, 2000 ]

What Are Level 2 Prices?

By Nigel Roberts (TMFNigel)

Chippenham, Wiltshire -- Recently we had a stand at the Sharex exhibition at Olympia, and on the day I was there I was asked many times about "Level 2 prices". I have to say that usually I had to adopt a completely blank expression and answer "err... what are they?" Apparently, Level 2 prices are a real must-have for any serious investor, and the fact that I knew nothing about them proved to some visitors to the stand just what a -- small f -- fool I was!

When I went to lunch I found myself sat next to an exhibitor from the ADVFN website, and being curious about a company and website that I had not heard of I asked what they did. Apparently they provide financial information to investors (and having had a look at the website I have to say that much of it appears to be very good, including free real time prices). When I asked him how they made their money I was told that they charge for some things; specifically, they charge £5 a month for access to their "premium bulletin board", and also £35 a month for access to their Level 2 price information. "Oh, what is that?" I asked. The shocked look showed that I had committed a real faux pas. "You mean you don't know what Level 2 pricing is? D'oh!" Well, after all that I had to find out what it was all about.

It seems that the terms Level 1, 2 and 3 pricing originated from the Nasdaq, where:

Level I is the simple quote for a stock that most investors see. Level 1 prices display trade and volume, and the best bid and best ask (offer) in a particular stock. It was originally designed for stockbrokers to give them a good general indication of a stock's current market, but is what you now routinely see on many financial websites, the Fool included.

Level II is a much more detailed quote for a stock and displays all of the bids and all of the offers and the actual size of those bids and offers from every market maker in a particular stock. It was designed to enable brokers to see what all of the market makers were doing with a particular stock at the same time, but in the US it has become used (abused?) by firms offering it to the general public to help with day trading. It was originally offered by firms that specialised in electronic day trading of Nasdaq securities, but has now become available on the web -- at a price.

Level III is a quote screen containing all the information in Levels I and II, but which is actually used by market makers change bid, ask and order size in a particular stock.

These terms now seem to have been adopted to describe the information that may be offered covering the prices from any stock market, including the London Stock Exchange.

What is the point of it?

With Level 2, you're seeing the same information that the market makers see, and some day traders would have us believe that having the total view of all market makers' quotes and quantities gives a hint at the future near-term direction of a company's share price. Now is that really possible? I would say an emphatic NO! But as long as people believe that it is possible then there is sure to be an ever-increasing demand for Level 2 pricing, and you can be sure that many other web-based stockbrokers will be offering Level 2 quotes in the very near future. But I have to ask: do we really need all the information that a Level 2 screen provides? Having spent some time today looking at one I have to say that it is fascinating, but it is fascinating in the same way as it is fascinating watching a line of ants raiding a dustbin; you see lots of activity, but it ain't giving you any real benefit!

Dealing direct with market makers?

One benefit is that you can make sure that your broker really has executed a deal at the best possible price, because you can see all of the various bids and offers from all of the market makers. But as brokers have a legal duty to ensure that your deal is executed at the best possible price, this really will not give you much help. Now it may become a different matter if a facility is ever introduced whereby you can actually place an order with a market maker of your choice, and the advent of Level 2 pricing in the UK may be making that day come ever closer. This may lead to lower commission charges from brokers, or even enable us to bypass brokers altogether, enabling the general public to buy and sell shares directly with market makers, who make their money simply on the bid-offer spread. It could conceivably indicate the end of commission-based stockbroking.

Conclusion

The information provided by ADVFN is pretty impressive, and certainly fascinating and addictive to watch. Is it worth £35 a month? Not to me, and I dare say that it is also not worth it for most regular day traders; but I do believe that many people will be clamouring to get this sort of information, and I am sure that the cost of providing it will fall quickly. Indeed, I bet that most online stockbrokers are providing this information for free to their customers within the next two years.

Where Next?

• ADVFN website
• ADVFN website -- help on level 2
• Proquote -- another source of level 2 pricing information in the UK -- thanks to kenmegsmith
• Frequent trading discussion board -- The Devil's Den