Trading Breakouts with Level 2 Data: A ‘Look Before You Leap’ Strategy

The Problem with Traditional Breakout Trading

Traditional breakout trading, which relies on price action breaking through a support or resistance level on a chart, is notoriously prone to false signals, or ‘fakeouts.’ A price may momentarily breach a key level, only to reverse, trapping breakout traders in losing positions. The missing piece of the puzzle for many traders is understanding the underlying supply and demand dynamics that drive these price movements. This is where Level 2 data becomes an indispensable tool.

Using Level 2 to Qualify Breakouts

Level 2 data provides a view into the order book, showing the depth of buy and sell orders at different price levels. By analyzing this data in conjunction with chart patterns, traders can gain a much clearer picture of whether a breakout is likely to be sustained. The core idea is to ‘look before you leap’ – to see if there is sufficient order flow to support the breakout.

For a bullish breakout, a trader should look for the following signs in the Level 2 data:

• Thinning of the Ask Side: As the price approaches a resistance level, a genuine breakout is often preceded by a thinning of the sell orders (the ask side) on the order book. This indicates that sellers are becoming less aggressive and are pulling their orders, making it easier for the price to move higher.
• Building of the Bid Side: Simultaneously, there should be a build-up of buy orders (the bid side) below the breakout level. This shows that buyers are stepping in to support the price and are willing to absorb any selling pressure.

For a bearish breakout, the opposite is true. A trader should look for a thinning of the bid side and a building of the ask side.

A Practical Example: Trading a Bullish Breakout

Imagine a stock is approaching a key resistance level at $50. A traditional breakout trader might place a buy stop order at $50.10. However, a trader using Level 2 data would first examine the order book. If they see a large number of sell orders clustered around the $50 level, with thin buy-side support below, they would be cautious. This could be a sign of a ‘sell wall’ that will be difficult to break through. Conversely, if they see the sell orders at $50 starting to disappear, while the buy orders at $49.90 and below are increasing in size, this is a strong indication that the breakout is likely to be successful. They could then enter the trade with much greater confidence.

Advanced Techniques: Iceberg Orders and Spoofing

Traders should also be aware of more advanced order types that can obscure the true picture of supply and demand. ‘Iceberg’ orders, for example, only show a small portion of a large order on the Level 2 screen, with the rest of the order being hidden. This can give a false impression of thin liquidity. Spoofing, as mentioned in the previous article, is the practice of placing large orders with no intention of executing them to manipulate the market. While regulators have cracked down on spoofing, it still occurs. The best defense against these tactics is to look for confirmation in the actual trade data (the ‘tape’). A genuine breakout should be accompanied by an increase in transaction volume at the breakout price.