Day Trading Futures has grown in popularity over the past few years, and traders are getting smarter in understanding what it is that they actually need to be successful, finding tools that professional traders use, and honing their skills. These “tools” are not an EDGE, they’re a must in trading futures and throughout this, I’ll be breaking down one of the most important tools a trader can have when operating in a highly liquid market.

One of the best things about the futures market is that we have all of the orders coming through the same exchange so that they’re all on display in the same area, visible to use, and how they interact with one another. The interactions between buyers and sellers, heavy-handed traders, and weak-handed traders allow us to identify the direction, the strength, and areas where to trade. All visible on one chart, the depth of market (DOM).

 

What is level II Data?

You’ve most likely heard of level II data and it has to do with the orders that are visible on the Depth of Market, or on the chart you’re looking at. When it comes to futures trading its convenient to have it all from one exchange in organized data that is presented in front of you, rather than with stocks you have to decipher it a little more.

The Level II data shows you real-time bids and offers at different price levels, beyond the current best bid and best offer. These are limit orders, meaning interest to enter the market, buy or sell. These are commonly referred to as passive orders in the market.

A quick tip: these orders are not what dictates real price movement. More on this in the passages lower.

This is what Level II for stocks looks like:

Level II stocks

Where you have the different exchanges, the bigs and ask, and the resting order, then with the tape on the right you have what goes in at the market, which is fairly useful to see the sizing and real acceptance.

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Compare it to the level II on the futures below:

level II on the Futures depth of market

The level II on the Futures depth of the market is in the light green box enclosure where we have the limit orders on the DOM for the bid and ask. These are passive resting orders waiting to be executed.

This is just the first piece of the puzzle that many traders spend so much time learning and trying to decipher without realizing, there is another DEEPER level that we have to dive into when it comes to the Depth of Market.

 

Importance of Level II data, misuse, and mistakes

Level II data on the depth of market is what we call passive orders, this is where we see all traders lining up to get filled, where we have resting passive orders, where icebergs enter, the whole shebang!

However it’s very commonly misused and misunderstood, this is just the surface.

One of the most common misused practices is looking for large outstanding orders that are sprinkled on the DOM and thinking that this is a price magnet where we want to run towards. This gives traders a false sense of direction.

For example, take the image below as a case study, here we have a relatively large order compared to the rest on the S&P500 futures sitting at 5295, 226 contracts waiting passively, while price trades at 5284, 12 points lower. Now this isn’t that big of an outlier, but let’s say this order was 500.

Many traders look at this and think that we are going to run up towards it to test the inventory. This is most likely a resting order that has no influence on price movement. When these large orders are more than a few points away from price, they’re not that influential.

movement in our understanding of Level II

Which brings up the context of the market and movement in our understanding of Level II. Large orders can have some influence on the market, however it’s in terms of context and if they actually trade.

 

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When large resting orders are close to price, that is when we want to put a little more emphasis on them in terms of “level II data”.

There are 2 instances that Level II data can give us immediate information about the market.

  1. When large orders appear close to price instantaneously.
  2. When price approaches large orders to fill them.

The only case that there is merit in following passive orders is when there are immediate price action shifts close to the traded price, otherwise these passive orders are even more boring and known as “resting orders”.

 

  1. When a large order appears close to the current traded price instantaneously.

Meaning let’s say we’re trading at 5299 on the ES Futures, and on the passive bid, at 5297 we see a large order appear with 400 lots sitting. This is a chase on the bid and price generally runs away from these orders that allow for continued upside momentum. Active traders see this attempted repositioning of larger orders and help price move away from them to carry on the trend. These orders rarely fill. Assume in the image below instead of 67, you have the 500 passive order resting.

ES Futures

Should they fill, they become market orders, where traders get absorbed and price continues in the upside direction of the trend, the opposite holds true for attempted offers coming in on the passive offer side.

Generally, large orders on the S&P 500 futures resting are 300 and higher, on the Nasdaq 40 and higher.

 2. When the price approaches a large order to fill them.

These orders can be resting or they might have appeared not long ago, these are important to see if price actually tests the order to get a reaction out of it.

 

Meaning, if we have a 400 resting order on the bid on the ES as the image above, sitting at 5295, and prices drop towards the order it’s imperative to notice if:

  • The order stays, or it disappears
  • If the order fills

Should the order stay, there’s a chance it’s real and price would expect to trade it then we would see the reaction off it, generally these orders if they’re bids would go as “market sell” meaning traders would get trapped at the lows and expect to see price reverse.

Should the order disappear, then the price would continue the trajectory, meaning continue to the downside in this case.

If the order is there and it fills, in the case of the bids, then we would expect to see a trapped trader into the lows, creating market sellers. If the order is on the offer side, price running up into it would trade at market “buy” in this case we could expect to see traders trapped into highs.

The reaction when these orders are imperative, that is why we cannot get full concrete information just from the resting orders, or passive orders on the DOM, which we would consider level II.

The data that is most useful to us as traders is level III, yes that’s right, unlocking a NEW level. Level III is still a component of the DOM (depth of market).

 

What is level III data?

Level III data is something of a dark spot in trading, meaning that it was commonly referred to as information hidden from retail before, that was used by market makers and large money. However the information that we’ll dissect here is going to be what we can consider to be level III these days or more so a juiced up version of level II data.

Level III data is commonly referred to as the real-time bid price, ask price, the size of resting orders sitting through the whole book, or 20+ levels of price, and the size of the last trade. This last piece of information is important, the actual market order that comes through at certain prices, because we want to navigate the reactions of those orders.

Order flow is so advanced these days that we can identify price and market imbalances in many different ways, from information extracted from Level II & Level III.

Generally the “definitive” level III is used by institutions and registered market makers that enter quotes, execute orders and send out trade-related information, so they’re not readily available to all retail traders.

Level III information includes all of level I and level II quotes, which allow investors to enter or change quotes, execute and send out confirmations of traders. Level III allows custom order execution.

Generally these custom orders can be hidden from the retail investor or trader in specific markets, however with the futures market, you get all of the information, even if it’s an iceberg, no order is going to go unseen, which gives us an advantage.

However, the good thing about this is that we can see all the orders that come through at market and all the orders that are attempting to get filled in our Level II DOM with a combination of a little piece of Level III.

 

Using Advanced Level II, with a touch of Level III.

The general premise of Level II is using the resting order book. In our case, we want to solidify market buying and selling to get a better picture of what is happening in the market, not just passive orders that might have an effect on the market.

If we combine the depth of the market with all the important information that we have about market movers, we can develop an advanced level II and understand how market participants interact to generate market moves.

If you have seen our work before at TRADEPRO Academy you know that we use order flow on the depth of market with 2 factors:

  1. Last traded quantity (somewhat of a Level III idea)
  2. Delta (imbalanced areas between buyers and sellers)

This strengthens the argument of Level II trading just using passive orders.

 

What are the main criteria that strengthen Level II?

Trading the Depth of Market with just passive orders, which is Level II on the bid and ask, resting limit orders, even if you have 40-50 levels of sitting data won’t give you too much useful information that will consistently provide you with an understanding of how the market is moving.

So we need to add another piece of information in the mix, this is what we had mentioned above.

 

  1. Last traded quantity (somewhat of a Level III idea)
  2. Delta (imbalanced areas between buyers and sellers)

 

These are add ons to the Depth of Market, they are the actual orders that come through the market to generate some market momentum, movement and direction.

  1. Last traded quantity (somewhat of a Level III idea)

These are the market orders that come through at a certain level in the market. On the depth of the market they are seen in the two middle columns. Between the passive orders.

In the image below you can see them defined in the green box.

The orders that are beside the blue bid column (in red middle) are the market sells, based on hitting the bid, you would hit the bid to get into the short side of the market, hence red.

The orders beside the resting offers, which are blue in the middle are the market buys, which come from lifting offers to get in at the market buy.

market buy

Using these to gather information on whether the market will go up or down or levels where the market is going to reverse is extremely important and the main use of these figures.

Generally, there are two things that cause markets to move.

  1. The reaction between the buyers and sellers
  2. The speed of the reaction

Notice I didn’t mention the size of the orders, although important it’s secondary to the overall reaction and speed. Meaning we expect to see heavy volume coming in on large moves, trapped traders, the works.

If I am looking for a sell, in the red column, I would expect to see larger quantities hit the book repeatedly, which would in turn actually cause prices to move lower on a reaction on each test of the area, and as they come in.

Speed is another criteria, where when a big seller comes in, you want to see the reaction lower to happen quickly, almost instantaneously.

For example, if there is a sell of 1000 contracts, which is sizable on the ES futures, and price drops 3-4 ticks instantaneously, that is a strong reaction, regardless of the buyer that is on the other side.

Look at the example below, 5292.75 offers market sell 1000 + orders, and we start a reaction lower. 860 try to buy a tick higher and get pushed aside by sellers. At the top we have 93 & 153 market buy with no one selling, this is a trapped move. In this case we would expect to see the prices start running lower! Where? Towards the area that has the bottom of all of the delta clustered at the 5288 area.

The result? We get our expected move lower.

Delta

2. Delta (imbalanced areas between buyers and sellers)

This is the second factor that is affected by real market participants that solidifies Level II.

Delta is the difference between market buyers and market sellers, the key here is MARKET participants that have actually entered the market, this is really useful on the depth of market in relation to the price and Level II present.

General rule of thumb:

  1. Large positive delta (buyers heavier than sellers) with price below means that buyers are trapped.
  2. Large positive delta (buyers heavier than sellers) with price above means that buyers are strong and holding prices out.
  3. Large negative delta (sellers heavier than buyers) with price below means that sellers are strong and holding prices below.
  4. Large negative delta (sellers heavier than buyers) with price above means that sellers are trapped.

These can help traders identify large market reversals, look at the example below based on the Nasdaq, we have heavy delta (150 + lots net of buyers) at the highs between 18599 and 18605. This is telling us within this area we have buyers that keep buying highs and are getting trapped. Weak-handed late buyers that are allowing for sellers to come through. Which turns into a large turn to the downside.

heavy delta

Level II and the other tools available on the DOM are great for finding moves, and reading patterns in the market, specifically when we talk about large market turning points and reversals.

These are best noted in identifying absorption & exhaustion, a combination of the two metrics that we discussed above.

  1. Last traded quantity (somewhat of a Level III idea)
  2. Delta (imbalanced areas between buyers and sellers)

These are the key tools to start reading patterns that allow you to see large market reversals.

Below is a quick breakdown, in another blog post we’ll break this down to its fullest.

 

What is trading Absorption & Exhaustion?

Absorption: Market orders are absorbed, or traded at a key area without any significant price changes and movement. This is the case where price is into a key resistance and large quantities of sellers are going in at market without moving prices lower. Or if price is at a resistance and large market buyers are trading into highs without prices moving higher.

Exhaustion: When markets move into resistance or support structure, and there are heavy orders on the limit side, but the market buying or selling cannot fill the orders, this is exhaustion. Or in the case where you have lesser and lesser orders that trade at the end of a move. Into a resistance, you would possibly see either smaller quantities of buyers trader allowing for new sellers to take control. Or you might see large quantities sitting on the resting offer, but only ⅓ or ½ getting filled, allowing new sellers to come through.

These are the most common trading strategies and moves that create large market reversals.

Absorption is created when limit orders go to market and get “trapped” which in turn create larger delta.

For example, this is what the general context of a trapped buyer looks like:

There are large limit orders sitting on the offer side of the market, they trade, these go at market BUY. They in turn generate an area where large positive delta accumulates and price DOESN’T move any higher.

This means that buyers are late to the party in this long and it’s weak handed buying, they keep trying to add more market buy into the high, but prices refuse to continue higher and this allows for the market seller to try their hand in offering for a move lower.

Below is an example on the Nasdaq Depth of Market.

When price comes up into the 18,600-18,610 area, we start to see that buyers are struggling on the Nasdaq, trading 30-50 contracts on the market buy at a time, which result in heavier buy deltas around.

We then see a market seller come in, although smaller, the reaction that creates the move that pushes prices lower is what guides the absorption of price and the push lower.

On 1 lot, on the Nasdaq futures, up over 50 points and over $1,000.

Nasdaq futures

Understanding how the DOM works is the first tool in understanding order flow, don’t let the basics of Level II trading trap you in not being able to really read what is happening in the markets.

For more of a visual representation, check out this video where we identify absorption and order flow traders getting trapped in prices: https://youtu.be/MbTwXJNFtrs