Wednesday, October 29, 2008

An Introduction to Trading - Market Auctions and Multiple Timeframes

The most recent post for the Introduction to Trading ebook introduced the idea of the auction market as a framework for understanding the stock market, using the simple illustration of an eBay auction. Now let's expand the conceptual framework to see how auction markets can bring together participants who operate at differing time frames.

Central to any auction process is the notion of value. Value is the price--or range of prices--that bring together buyers and sellers. Because the auction exists to facilitate trade, the auction process constantly hunts for value: that price level that will enable buyers and sellers to transact with one another.

It is important to recognize that value has both an objective and a subjective meaning. An objective definition of value in the Market Profile framework is that range of prices during a day or week that encompass approximately 2/3 of the volume for that period. This value range represents the prices that brought together the majority of buyers and sellers; it is objectively measurable as a function of time, price, and volume.

Value also has a subjective meaning to auction participants, as each has his or her own ideas of what a market is worth. A value investor may define value well below the market's current level, because that is what stocks are worth according to his or her metrics. A short-term trader may perceive value in an uptrend when a market pulls back to a 20-day moving average line. A longer-term trader might find value when there is a significant expansion of the number of stocks making fresh 52-week lows.

Trading occurs at the intersection of a trader's subjective definition of value and the market's objectively determined placement of value. If I think "true" value is well above or below the market's current assessment of value, I have an incentive to enter an order to take advantage of this discrepancy. My trade reflects my assumption that the market's assessed value will, over time, move toward my value assessment. If I place value where the market is currently trading, I may have no incentive to enter the market. By my subjective criteria, the market is fairly priced, and I will wait for the market to move below my value level to make buying profitable.

Imagine an auction with participants at many different time frames, each with very different subjective definitions of value. An automobile auction, for example, might feature active participation among people who have used cars to sell and others who wish to acquire used vehicles. Bidders and sellers have an idea of what constitutes fair wholesale and retail prices and try to obtain prices as close to those extremes as possible.

Suppose, however, that--lurking in the background of the wholesale car auction--is a group of dealerships that make their living by buying inexpensive used cars, fixing them up, and then selling at close to retail prices. They will only bid on cars when an oversupply situation pushes prices to or even below traditional wholesale levels; this enables them to make a nice profit, even after they put work into the vehicles. This means that a whole new source of demand--and volume--will enter the auction market when prices hit levels that constitute subjective value for large, longer-time frame participants.

Above and below the market, you always have value-oriented institutions (such as mutual funds) ready to acquire stocks when they're cheap (by the institutions' criteria) and sell them when they're priced above (the institution's definition of) value. No doubt you've seen markets that have traded in a narrow range on quiet volume, only to move higher on increased volume following a range breakout, and then reverse sharply on even stronger volume. During the narrow range bound action, market makers were dominating the action; technical traders (including short-term prop traders) jumped into the market on the breakout; and value-oriented traders (including hedge funds) sold into the strength as stock index futures went to sharp premium to cash. This is a simple example of how auctions bring together participants across different time frames.

When I first began work at a prop firm, I was surprised to observe that the traders focused on something quite different from the average traders I had run into. They used price and volume information (including information from the order book) to identify *who* was in the market. They wanted to know if there was above or below average institutional participation; if moves to new price highs or lows were attracting momentum participants; etc. By using "technical" market data to make inferences about underlying auction processes, they were able to make reasoned judgments as to whether market moves were likely to continue or reverse.

In the next segment of the book, we'll take a closer look at how savvy traders develop trading ideas from auction-generated market data.