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 developing an understanding of how prices are negotiated by market participants, identifying any demand and supply imbalances, and eventually reaching a fair value at which most trades can be enabled. 

Understanding the AMT provides traders with a better framework for understanding 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 continuous process of auctions, in which buyers and sellers constantly negotiate prices. 

• Market participants aim 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 arise from 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 that indicates the equilibrium point at which buyers and sellers agree on the asset's value. In this context, there is the spot price, the current market price at which an asset can be sold/bought for immediate delivery. The interaction between buyers and sellers determines this. 

• There are also bid and ask price dynamics, where the latter is the lowest price a seller is willing to accept for an asset, and the former is the highest price a buyer is willing to pay for it at the current moment. The gap between the bid and ask prices indicates market liquidity: a smaller spread reflects higher liquidity, and vice versa. 

• Volume provides insight into the strength of price movements, indicating whether sellers or buyers are dominant in the market. Time indicates the time frame of price movements 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 that execute buy and sell orders for investors, acting 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 participate in auctions to achieve 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 through brokers to buy or sell shares. 

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

• Market Makers: They contribute to the auction market by increasing liquidity and enabling trades, thereby indirectly influencing the process. 

• Depositories: Depositories are intermediaries that hold investors' digitised shareholdings in secure accounts, 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 

The market profile is a method of data organisation that provides insights into several AMT principles in real time. It resembles actual auctions, where prices move in response to demand and supply.

If buyers are strong, prices rise, and they compete to buy the asset. On the flip side, if sellers are stronger, 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: accumulation, markup, distribution, markdown, and re-accumulation and redistribution. 

As per the auction market theory (AMT), the financial market operates like an auction, with prices rising in search of sellers and falling in search of buyers. Based on the market profile type, it can be a normal day (prices staying within the initial balance for the whole day) or a normal variation (when the prices move outside the initial balance, 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 is to determine whether the market is balanced or imbalanced and to apply the strategy accordingly. 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 prices higher during the discovery phase of the buy imbalance period, as they search 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 orders specifying the quantity and price they wish to buy or sell. These orders are matched by an automated system based on time priority and price, resulting in 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 by the highest price the buyer is willing to pay (bid) and the lowest price the seller is willing to accept (offer). They are then matched for the trade to take place. Trade matching occurs simultaneously across 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 tool for understanding market dynamics. 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.