Using the Electronic Book

This is the longest section, but this is the one I had the most fun writing. Here is my plan:

  1. The "book"
  2. Placing orders
  3. Supply and demand
  4. Quick hits
  5. When to use the book

1. The "book"

The "book" is a wonderful tool. Every investor in the French market, from the biggest institutions to widows and orphans, has access to it. Let's see what it looks like:

Book example
The book

Last price was 391. The "book" is the box in the middle. It tells you that now you have 5000 shares bid at 391 and 2699 offered at 392. There are 3 orders on the 391 bid and one on the offer. It shows you what is above and below the market. On the buy side, you have 2000 bid at 390.80, 1727 at 390.60 and so on. On the sell side: 1494 offered at 392.40, 2460 at 392.50 and so on. The right-hand side box is the "tape". It shows you the trades real-time, together with their volumes. In this case, last trade was 5000 shares at 391. The previous trades were one-lots between 392 and 392.40. I don't use the "tape" much, but it is good that it is available.

The electronic book has three main uses: placing orders, gauging supply/demand and making "Quick hits". Before we go to the details, we need to have two principles in mind:

      First principle: Using the book is an art and not a science.
      Second principle: The less liquid the stock, the more useful the book.

2. Placing orders

Food for thought

One should consult the book before placing an order. The least you should do is ask your broker for the best bid and offer together with size. Else, using the book to place orders is pretty much a question of determining support and resistance. If this sounds simple enough, let me ask you a question: do you think the market moves toward or away from size orders? Intuition says the market moves away from size. Let me tell you that this is far from obvious in practice.

In "The battle for investment survival" Gerald M. Loeb's states that price moves toward size orders. The market profile philosophy that "markets exist to facilitate trade" and prices move so as to maximize volume, infers the same. I certainly observed the phenomenon again and again in the oil market. This is really counter-intuitive.

However, sometime price moves away from size as intuition suggests. So, I am still in the process of developing a philosophy. I suspects that the answer might depend on timeframe and liquidity. Or maybe it is just a false issue and I am wasting my time.

Anyway, since it is all an art, not a science, I will stop theorizing. I will content myself with giving three examples of order placement.

Example 1

A CAC40 share

What matters first is order size. Looking at the tape we see that 1000 lots orders are relatively big orders. Checking the daily volume, we see that a 1000 lots order is less than 1% of normal daily turnover. 1000 lots or more should slow down the price but not stop it. If I am a buyer, I see size starting at 238.10 all the way down to 237.80. I would have no qualms putting my bid at 238.20 or 238.10. If I am a seller I don't see much size. The 238.60 (only 50 lots) will certainly be taken out and next stop is 238.70. I would certainly not sell below 238.70.

The second thing that matters is order balance. Here, we see more on the bid than on the offer. Odds are that the stock will trade up in the short-term. Depending on what I know of the stock volatility and liquidity, this may draw me to buying or selling at higher prices than those mentionned in the previous paragraph. If the stock is volatile, I would not up my bid price: chances are that I will be hit sometimes later, even with this order imbalance.

The third factor to consider is the stock itself. Schneider is included in the CAC40 and an actively traded blue-chip. This means that the book does not reflect supply/demand as accurately as it would for an illiquid stock. In particular, there are always many hidden orders: people wait for the stock to trade at one given level before entering orders in the system. A size sell order might take the form of a series of small market orders that repeatedly hit the bid without staying on the screen for too long. For this reason, I always have less faith in the book of a very liquid stock. Here the "tape" can help.

Example 2

A "Reglement mensuel" share

This share is liquid but less than Schneider. I will trust its book more. It has been trading 2000 to 4000 lots daily. The 556 sold at 2075 will offer resistance. So will the 700 at 2085. As a seller I would put my offer around 2074 or 2084. As a buyer it would be less easy. There is not a lot of support except for a small one at 2055. I would buy at 2056 or above. Exactly where depends on my agenda.

There is more information than meets the eyes here. Looking at the tape, you see that 64 shares traded at 2075. There are 556 lots at 2075 on the book. We probably had an original order to sell 600 for 2075, getting partial fills. The fact that one person sells 600 for 2075 makes this order more significant than if it was four persons selling the same quantity. By contrast, look at the two persons selling 6 lots at 2080, that is 3 lots each: not a significant order. Now, the fact that professionals (these are $250K and $300K orders) sell at 2075 and 2085 in similar sizes, makes me think that it could be the same person scale selling in 10 francs increments. I may use this info or I may disregard it, but I have it. For instance, if I am a buyer and need to move size, I may put my bid at 2065 on the chance that the scale seller will take my bait.

Example 3

An illiquid share

This share is illiquid. It is a « Fixing A » share and less liquid than many. I am long but want to get out, taking a loss. Where should I put my order? You will not see it here, but the 139 offer and 133 bid have been around for over two weeks. The share has not been trading except in one lots. These one-lots are from a broker hired by the company to have the stock post a quote at least once a day. The intriguing thing is that the one lot trades have all been executed around 133.50. This is very near the bid and never close to the offer. This tells me that someone has a vested interest in having this share quote and be reported near the bid price, to have it look weak. If someone wants it to look weak, then perhaps it is not a good idea to sell right now. I decide to refrain from putting in a sell order. Wait and see...

As we moved from a liquid CAC40 blue-chip to an illiquid share, decisions were easier and easier to make. The book easier and easier to read. A good illustration of my second principle: the less liquid the share, the more useful the book.

3. Supply and demand

We gauge short-term supply and demand for a stock, in order to determine the probable direction of its price. Supply and demand is assessed by studying price and volume. Some might call this activity technical analysis. I prefer to call it tape reading, as it is achieved without the use of charts or indicators.

The presence of the book adds depth to tape reading. Since the tape registers only price and volumes that have traded, it shows only the intersection of the supply and demand curves for a given security. The book shows the shape of the curves as well, and how they change in time. This additional information allows better and more timely calls.

Who is buying?

One priority in analysing the book, is to answer the question: "who does what?". Are the institutions buying? Is the public selling? You want to build two sets of supply/demand curves: one for the public and one for the institutions. Here are some pointers:

Small is beautiful

The smaller, less liquid and less followed a stock, the easier it is to interpret its book. There are less orders to clutter the book and it tends to change only slowly, sometime over weeks, allowing leisurely study. I tend not to tape-read the CAC40 stocks. Not only are they big active stocks, but also the presence of numerous index arbitrage trades muddies the water. Arb trades have nothing to do with the underlying supply and demand for a stock. Another element that can distort a book, and complicate analysis is the presence of a market-maker (contrat d'animation). Again, a market-maker's buy and sell orders have nothing to do with the underlying supply/demand. Unfortunately, many smaller companies hire the service of a broker to animate their stock. With some experience, it is possible to spot the market-maker orders, but they are just a pain in the neck.

The nicest aspect of small stocks is that most of them are not followed by institutional investors. This means that you only deal with the public. This makes for very pure books. Supply and demand gauging becomes very accurate. Sometimes there is only one institution, or one insider, trading the stock and showing size. This situation is even better for our purpose.

If you think about it, smaller stocks are not great only for tape-reading and book gauging. They are also much more amenable to fundamental analysis. It is easier to study a one-product, one-country company than a diversified multinational. And I think that they are just wonderful for technical analysis! They are less affected by macro and external factors (dollar, Wall street, interest rates) than the big caps. Their price and volume behavior tends to reflect company-specific factors. This makes the charts more reliable. You don't even need the book to assess supply/demand. I have noticed that very often smalller caps display textbook behavior. In particular, there have far less false breakouts than bigger caps.

Taking profits

Taking profits is one of the tougher aspects of investing. Most difficult is when a stock breaks all-time highs and goes ballistic. When this happens, some people look for Fibonacci targets. Other follow charts, looking for signs of blow-off. This is is a situation where the book can help, and give a jumpstart over technical tools.

During the ballistic move, book behavior is quite simple. There is some offer showing, and it keeps being hit. There is less and less volume on offer as the price goes higher and higher. At this stage, it is to early to sell. Then comes one day when the move stops. Either there is no offer or the bid doesn't hit the offer. It is still too early to sell, the move might resume on the morrow. At one point though, offer appears in the book. Instead of lower volumes on offer at higher prices, the book shows high volume above the market. This is a danger signal. If offer starts hitting the bid, then it is time to take profits. If the stock is a long-term play, I close half my position.

4. Quick hits

The book facilitates the execution of some trades that are difficult to implement otherwise. I call them "quick hits", because they are essentially short-term trades. A word of caution: DO NOT ATTEMPT THESE TRADES UNLESS YOU ARE VERY EXPERIENCED. Even if you have experience, you should probably not try them. In particular, the first one, which is quite "hairy".

Catching a spike

"Trying to catch a falling sword" is an absolute no-no of trading. Well, here we are trying to perform this very act. Prior to considering the trade, a number of elements must be in place:

If all these conditions are met, you can now look at the book:


Let's say last close was 135 and the security trades on the Second marche (5% circuit breaker). This book structure is ideal for the trade:

  1. The sell orders are smallish. Moreover they are not in round numbers. These orders are probably from the public.
  2. There is a sell market order (MX).
  3. There is some demand below the market
  4. The best bid is 11% below last close. This stock will not trade there now since it is more than the 5% authorised variation.

I would put my bid at 128.50, just above the price that would trigger the limit down. This will catch the 277-lot market order. Odds are that it will trade back up to 140, giving me an 8% profit in one or two days. On the charts my catching the market order will look like a spike. Hence the name: "catching a spike". A few important points:

  1. Be quick to get out if things turn sour. If the stocks trades below your buy price, GET OUT IMMEDIATELY.
  2. I said that the price should be near support, but you can place your bid below support. What needs to be near support is last closing price(s).
  3. Here, we have a sell market order. I have done the same trade without market orders on the book. If your bid is filled when no market order was showing, look at the size. I would not feel very good if my whole order was taken out in this situation. A partial fill would be better, making it likely that I caught the last panicking seller.
  4. There are also bids below the market, giving some clue as to the downside (7%). I have done this trade with no bids below me. It worked, but it is really hairy and I certainly don't condone it.

8% upside and 7% downside might look like poor risk/reward. I do not think it is. What matters is the probability of the risk versus the probability of the reward. The odds are high for the upside. The mathematical esperance of gain for the trade suits me.

Making a market

Specialists on the NYSE keep the book. In France, the book is available to every man and is dog. So, every man and his dog can make a market. The stock must be suitable, but unlike "catching a spike" where the set of conditions I gave absolutely had to be met, here we merely have a list of favorable conditions:

One very important point is: always trade from the long side. Ideally, you should own the stock and make a market with only a small part of your inventory. Remember that professional market-makers carry an inventory.

Now, let's look at an example. First, I would like to see this type of chart:

Chart example

The trend is flatish. Daily ranges are wide enough and tend to be fairly homogeneous over some periods. Point 1 is a breakout upon report publication, you should not have been market-making around that time. Point 2 is dividend payment.

If most of my conditions are met and I like the feel of the chart, then I can consider making a market. I would then look at the book:

Book example

This particular stock has a market maker. It means I will have to live with tighter spreads, but it goes to show that my conditions are flexible. Here, I could buy at 93.10. If I am filled then I will sell at 95.40, turning in a 2.47% profit, more than 1% after commissions. Bear in mind that market-making is based on slow grinding. Take care of the pennies...

5. When to use the book

I hope I didn't give the impression that the book is something to follow real-time. My recommendation is to minimize time spent observing the market. The way books keep changing can be fascinating. There is a danger of screen addiction. I have heard of some people that spend their day glued to the screen. It is not only pricey in feed costs, but I am sure this is counter-productive. I only look at the book when:

The decision to buy or sell is made ignoring the book. The book is consulted only at execution time. In particular, I do not systematically look for the "quick hit" trades I mentioned. I seize the opportunity for these trades when it shows up in a stock that I already own or want to own. In the end, I consult the screen only two or three times a week.

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