Auction Market Dynamics



This is the second article in the series, that will discuss a few concepts of Auction Market Theory and how we can readily apply them to the financial markets in order to have a better understanding of what's going on and why. As with the first article in this series, what follows is my personal rationalization of things. It's not the absolute truth, it's just another piece of the puzzle.

1. The Auction Process in Financial Markets

Let's start from the very basics. The function of any market is to facilitate trade, which means help buyers and sellers find their counterpart. As price gets pulled higher, it attracts sellers; as price gets pulled lower, it attracts buyers. These rotations up and down are the process called “price discovery”, with which the auction process discovers the price that both sides agree upon, thus establishing “value”.

Auction markets are a dynamic process, and looking at the markets as if they were one giant auction helps to explain how they work, and provides reference points where decisions can be made. However, this view of the markets is not a “trading system” in itself. It is one of many ways to understand where focal points are, in order to exploit them. The main takeaway from the auction process is to spot the points where the auction looses it's balance, which gives way to crowded trades where players from many different time frames.

2. The Concept of Value in AMT

Value is based on the market participants' perception of “fairness”. When the market spends very little time at a particular price, the price is considered to be “unfair”. Unfair levels show up as price rejection spikes. For each time period, the market participants actions determine what the “fair” price is or value for that time period. Vertical movement instead shows that the market is out of balance and all market participants want to be on the same side of the market. Usually there is a very good underlying reason to this (that may be unknown to the chartist) but the footstep it leaves is usually that of large money flow. After all, the market cannot move much without big money stepping in to propel it.

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Humans, not machines, make the markets and price rejection and/or consolidation is a behavior that can be mapped and exploited time and time again. In no place like the markets does history repeat itself in such a precise manner.

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3. Mapping the Auction Process: Supply and Demand

In my experience, professional traders day in & day out highlight supply & demand zones and then wait for certain characteristics in order to initiate a trade. Logically, a demand zone is a zone from which price has been propelled higher. And a supply zone is a zone from which price has been propelled lower.

There are always a great number of supply and demand zones on the charts, simply because the perception of value is constantly changing. Market participants are constantly trying to price in (or discount) what will happen tomorrow, next week, next month, next year (which are all uncertain) and thus create an expectancy. Thus something that is highly in demand today may be sold aggressively tomorrow or next week.

So what do supply and demand zones look like on a chart?

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Of course, as many other things with the markets, we should always look at the most evident imbalance zones. The more evident the zone, the larger the imbalance and the more momentum is created.

Now, due to the fractal nature of the markets, these imbalance zones are created on all time frames. It's up to the trader's own objectives and risk-tolerance to decide whether to use them on all time frames or whether to stick to a handful of chosen time frames. Obviously the higher the time frame, the more participants are active and see it. Therefore, the more weight that particular zone/level may have.

There are many other traders that use this information and they each have their own way of interpreting these areas. Some believe that the “pop” in order flow will leave some latent orders at the breakout level, which will activate during the next touch of that level. This gives birth to the “touch trade” mentality, where an evident support or resistance – once broken – should hold upon the first touch on the way back. Other traders look at these imbalances as “momentum” either in line with trend or against the trend and decide whether to play them via “touch trades” or via a rejection (i.e. Waiting for some further evidence that there are in fact orders waiting).

The way I personally interpret these areas is as such:

1) a big evident supply/demand imbalance zone generated on the big hourly charts usually holds up next time round. I then wait for price to reject this zone before entering.

2) I look as these zones as possible places to re-enter in line with the prevailing market sentiment (or trend). I do not generally appreciate the odds of playing counter-trend.

3) Frequently, the same area holds up multiple times upon inspection, becoming a “technical” support or resistance level. When this happens, waiting for a rejection becomes increasingly important. Stops will be building on the other side of the level/zone and may very well give birth to another imbalance on the other side.

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So I hope that you have found this view of market dynamics interesting and hopefully you can incorporate this view of the market into your daily trading routine. I have not given precise indications on how to use these zones because, very frankly, each person has his own interpretation. The important thing is that we can all agree on the fact that these imbalance zones do exist and can be exploited. Remember: we are all small compared to the market so when we risk our capital it makes sense to risk it at a place where many other big players should enter the market as well – and hopefully take our trade for a nice profitable ride with them!

That's probably one of the main lessons that I have learned on my journey: try to understand where others may enter (or exit for that matter) because it takes active participation (high volume) to take prices on their merry way.

In the next article, we shall explore the fractal nature of the market and how understanding this fractal nature can help you in your trading.

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