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Auction Market Theory

The origins of auction theory can be found mainly in the studies on Market Profile carried out by J.P. Steidlmayer. Steidlmayer, together with other authors such as James Dalton and Donald L. Jones, later defined a series of concepts that constitute said theory.

It is based on the fact that the market, with the primary aim of facilitating trading among its participants and under the principles of the law of supply and demand, will always move in search of efficiency, also known as balance or fair value.

Auction Market Theory

Efficiency indicates that buyers and sellers are comfortable trading and neither has clear control. That comfort arises from the fact that, based on current market conditions, the valuations of both are very similar. This balance is visually represented on a price chart through the continuous pivoting of the price (within price ranges). These sideways price movements represent said balance. It is the evidence of a context in which trading is being facilitated, the state which the market is always attempting to reach.

Then we have moments of inefficiency or Imbalance. These are represented through the trend movements. When new information reaches the market, it can cause the value of said asset, as perceived by both buyers and sellers, to change, generating a disagreement between them. One of the two will take control and move the price away from the previous balance zone, offering us a trading opportunity. What is evident in this context is that the market is not facilitating trading and therefore it is deemed to be in an inefficient condition.

The market will be constantly moving in search and confirmation of the value; in situations where buyers and sellers are in a position to exchange stocks. When this happens, it is because the valuations that these participants have regarding price are very similar. At that moment, trading activity will once again generate a new zone of balance. This cycle will be repeated over and over again without interruption.

The general idea is that the market will move from one balance zone to another, through trend movements, and that these will start when the market sentiment of both buyers and sellers regarding current value differs, causing the imbalance. The market will now start searching for the next area that generates consensus regarding value, among the majority of participants.

It is worth noting that the market spends most of its time in periods of balance. This is logical, since it is the nature of the market to promote trading among its participants. This is where those accumulation and distribution processes take place, which, as we all know, is the focus of the Wyckoff Method.

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Variables

The auction process in financial markets is fundamentally based on value. To try to determine where said value is found, three additional elements need to be evaluated:

Price

In the auction mechanism, the price is used as an exploratory tool. The negotiation is facilitated through the movement of the price, which fluctuates up and down, exploring the different levels in order to see how the participants react to said probing.

These price movements herald opportunities. After this probing the participants will start to trade with each other, if they believe the price to be fair.  Conversely, if this exploration of new price levels is not perceived as attractive for both participants, it will be rejected.

Time

When the market offers an opportunity (reaches an attractive level), it will use time to regulate the duration that the opportunity will be available.

The price will spend very little time in those areas that are advantageous for one of the two sides (buyers or sellers).

An efficiency or balance zone will be characterized by a greater consumption of time; while an area of inefficiency or Imbalance will last for a shorter period of time.

Volume

The volume represents the activity; the amount of an asset that has been exchanged. This quantity indicates the interest or disinterest there is at certain price levels.

There are zones that are more valuable than others, based on the volume. The basic rule of thumb is that the more activity observed in a given area, the higher the value placed on it by market participants.

Price + Time + Volume = Value

These three elements provide us with a rational perspective regarding where market participants consider the value of a particular asset to be based on current conditions.

The market explores new levels using the price. The consumption of time suggests that there is a certain acceptance in this new area and finally the generation of volume confirms that the participants have created a new zone of value where they trade comfortably.

As we know, conditions are always changing, so these elements need to be continuously re-assessed. Knowing where the value is key since it defines the condition of the market. We can then take different approaches to trading, based on this.

Perception of value

The market is constantly pivoting between two phases: horizontal development (balance) and vertical development (Imbalance). Horizontal development suggests an agreement between participants, while vertical development is a market in search of value, in search of participants with whom to trade.

Auction Market Theory for Volume Profile traders

 

The fact that the price is moving comfortably in a trading range (horizontal development) represents acceptance in said zone; a context where price and value coincide according to the participants. When the market is in a trend situation (vertical development) price and value do not coincide. In this context the price will move first and the value may follow or not (as a sign of acceptance or rejection).

In an balance zone, the fairest price will be located in the middle and the two extremes, both above and below, will represent unfair levels or levels not accepted by the participants.

If the fairest value is in the middle of the range, a move to the higher end will be seen by buyers as expensive, while sellers will see it as cheap, and their actions will send the price back to the fairest area. Similarly, a visit to the lower end of the range will be seen as cheap for buyers and expensive for sellers, which will lead to a new reversal upwards.

This is what is commonly known as range trading, where traders look to buy at the lows and sell at the highs, hoping that the price will continue to reject these extremes. And normally the market will continue like this until its condition changes.

What is interesting is when Imbalance occurs and the price leaves the value area. What happens then? When the price leaves a trading zone, a change in the perception of value may take place.

The trader’s task is now to assess whether these new price levels will be accepted or rejected. Price moves ahead of the other two variables in determining potential value areas, but it is time in the first instance and volume in the last, that will confirm whether a new area is accepted or rejected.

We interpret acceptance of a new area when the price manages to stay at that level (it consumes more time) and contracts between buyers and sellers begin to be exchanged (volume), with all this represented by a certain sideways movement of the price. By contrast, we would identify rejection when the price quickly reverts back to its old value area, denoting a lack of interest and evidenced by a sharp reversal.

All horizontal developments end when there is no longer agreement between the participants about the value; while all vertical developments end when the price reaches an area where there is agreement between them once again. This is the continuous cycle of the market. This idea in itself is very powerful and, with the right approach, you could build trading strategies around it.

As with one of the universal principles of technical analysis (the market discounts everything), we don’t really need to analyze why this change in the perception of value by the participants takes place. We know that based on current conditions and the information available at that precise moment in time, all the participants value the price of the asset in a certain way. Something may then happen at a fundamental level that changes said perception, but the advantage of this approach is that we don’t need to know and interpret what has happened for the participants to have changed their perception.

It is important to note that auction theory is universal and can be applied in the evaluation of any type of financial market, regardless of the time frame in question.

The four steps of market activity

This is a process with which Steidlmayer represented the different phases through which the market passes during the development of its movements.

The four phases are:

The four steps of market activity

  • Trend phase. Vertical development, Imbalance of price in favor of one direction.
  • Stop phase. Traders in the opposite direction start to appear and the previous trend movement is stopped. Upper and lower range limits are set.
  • Sideways phase. Horizontal development. Trading around the stop price and within the limits of the new balance range.
  • Transition phase. The price leaves the range and generates a new Imbalance in search of value. Said movement may be a reversal or continuation of the previous trend movement.

Once the transition phase is over, the market is in a position to start a new cycle. This protocol will develop uninterruptedly and is observable in all time frames.

Visually, until step three, a P or b shaped profile will be observed. We will look in more detail later on at how the shape of this profile is generated and what trading approach should be adopted here.

For structure traders, this four-phase protocol will be familiar, since in essence it is exactly the development from Phase A to Phase E proposed by the Wyckoff methodology:

Wyckoff methodology phases

  • Stopping the previous trend
  • Constructing the cause
  • Assessing the opposition
  • Starting the trend movement
  • Confirming the direction

Although Richard Wyckoff, as well as his later students and other traders who have contributed to the dissemination of his ideas, worked solely on the basis of analytical tools and technical analysis principles, we can see that they were already implicitly applying these auction theory concepts, even if they didn’t use these exact same terms.

For this reason we consider using the only technical analysis approach that is based on a real underlying logic: auction theory and the law of supply and demand.

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