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If you have not worked with level II screens before, they contain a considerable amount of valuable information. |
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This is a screen for Microsoft (MSFT) that shows the "inside market," which is the best bid (120 3/8) and the best offer (120 1/2). These are the best prices available in the market at this instant. |
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The size column shows "10," which is shorthand for 1,000 shares. (Remember that the market maker had to take two hits at 1,000 shares each. So, you can see that these prices are well supported by seven market makers on the bid and by nine on the offer. At 2,000 shares per market maker, there was a considerable amount of liquidity to trade against. |
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The spread, which is the difference between best bid and best offer is a comfortable 1/8 of a point. The astute trader could, at a glance of the Level II screen, discern price support and spread risk. |
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Then, a much debated rule change, the Actual Size Rule, became effective in January 1997 which had significant, practical affects on trading. The major change in this rule was that the market maker only had to honor one 100 share execution at this posted price. This reduction, from 2,000 shares to 100 shares, represented a 95 percent reduction in liquidity. In early 1997, a typical level II screen might have looked like the one in Figure 1.3. |
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Now, the inside market shows just two market makers' bid at 120 3/8 and just one on the ask at 120 1/2. |
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Worse, the size now shows "1," which is short for 100 shares, and the market maker is now responsible for only one "hit." |
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Although the spread still looks to be 1/8, the "effective spread" is actually much wider because of the reduced liquidity at the best bid and best offer. A trader can only buy 100 shares at 120 1/2; any other shares the trader wants will cost more, effectively widening the trader's spread. |
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Traders quickly learned that they could not count on getting orders filled quickly, or at a satisfactory price, through SOES. A better alternative was needed. |
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Led by the Island and Archipelago ECNs, traders soon were given excellent alternatives to SOES. The ECNs brought fast, electronic matching capabilities to the market, along with a considerable increase in liquidity. |
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Figure 1.4 shows what a typical level II screen looks like now that the ECNs of the Fifth Market have become active. |
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The first thing you will see is that the ECNs brought liquidity back to the markets; they are showing substantial size behind their bids and offers. For example: |
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