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Get Ready for a Level II World

Mark Ingebretsen

In my last column, I talked about how to Build Your Own Trading Info System for Free and reported that Nasdaq charges $50 a month for Level II quote data, a key part of a trader's information arsenal.

As it happened, the following Monday, Nasdaq announced it would lower the Level II fee to $10.

Level II quotes, as you may know, give you the kind of detailed financial data professional traders and daytraders have long relied on. The Securities and Exchange Commission still must approve the price cut. No one at Nasdaq wants to say when this will happen, although previously, such approval has come in as little as a month.

Whenever the new fees take effect, you can bet that hoards of traders will demand that their brokers and favorite financial Web sites dispense Level II data. The whole marketplace for financial-data services will likely change as a result.

Let's take a look at how the advent of low-cost Level II quotes, together with some other developments, could change the way people act upon financial information in the future.

Level II for Everyone

As I mentioned, low-cost Level II data means that the landscape for quote providers will change dramatically. That said, there's a danger that many people may not be prepared for the information deluge a Level II screen provides. A very successful trader I spoke with said she wanted to run from the room the first time she saw a Level II screen. The blinking lights and constantly changing numbers looked to her like an air-traffic control station.

Certainly, watching the constantly changing bids and offers placed by market makers and over ECNs, or electronic communication network, can be confusing. And the fact is, for most traders, Level II is simply too much information. If you're determined to trade with Level II data, read a book on the subject. The reputed classic is Jay Yu's The Underground Level II DayTraders Handbook, which is available only on the Web. You might also check out The Electronic Day Trader by Marc Friedfertig and George West. Sites like Daytraders U.S.A. sell manuals and courses to get you up to speed.

If you want to get a sense of what trading using streaming real-time data is like, try out the demo at Interactive Brokers. The site makes it fairly easy to create a dummy account then execute simulated trades while watching real-time data.

Interactive Brokers, I hasten to add, actually shows you Level I data. Level II is an order of magnitude more intense. Another download, the CyberTrader 2.0 simulator uses historical Level II data, which it shows you via an actual Level II screen.

A Higher Level

As it turns out, Level II is probably not the last word in market data. That's because trading on ECNs like Island or Instinet, when added together, can account for as much as 30% of the daily volume on the Nasdaq. Right now, Level II screens list the best bids and offers from each of these ECNs as a single entry -- the same way they list orders from individual market makers. In other words, a Level II screen does not reveal the depth of bids and offers that exists within each ECN.

A nonprofit group called Central Trade Portal is trying to change that. The group's goal is to create a unified order book that represents all SEC-approved ECNs, exchanges and broker dealers. The move is being spearheaded by NexTrade, an ECN that began 24-hour trading early last April. NexTrade's proposed Central Trade Portal would accept limit orders only. And it would be operational only during after-hours trading. This is a particularly critical time, since at present, each ECN becomes a world unto itself once the regular exchanges close. That means, for example, that America Online (AOL Quote - Cramer on AOL - Stock Picks) might be selling for 52 1/2 on Island but 52 3/8 on another ECN, such as REDI.

Nasdaq is also working on a version of a comprehensive trade-order book, but there's no definite word on when that might arrive.

Right now, mainstream brokerages -- those that cater to average investors -- offer after-hours trading through just one or two ECNs. So if you're trading after hours through one of these ECNs, you can't be sure you're getting the best available price.

Active traders and brokers, on the other hand, have software that executes trades at the best possible price by scanning the order books of the entire market, including all the ECNs. The software goes by the term "intelligent order routing." You can read about it in one of my previous columns.

Something like the Central Trade Portal could increase transparency and improve executions even more. And it would help during the day as well as after hours. During the day, it could list the best bids and offers from ECNs and other trading systems. Yes, that would mean a lengthy list of bids and offers to scan. But, as with the current Level II book, traders would need to focus only on the top tier of bids and offers.

And as for less experienced traders: Hopefully, mainstream brokerages will make intelligent order routing available to them. That way, by pressing the confirm button, their customers can be assured they're getting the best possible price, whether after hours or during regular trading.

Intelligent order routing software will become especially critical in the years ahead as more of us trade via cell phones and PDAs (personal digital assistants). Nobody's going to watch a Level II screen when it's been reduced to the size of a belt buckle. The mainstream brokerages that realize this will be the ones that thrive in the future.