Figure 10.3. Level II Snapshot 2

Although the Level I quote has remained the same (17.38 x 17.39). 2300 shares of Cisco have been bought at 17.39, and two other market makers have joined the best bid. A bujing situation is created when the best bid tier expands, and the best offer tier contracts. Likewise, a selling situation is creaied when the best offer tier expands, and the best bid tier contracts. In this situation, momentum tradeis will rush in to buy CSCO at 17.39 since only one market maker remains, hoping that Morgan Stanley (MSCO) will finish selhng shares at 17.39 and raise the offer to apiice of 17.40 or higher.

So. the momentum trader has bought shares at 17.39 and is now waiting for a higher offer. Before continuing with our example, we examine the practice of Level II trading before decimalization (B.D.) and after decimalization (A.D.). In 1995 B.D., a trader couM SOES in for 1000 shares at 17 4, and as soon as the offer was raised, try to seh it immediately for 17 3/8 in order to pocket a quick $125 (not including commissions). In 2002 A.D., a stock such as Cisco has a penny spread, which invafidates the original SOES strategj. As a result, some traders have adapted by trading more size and staj-ing in the trade longer, in contrast to the\irtuallyrisk-ftee trade ofthe past.

Several minutes later, CSCO is trading up to 17.45. Now, the trader can act as amarket maker and use any ofthe ECNs to sell 1000 shares of CSCO at fiie offer price of 17.45. For exanple, the trader may use ISLD to display its offer as shown in Figure 10.4. If the momentum confinues, then the trader will sell the

shares and make sis cents in se-eral minutes. For 1000 shares, the profit wih be $60 minus commissions.

Figure 10.4. Level II Snapshot 3

Si5>pose that the momentum stalls before the trader is able to seh the shares. Further, the Level II window shows that maiket makers are lowering their bids and/or offers. Ifmomentum is reversing, then the trader should be able to seh at the best bid price, in this case at 17.44.

10.2.4 Case Study; ImCloneSystems

The case oflmClone Sjstems (IMCL:Nasdaq)is an example of combining news and tracking madiet maker movement to predict price direction. The company was expecting the FDA to approve its cancer drug Eibitux before the end of calendar year 2001. The stock had been shding ftom the se-enties into the ftfties near the end of December. On the moming of December 27*, a Merrill Ljmch analj-st issued the foUowing comments regarding the drugs sppro-al

Its "not uncommon" for companies to be asked for more information about their dmgs and the analyst said Erbitux still appears to be headed for approval in the coming year. "We believe that over the next six months ImClone will have its file activated and we expect the product to be approved in 2002"

Given that Merrill Ljnch is a top market maker by volume in hnClone, the logical step was to monitor the market maker MLCO on the Level II window. Most direct access software lets the trader highlight market makers or ECNs in the Level II window. The trader can learn much by obser\Tng the actions of a highlighted kej market maker.

-10 min NASDQ 12/31/2001

11:10:10 13:10 14:10 15;10 12/31 ;40 11:40 12:40 13;4Q 14 40

1 10.5. hnClone Intraday

At approximately 3:30 pm on the Friday afternoon of December 28", Merrih Lynch went low offer on IMCL. For the next thirty minutes until the closing beh, ML CO remained on the best offer. As ECNs rushed to step in front of MLCO to sell shares, the market maker aressively lowered its offer price to sell stock. The price plummeted several points over the last three bars, as shown in Figure 10.5.

Then, with the whir of a fax machine m ImClones offices on Dec. 28, the FDAs letter arrived, rejecting the bahyhooed Erbitux trial and casting doubt over tiie drugs future. Wall Street Journal, February 7, 2002

At 7:14 pm that ewrting, ImClone announced that the FDA had decided not to accept the filling for the Erbitux application. On Monday morning, Januarj 31, IMCL opened at 45.39, down 9.86 points from Fridays closing price (refer to Figure 10.6). An investor may have been inclined to listen to the analysts posi

rive comments for guidance andbujthe stock, but the astute trader lets price do the talldng and tjpicahy does the opposite ofthe investor.

LAST-Daily 01/04/2002

I • t

Figure 10.6. hnCloneDaily

As shown in the ImClone example. Level II trading is not about plopping in front ofthe screen and hitting hot kej-s. Use the technologj and combine it with market knowledge to exploit unique trading opportunities. Further, use other data sources to refine your understanding of any given stock and understand its pattem oftrading.

The Nasdaq Market Data Web site offers detailed data reports such as the Market Maker Price Movement Report and the Time and Sales Report; these are dahy replaj-s of Level II price movements and trade history, respectively Order a few ofthese reports and track a stocks price movement throughout the enthe trading day.

10.2.5 Case Study: Comverse Technology

The following example illustrates the power oftape reading-no multi-colored screens or multiple time frame charting. We think a trader just starting out should sit down in front of the television, tune into CNBC, and then hit the mute button. For the next few days, the trader should just read the tape, watch ing the ticker scrdl across the bottom of the screen.

As the sjmbols pass by, certain pattems begin to emerge. Focus on the trades in ten thousand share blocks and higher, e.g., lOK, 20K, 50K, etc. Then note whether the trades are printed in green (up ticks) or red (down ticks). The usual large-cap suspects will appear on the tape. Newsworthy stocks wiU appear as well, but we want to focus on those stocks with no apparent news, so review the moming news to ehminate the known ones. This skiU becomes second nature with experience.

OnJuly 9 and July 10*, 2001, sewral casual glances at tiie ticker revealed some imusual activitj in Comverse Technolcgj. Large blocks of CM\T were crossing the tape, and no news had been released about the company. Ah ofthe trades were at least 10000 shares in size, and ah of the trades were occurring on down ticks.

CMVT LAST-Daily 07/13/2001

t t t f M t

30.000 25.000

Fure 10.7. Com

le Technology

OnJuly 10, Comverse annoimced that they were cutting earnings estimates for the next two years. The stock gapped down o-er twalve points that moming (Figure 10.7). In retroapect, one wonders whether or not anyone knew about these cuts ahead ofthe annoimcement (tongue planted firmly in cheek). One monthlater, investment houses upgraded the stock(tongue deeply embedded).

In the following sections, we show the trader how to analyze stocks based on their volume, and explore how to detect unusual trading volume in small-cap stocks. As with our trading systems, we want to analyze the market from as many perspectives as possible.

10.2.6 Case Study; OSCA Inc

hi early 200Z OSCA had an a-erage dahy volume of 85,000 shares. Then, on Februarj 19* the averse dahy volume was exceeded at 9;55 am, inthe absence of news. After spiking up to 22, the stock puhed back to 20 and then slowly gained ground for the rest ofthe day on heavy volume. At 2;30 pm, the price apiked back to 2Z where it closed on the day (Figure 10.8).

The rarious news organizations had picked up stories of acquisition rumors throughout the aftemoon, but an a-erage volume filter detected this imusual movement eariy in the moming. The formula is easj; calculate the average dahy volume ofthe stock for the past twenty dajs; we want to focus on illiquid stocks with average dahy volumes ofbetween fifty to two himdred thousand shares. Then, compare the volume ofthe current trading day to the highest volume of the past sLxtj ds to see ifvolume is tracking higher.

X NASDQ 02/20«002

27 0 26.00 -25.00 24.00 23.00 22 0 21.00 20.00 18.00

450.00

2/19 11:20 12:50 ;20

150 I

FigurelO.8. OSCA. Inc.

Example 10.1 is an example ofaFirstAlert filterfor detecting unusual volume in alow-capitahzation stock

Example 10.1. Unusual Volume 1 1

ftl Volume > (VolHlgb60 d% l) 2 Voliimn > wooo III \1 \ - } MMKIlt «1 <>1 ; » v