What it means
Level 1 data gives you the best bid and the best ask. Level 2 goes further by displaying a ladder of orders on each side: several price levels of buyers underneath the market and several price levels of sellers above it.
Each line typically shows the price, the number of shares and, in many systems, which firm or venue placed the order. The information is useful because it shows how much liquidity is available at each price.
If the best ask is $50.02 for only 500 shares, the next ask is $50.03 for 500 and the next is $50.05 for 1,000, a large buy order will have to climb through these levels and pay more as it goes. Level 2 lets you estimate that before placing the order.
Traders also read the pattern of the book for clues. A large wall of sell orders just above the market may act as a barrier to a price rise, while a thick layer of buy orders below may provide support.
These signals are not reliable predictions, because orders can be cancelled in an instant, but they help judge short-term pressure. The idea is called market depth.
A deep market has many orders at many price levels, so a large trade barely moves the price. A shallow market has little behind the top quote, so even a modest order can push the price a long way.
For a finance manager or a casual investor, Level 2 is rarely necessary. It matters to anyone trading large amounts, trading actively through the day, or dealing in thinly traded shares, where the visible price on a standard quote can be misleading.
It is also distinct from Level 2 assets in accounting, which are assets valued using observable inputs other than direct quoted prices. The names are similar, but one is about market data and the other is about valuation.
In practice
Real-world examples.
Example
A day trader checks the order book before buying a mid-sized stock. She sees plenty of sellers lined up just above the current price, and decides to use a limit order rather than pay up. The depth information saves her from chasing the price.
Example
A treasury dealer at a corporate bank needs to buy $5,000,000 worth of currency for a client. He reads the depth of the market on his trading screen and splits the order into smaller pieces so that he does not move the price against his client.
Example
An investor wants to sell a large block of shares in a small company. The Level 2 screen shows that the buyers are limited to a few small orders. She breaks her sale into smaller parts over several days to avoid pushing the price down.
Formula
Calculation
Average execution price = Total cost of shares bought / Number of shares bought
Slippage cost = Total cost - (Best price x Number of shares)
Worked example: the ask side of an order book shows 500 shares at $50.02, 500 shares at $50.03 and 1,000 shares at $50.05. A trader wants to buy 1,500 shares at market.
The first 500 shares cost 500 x $50.02 = $25,010. The next 500 cost 500 x $50.03 = $25,015. The remaining 500 come from the third level at $50.05, costing 500 x $50.05 = $25,025.
Total cost = $25,010 + $25,015 + $25,025 = $75,050. The average price is $75,050 / 1,500 = $50.0333 per share.
If all 1,500 shares had been available at the best price of $50.02, the cost would have been 1,500 x $50.02 = $75,030. The slippage is $75,050 - $75,030 = $20.Case study
Seen in the real world.
Tidewater Capital is a fictional investment boutique that needed to sell 40,000 shares of a small listed company. The head trader opened the order book and saw that the best bid of $12.00 was for only 2,000 shares, with the next bids at $11.95 and $11.85.
If the entire block had been sold at once, the average price would have fallen to around $11.60, costing roughly $16,000 against the top-of-book price. Instead, the trader sold in tranches of 3,000 to 5,000 shares during the day.
The average sale price came to $11.92. This is an illustrative story, but it shows how depth information helps a trader to protect value when selling a large position.
Watch out
Common mistakes.
- Trusting the visible order book as certain demand. Orders can be pulled or hidden in seconds, so the book shows intentions rather than commitments.
- Assuming Level 2 predicts price direction. It shows the balance of orders right now, and cannot tell you what news or new orders will arrive.
- Paying for depth data you do not need. If you rarely trade or trade only liquid shares in small amounts, Level 1 data is normally enough.
Questions
People also ask.
What does Level 2 show that Level 1 does not?
It shows multiple price levels and the number of shares at each, rather than only the best bid and ask. This reveals how much the price would move for a given order size.
What is market depth?
It is the volume of orders available at various prices on each side of the book. Deep markets absorb large orders with little price change.
Is Level 2 the same as Level 2 assets?
No. Level 2 market data is a view of orders, while Level 2 assets are items valued using observable inputs other than direct quotes.
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