Auction Market Theory is the cornerstone of order flow trading. Applying auction market theory to your analysis of the markets will help remove noise and doubts.
Let’s take a look at what auction market theory is composed of followed by a real world example.
What Is Auction Market Theory (AMT)
Auction Market Theory is a philosophy that financial markets move higher and lower due to imbalances between buyer and seller aggression (caused by market events) until price discovers a level where aggression is balanced and the most trade can be facilitated (Fair Value).
There’s no agreed upon definition of AMT, but this is my definition and I think it’s pretty logical.
To dive a little deeper into AMT let’s take a look at fair value and imbalances.
Fair Value is the price area that facilitates the most trade between market participants. Buyer and seller aggression are closely balanced resulting in price trading in a tight range on higher volume. When a security is trading at fair value it’s in a state of balance.
Market Profile Traditionalist use 70% of session volume (instead of 68.2%) to determine Fair Value where the point of control is used as the mean. The point of control is simply where the most transactions took place represented by the most volume.
Thus, prices above or below the high-volume fair value price are considered “unfair” prices (i.e., not accurate reflections of the traded security’s true intrinsic value).
Imbalances occur in the market as a result of market events that that cause either buyers or sellers to become the aggressor.
We can determine buyer and seller aggression by analyzing speed of tape, volume, delta, and bid versus offer liquidity.
The goal of AMT traders is to determine if the market is balanced or imbalanced and then apply the appropriate trading strategy based on that analysis.
In balanced markets, AMT traders will look to fade moves away from Fair Value (Mean Reversion). Conversely, when markets are imbalanced, AMT traders will look to trade in the direction of the imbalance as the market goes into discovery.
When the market is in the discovery phase during a buy imbalance, buyers will drive prices higher in search of new sellers. In the same manner, when a sell imbalance occurs sellers will drive price lowers in search of new buyers.
The flow chart above represents the constant rotation the financial markets go through, from balanced to imbalanced and back to balanced through discovery.
To help drive the concept of auction market theory home, let’s take a look at another market that you’re probably much more familiar with, the new car market.
Auction Market Theory Example
It’s well known before you even step foot on a dealership lot that there there will be some negotiating.
Car buyers want the lowest price for a new car while dealerships want the highest price to maximize profit. No different than someone buying or selling a share of Tesla.
In the example below, the current price of a new car is $35,000 (Fair Value)
Some buyers will pay a little less than $35,000 while others will pay a little over as a result of negotiating, but the average will remain near $35,000 until a market event occurs.
Let’s use the recent chip shortage in the auto industry as our market event. Car inventory dropped drastically, yet demand was still strong. In order for Dealerships to continue making a reasonable profit they now have to sell at higher prices as they will have less cars to sell.
The price of the car goes into what we call a discovery phase. Buyer demand drives the price of the car up until it hit’s a level where the supply of cars matches the buyers demand. In our example above this new price is $40,000.
The new car finds balance (enough sellers to meet the demand) at $40,000.
The next market event is two-folded, supply is increasing as chip manufactures catch up but the world is heading into a global recession reducing demand. Price breaks away from fair value and goes back into discovery mode until ample demand is found. The market finds balance at $36,500.
The financial markets operate in the same manner as this example. There’s two forces driving prices back and forth until they find a level where both sides agree on fair value.
Why Auction Market Theory is Important
A core understanding of AMT enhances your capacity to organize ideas, recognize patterns, solve questions of value, and to extract the essential pieces of data from endless quantities of information. It also helps us to take the views of multiple market participants opinions into one unified whole.
Traders who fail to learn or understand the basic concepts of Auction Market Theory will always be trying to predict the market rather than reacting to the information the market gives them.
As a trader, you need conviction in your decisions. When you’re trading a strategy that you don’t understand the fundamentals behind or the logic as to why it should work you will lack that conviction.
My advice to you is anytime you’re looking at a pattern, setup, trigger, indicator, chart type…. always try to relate it back to AMT.
Auction Market Theory is just the beginning of understanding fair value, imbalances, and other order flow trading concepts.
If you find AMT logical and interesting I suggest you continue down the path by learning about volume profiles. This is when you will begin to see the practicality and logic of Auction Market Theory.
If you have a question or something cool to say leave a comment below!