Anyone that has been investing long enough has probably heard the term level 2 or L2 thrown around numerous times. Level 2 is discussed frequently because it is not only a tool but a critical one when trading higher risk stocks particularly those in the pink sheets. It is the single tool that allows even the most inexperienced trader to have access to the same information that the best traders have without having to have a massive portfolio to have it. In fact, many brokers offer level 2 as part of their trading platform.
In order to better understand level 2 it should be broken down into easier to digest sections. Keep in mind that this is simply one take on the information that is being seen with level 2 and that all investment concepts or ideas should be run part a licensed professional before making any judgment call on a stock.
Part I: What is level 2?
For lack of any real good definition of level 2 it is simply a tool that monitors trading activity. With level 2 a trader is able to see transactions on both the bid and ask side along with the market maker that is routing that bid or ask. Also on most providers the level 2 will also show running transaction information. A list of the latest transaction sizes, the high of the day, low of the day, and current time are pretty normal features of level 2.
What most people don’t realize is that while the level 2 may appear to provide incredibly simple information it is actually giving the trader a much bigger picture as to what is really happening with a stock. With proper observation a trader knows when the best time to buy or sell the stock may be as well as when there is something truly bad happening. Even short selling can be detected by the trained eye monitoring level 2.
Part II: When to Buy
Level 2 is going to show a trader something that is really important and that is when to buy. This is done by simply looking at level 2 and waiting for what many refer to as BID SUPPORT. Bid support is simply a stacking of market makers on the bid side. The more market makers that exist on the bid, the greater the bid support. When looking to buy a trader is looking to see that there is a great deal of bid support at or just below the current price of the stock. If the stock normally has a single market maker at .005 for example and there are currently 5 market makers at .005 then there’s a good chance that something is about to happen on this stock.
By seeing an increasing number of market makers appearing on the bid side of the stock just below the current price and NEAR the ask price that is often a sign that buying pressure is going to start picking up. With so many market makers on the bid it means that in order to get shares traders would have to buy on the ask ultimately moving up the price. This bid support would prevent the stock from going down and over time the buying at the ask would eliminate pressure on the ask side and move the stock upward. So while bid support doesn’t mean the stock will go up in price, it typically means that the stock isn’t likely to go down in price as quickly.
To summarize, bid support simply states that the risk is lower than it would be with normal bid support as it would take greater selling volume to drop the price than it would to raise the price.
Part III: When to Sell
When looking at level 2 in order to determine when to sell it is important to look closely at both the bid support and the ASK. If the bid support starts to disappear that is a good sign that investor interest is fading and fast. If there were originally 5 market makers and now it is down to 3, that’s a good sign that there are fewer people interested in the stock than there were. This is often a good time to start looking at an exit strategy. If your shares are already green and profitable then taking profit is always a good idea. If your shares are red then taking the loss now may be a good consideration to prevent further potential loss. This is something that needs to be considered carefully before making a move.
Another sign that it may be time to sell and normally something that appears just after the market makers disappear on the bid side is the stacking of the ask. When suddenly 3 or more market makers appear on the ask side or it appears that constant buying isn’t removing the ask it may be a good idea to consider exiting the stock. This is often a sign of huge resistance and it may be time to at least take profits in order to lower risk at this point in time.
Part IV: When there is a short or manipulation
Stacking of the ask may also be a sign that there is a short position on the stock. Often times a short will attempt to make the stock look weaker than it really is. This is done by selling at the bid to show more sells than buys but also by placing a small number of shares on the ask with several different market makers.
If buying pressure typically wipes out the market makers on the ask with only a small number of shares this is classic ask stacking by a short position. It costs too much to play the game with large numbers of shares on the ask so normally a short will put small blocks to just give the appearance of resistance to slow down the buying. Once the buying has stalled and the bids are pulled that’s when the short goes to work. Now the short is going to start hitting the bid with small blocks of shares. This is done to see how strong the bid is and to see if they can drop the price further. This constant attack at the bid will also scare off new buyers and often times will get the person sitting on the bid to go away allowing the short to continually take the price down.
Without any further buying pressure a short can easily drop a stock down in price significantly. It is important to pay attention for this so that a plan of action can be taken to either get out of the stock altogether or at least make a determination as to whether or not it is believed the buying pressure will return to the stock.
Part V: Company dilution or big block selling
One of the most common pains of the pink sheet market is dilution by the company. This is where the company will sell shares in order to raise money. They will often times not only sell shares themselves but also bring in a promotion company that will be compensated with shares. This creates an evil situation for the investor as it means they are fighting an almost impossible battle where tons of extra shares are being added to the open market.
To notice dilution it is pretty easy on level 2. Simply watch to see how easily the stock moves. If the volume keeps going up but the price doesn’t there’s a good chance that there’s a large block holder that is selling. Since large block holders are often times close to a company or have been given a large chunk of shares it can normally be traced back to dilution, promotion, or both. Either way there is far greater risk in this stock than possibility.
Often times when the volumes tops coming in and the buying stops at the ask shares will be tossed at market on the bid side dropping the price rapidly. As there will already be a great deal of uncertainty in the stock many will simply drop their shares in order to prevent themselves from losing even more. This will drop the price down considerably more. Dilution situations often create panic selling and dumping and could result in substantial loss in a very short period of time.
The basic idea is that if something doesn’t look right then it probably isn’t.
Part VI: Final Notes
When watching level 2 be certain to pay attention to the volume. When volume starts going up the price should move along with it. If the price isn’t moving but the volume is then it could be a sign that the stock might not be as good as it sounds. This of course is also dependent upon the share structure of the stock, but for the most part a lot of buying with no action isn’t the best of signs.
It is also important to realize that reading level 2 takes a great deal of time and experience before it can truly be relied upon. It should be used merely as a tool for making decisions and not a definitive guide to investing. For those that are new to level 2 it may be a good idea to simply watch it closely on trades and then compare reactions to what you think happened. Learn through the reactions of others and it will make understanding level 2 that much easier.