Level 2 Tips: Bid/Ask Ratio

Utilizing Level 2 screens is a great way of gauging the supply and demand for a stock on any given day. Unlike a simple Bid/Ask quote, the Level 2 screen gives a much deeper insight into the supply and demand for each stock because you can see a multitude of different orders.

One thing I pay very close attention to is the amount of shares on the bid compared to the amount on the ask. I incorporate the observations into my risk/reward analysis strategy. I’ll use an example to illustrate my point. This example is live from today’s trading.

A simple quote from your broker would tell you this:

Last price: $0.0256

Bid: $0.0256 (74,000 shares)

Ask: $0.028 (190,000 shares)

When you do a more thorough Level 2 analysis, you can see this:

367,000 shares would need to be purchased on the ask to push the stock price to .03 for a 17.2% gain from the current price level.

225,000 shares would need to be sold on the bid to push the price down to .0162 for a 36.7% loss from the current price level.

Considering the stock has only traded 163,000 shares today, a price movement in either direction could have a huge impact.

This analysis shows that the stock could drop faster than it could go up. If you were to do a basic risk/reward analysis, you would notice that the stock has a higher chance of risk than it does reward.

All of that being said, it is important to keep in mind that this should not be the sole basis for your judgment of a stock. I happen to be long on the stock above even though I mentioned the short term risk is higher than the short term reward (intraday).

Other factors play a role. First, and most important, not all orders are shown on Level 2 screens. Only one order is shown for each market maker. There may be stronger bid support or resistance on the ask. Sometimes you can see this during the day as price goes up. Additionally, people may also enter new orders as they see the price shift in either direction. It is important to learn how a stock trades. For example, the stock used for the example has stayed in the range of $0.025-$0.028 for quite some time. There are not too many anxious buyers or sellers, but big catalysts are expected. This means that it is still prone to risk, but historical data lets us know that sellers are not looking to bring the price down quite yet.

Overall, this method should be used to help find true support and resistance levels. Utilizing this strategy can help minimize your risk as you are more aware of how the public perceives the value of the stock. This is especially helpful when contemplating entering a position during a breakout. The price of the stock may be skyrocketing, but without strong bid support it could fall fast. Similarly, if more shares are available on the ask, this can create resistance. Try to use this strategy to understand how fast a stock can rise or fall intraday.