Translated from: https://tradingriot.com/auction-market-theory/
What is auction theory?
Market auction theory explains the main purpose of the market and the way market participants interact to achieve this purpose.
The main idea is that financial markets are no different from any other auction floor where buyers and sellers come together and interact on a daily basis.
There are two main goals to achieve:
1) Facilitate transactions during the double auction process
2) Seeking the fair value of assets
A double auction means that the end of the "up" auction is followed by the start of the "down" auction, and vice versa. This is then represented by tools such as market or volume price charts.
These bell curves (Figure 1) indicate that market fair values are within 68% of one standard deviation.
A practical example of the application of auction theory in financial markets
An example in the stock market, suppose Samsung stock is priced at $50 per share. Samsung launches a new phone, but it is of poor quality, the battery does not work properly, it overheats and explodes, etc. Due to this incident, the Samsung stock price begins to fall until it finds a new buyer at $30.
This is where new areas of value are formed.
After a while, the phone is magically patched and the stock price starts to rise again. Where in the market is it likely to stop rising? The previous value area of about $50.
This is what every market ultimately does: market participants negotiate prices between balanced and unbalanced values.
Market auction theory defines the area where 68% of the transaction volume is located as the value area
There is also a Point of Control (POC) within the value area, which is the price level where the market has the most volume or has stayed the longest.
1) Market charts represent value areas and points of control over time.
2) Volume-price charts represent value areas and points of control based on volume.
Figure 2 can represent this value-seeking broadcast mechanism and price.
Key components of market auction theory
1) Price - Broadcasting opportunities in the market
2) Time-Regulated Price Opportunities
3) Volume - measures the success or failure of an auction. Volume measures the interaction of market participants at different price levels.
Balance and Imbalance
In a balanced market, buyers and sellers agree on prices and are willing to buy/sell at current prices because they believe those prices represent fair value.
A balanced market generally represents low volatility.
Likewise, imbalance is the opposite of balance. Imbalance is a disagreement about fair value. Market participants act more aggressively on one side, which leads to market trending, i.e., prices will go through a one-sided rise/fall.
In general, the market is in a unilateral trend state only 20% of the time, and in a range-bound state 80% of the time.
Five rules of auction market theory
See Figure 4
1) If the price is accepted by the balance zone, it is likely to reverse to the other side. The price will usually retest the edge of the balance zone before going in the opposite direction.
2) Prices within the equilibrium range are expected to be rejected at the edge and become more volatile.
3) Once the price is accepted outside the equilibrium range, it is likely to become unbalanced and seek a new value - usually the Point of Control (POC) of the previous equilibrium range.
4) If the price has a clear and strong reaction in POC, Rule 1 is invalid.
5) If the time/volume chart is forming on the edge of the equilibrium zone, this is likely a sign that price is about to be pushed further down.
Summarize
Market auction theory determines the equilibrium and imbalance of the market by analyzing the distribution of transaction volume at different price levels. It can provide new ideas for understanding market dynamics and market behavior beyond simple price behavior.
Market auction theory emphasizes how the market supply and demand relationship and the interaction between market participants drive prices to form price ranges and unilateral trends. It provides a very valuable perspective to analyze market behavior.
When used in conjunction with other analytical tools, market auction theory can help investors better plan entry and exit points.
