Level 2 Trading- How to Apply It Like a Professional Trader
If you’ve been day trading for any amount of time, you’ve likely heard about the benefits of Level 2 trading.
Level 2 (also known as an order book, depth of market, or price ladder) is an electronic list of open buy and sell orders for a particular financial asset. Which is organized by price levels and updated in real-time,
Knowing how to read the order book is extremely important to us as day traders because it helps us spot liquidity and identify shifts in supply and demand. This can provide lucrative trading opportunities on a daily basis.
In this article, we are going to explain how to read an order book, as well as offer a couple of tips to help you implement Level 2 trading into your arsenal!
Level 2 Trading- Basics of the DOM (Depth of Market)
The order book below is for the SP500 futures and displays price levels in the middle column, with the number of bids (buyers) for each price displayed in the left column and the number of offers (sellers) displayed in the right column.
The numbers in the Bid and Ask columns tell us how many contracts are sitting as limit buy orders or limit sell orders at each price level.
What you see on the price ladder is 10 ticks or 2.5 points of order book value in either direction. The best ask price is the lowest of the 10 ask levels and the best bid price is the highest of the 10 bid levels (highlighted below in yellow)
During the trading session, the current price will always fluctuate between the best bid price and the best ask price.
In the above example, we see that the current price is at the best bid price ($2884.50). Meaning the last trade happened at the best bid price.
One thing important to note is that market orders are matched with the limit orders waiting at the best bid/ask price levels.
This means that the market will not trade into any of the pending limit orders on either side of the price ladder until a buy or sell market order is placed.
Looking at figure #1, the best bid price ($2884.50) has 13 contracts bidding at that level. While the best ask price of $2884.75 has 41 contracts offering to sell that level.
In order for the SP500 to trade a tick lower ($2884.25) from the current price ($2884.50). Thirteen sellers from the $2884.75 have to move down the ladder. They must hit the bid (place sell market orders) in order to absorb the remaining liquidity (13 buy limits) and trade lower (see figure #2 below)
Alternatively, in order for the SP500 to trade into the $2885 level, forty-one buyers sitting between $2884.50 and $2884.25 would have to climb the ladder and lift an offer (place buy market orders) in order to remove the sell-side liquidity of 41 contracts at that price in order for the SP500 to trade higher (see Figure #3)
Level 2 Trading- How to spot trading opportunities
Now that you know how to read the depth of the market. We’re going to introduce you to a couple of tips with regards to using the level 2 order book. To find trading high probability opportunities.
Price Moves into Liquidity
Far too often traders are under the impression that the more inventory they see at a certain level. The less likely it is for the market to trade into that level. Unfortunately, that could not be further from the truth. As price moves to and through liquidity. So if you spot a large stack of orders in the book, take note because it will act as a magnet. The market is likely to test that level at some point in the session.
The first tip when using the Level 2 order book is to identify the price levels. Where the most inventory is currently located on the bid and the ask side of the market.
The largest inventory on the bid side is 98 contracts at $2882.25 and 151 contracts on the ask side at $2887. This provides us the short-term range for price and since we’ve got over 350 sell limits sitting between $2886.50 and $2887
This large inventory is sitting around 10 ticks above the current price. This will likely act as a magnet for the price to reach into. Where we can look to qualify a long trade to position ourselves for this move higher.
Look for Changes in Inventory
The second tip when using the Level 2 order book. Look for changes in inventory in order to identify potential support or resistance levels.
For example, If prices are ticking higher and an uptrend approaches a level where offers are building up. This could be resistance. Looking at the order book below. If price started trading higher into the large inventory at $2887 and offers were being added to the level as the price was coming closer. (151 increases to 200, etc). Then this could be seen as sellers not being afraid of stepping into the market. This could be a nice level to qualify for a short trade.
Alternatively, if we are in an uptrend and price approaches a large inventory level where offers are being pulled. It could accelerate the rally. Using the order book above. If the market started to trade into the large inventory at $2887 and the offers at that level were being pulled (from 151 down to 75, etc). Then this could be a sign that the offers were spoofs and the sellers are scared to be filled. This provides fuel to rally higher.
This concept works the same on the flip side! If we are in a downtrend and price approaches a level where bids are building up it could be a sign of support. With the potential to qualify a long opportunity. Alternatively, If we are in a downtrend and price approaches a level where bids are being pulled. It can accelerate the sell-off and provide us with opportunities to qualify short trades.
Level 2 Trading- Conclusion
If you’ve made it this far, you should now be familiar with the level 2 order book. How to read it and how to find low-risk trading opportunities utilizing the data.
Your next step is to learn how to qualify high probability trades by combining the level 2 order book with other powerful order flow tools.
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The information contained in this post is solely for educational purposes and does not constitute investment advice. The risk of trading in securities markets can be substantial. You should carefully consider if engaging in such activity is suitable for your own financial situation. TRADEPRO Academy is not responsible for any liabilities arising as a result of your market involvement or individual trade activities.