What is Auction Market?

The auction market theory (AMT) is a specific trading system that perceives financial markets as a process of continuous auctions. Thus, in the auction market, share prices are determined by the continual interactions between buyers and sellers. The core focus here is on growing an understanding of how prices are negotiated by market participants, along with identifying any demand and supply imbalances, and eventually reaching a fair value where most trades may be enabled. 

Understanding the AMT gives traders a better framework for knowing how markets function, particularly buyer-seller interactions. You’ll also learn to identify potential profit or loss areas, based on the volume and price movements. You can also use this theory to create trading strategies that concentrate on capturing price movements during periods of imbalance. 

How Auction Market Functions 

There are several intrinsic differences between an auction market and a regular market model in terms of structure. Here are some key aspects regarding the process of an auction in the stock market

• The market is perceived as a continual process of auctions, where buyers and sellers are negotiating prices constantly 

• The aim of market participants is to achieve the fair value of an asset, the price at which the largest number of trades may occur, thereby reflecting both demand and supply.  

• Market movements will be driven by imbalances between buyers and sellers, which may happen due to market events or other news 

• Point of Control is also the area where the highest trading volume takes place, indicating a period of balance or equilibrium in the market 

• The price is a key element, indicating the point of equilibrium where buyers and sellers agree on the asset value. In this context, there is the spot price, which is the current market price at which an asset may be sold/bought for immediate delivery. This is worked out by the interaction of buyers and sellers. 

• There is also the bid and ask price dynamics, where the latter is the lowest price a seller is willing to accept for any asset, and the former is the highest price that a buyer will pay for the same at the current moment. The gap between the bid and ask prices indicates market liquidity, with a smaller spread reflecting higher liquidity and vice versa. 

• Volume offers an understanding of how strong price movements are, showing whether sellers or buyers are dominant in the market. Time indicates the timeframe of movements in prices and the duration of imbalance and balance periods. 

Key Players in an Auction Market 

Here are the key players for an auction in the share market

• Stockbrokers: They are registered entities enabling the execution of buy and sell orders for investors, working as intermediaries and helping investors participate in the process. 

• Institutional Investors: Banks, mutual funds, insurance companies, and other large investors fall into this category. They often take part in auctions to meet various goals. 

• Retail Investors: Individual investors who trade on a smaller scale fall in this category and may also participate in auctions. They may place bids via brokers for selling or buying shares. 

• Exchange: Stock exchanges play a vital role in terms of conducting auctions and enabling a fair pricing system.

• Market Makers: They contribute to the auction market by ensuring higher liquidity and enabling trades, which indirectly influence the process. 

• Depositories: Depositories are intermediaries that keep the digitised shareholdings of investors in a secure account, thereby facilitating trade settlement after the auction. 

• Depository Participants: DPs are agents who work on behalf of their investors for depositing shares and other securities. 

Market Profile Analysis and Trading Strategies 

Market profile is a method of data organisation that provides insights into several AMT principles on a real-time basis. It resembles actual auctions where prices move based on demand and supply. If buyers are strong, then prices go up, and they compete to buy the asset in question. On the flipside, if sellers are stronger, then prices go down, and they compete to attract more buyers. Another key concept is the market cycle, which is when markets move up or down through multiple stages, including accumulation, markup, distribution, markdown, and then re-accumulation and redistribution. 

As per the auction market theory (AMT), the financial market will work in the manner of an auction, where the price will go higher in search of sellers and lower in search of buyers. As per the market profile type, it can be a normal day (prices staying within the initial balance for the whole day) or normal variation (when the prices move outside the initial balance, subsequently without creating a range higher than twice the initial balance). Then there is the double distribution trend day, neutral day, and neutral centre day. 

In terms of strategies, the goal of any AMT trader will be to determine whether the market is balanced or imbalanced and apply the strategy alongside. In a balanced market, you will look to shift away from the mean reversion or fair value. When markets are imbalanced, you will look to trade in the direction of this imbalance. Buyers will drive the prices higher when the market is in a phase of discovery during the buy imbalance period, searching for new sellers. In the same way, whenever there is any sell imbalance, sellers will keep driving the prices lower in search of newer buyers. 

Auction Market vs. Order-Driven Market 

In an order-driven market, buyers and sellers place their orders, specifying the quantity and price they wish to sell or purchase. These orders are matched with an automated system based on time priority and price, leading to the trade. It will contrast with the quote-based market, where the market makers quote their prices. Some key elements of order-driven markets include automated matching, order book, price discovery, and direct trading without intermediaries. 

On the other hand, the auction market is where the price is determined based on the highest price the buyer is willing to offer (bid) and the lowest that the seller wishes to take (offer). They are then matched for the trade to take place. Trade matching takes place simultaneously in these markets, with instant electronic execution. If the bid does not match the offer price, the order will stay pending until the right corresponding ask and bid are matched. 

Also Read : How are Stock Prices Determined?

Conclusion: Using Auction Market Theory for Trading 

The auction market theory (AMT) is a useful trading tool that will help you understand market dynamics better. Evaluate buyer-seller interactions to unearth valuable insights regarding price movements and also boost trading strategies and risk management alike.

AMT has its limitations, too, although it remains a crucial tool for serious traders in the market.