Wednesday, October 01, 2008

An Introduction to Trading: The Market's Auction Process

[Note: This is the latest installment in the free e-book that I am assembling one post at a time. By the end of this process, the goal is to have an introductory guide to trading theory and technique that can get new traders started on their learning curves without the inconvenience and high cost associated with many educational efforts. The full contents of the book can be found here].

Market mastery requires more than a computer, mouse, online connection, and simple setup patterns to trade. If trading is to be pursued as a career, it is important to understand how and why markets move. Such an understanding enables traders to recognize and adapt to shifting market conditions; it also helps them know when to take risk and when to preserve capital.

The first element in a conceptual framework for traders that we've covered in this book is the notion of non-periodic cyclical movements. Equity markets tend to not go up or down in a straight line. Rather, trending movements are punctuated by periods of transition in which some sectors continue trending, while others fall into a range or even reverse. These periods of trending and transition occur across multiple time frames, such that a trend at a short time frame may be embedded within a transitional phase at a larger one.

This idea of cyclical movement tells us about the form and structure of market movement, but doesn't explain *why* this movement occurs. For such an explanation, we must turn to a second facet of our conceptual structure: the market as an auction process.

Let's begin with a very simple example: imagine that Dr. Brett is selling his latest book on e-Bay. He offers the book for sale at $36.00, a 20% discount from the $45.00 list price. He has 100 books to sell, and the first few are snapped up at the offer price, the $36.00. These readers are highly motivated to read the book, so they are willing to pay the offer price (a.k.a., "lift the offer") in order to ensure their copy.

If the orders are coming in fast and furious, Dr. Brett could raise the price to $40.00 and take advantage of the motivation of the buyers. Some buyers would be willing to pay this price; a chart of the book's price movement would show an upward trend.

The $40 price is not as attractive as the initial $36 price and, eventually, buying orders slow down. For a while, the price stays at $40 with relatively few orders. The market is finding reduced demand at $40; participation in the buying process is waning. In market terms, the buying is "drying up".

Seeing this drying up of price, customers begin bidding $36 for the book, figuring that they can drive a bargain for themselves. If Dr. Brett is motivated to move the inventory, he may well accept the bid and sell books at the original listing price. The fact that he is willing to "hit the bid" of the customer shows that the seller is now more motivated to make the transactions. A few aggressive buyers decide to bid only $32 for the book and Dr. Brett hits their bids as well. This motivates other buyers who now see that the book is selling for a significant discount, and the bids come in. The market for the book is now in a downward trend, as lower prices bring increased interest (volume). Eventually, buyers will probe prices that are too low for Dr. Brett and his publisher, and they will refuse to hit those bids. At that point, the selling motivation is "drying up" and less volume is transacted.

Over time, exogenous events will affect the market for the book. When a convention comes to town featuring a presentation on trading psychology, demand for the book may increase and prices will reflect the buyers' willingness to pay what sellers are offering. When markets calm down, traders sustain less interest in psychology and demand for the book tails off. In that scenario, prices will reflect the sellers' willingness to move the inventory.

This is a highly simplified example, but it illustrates an important principle: auctions bring together sellers, who are motivated to part with their goods at an offer price, and buyers, who are motivated to obtain the goods at their bid price. Where transactions occur within the bid-offer matrix reflects the moment-to-moment shifts of sentiment among buyers and sellers. It is the transitioning of buyer and seller interest at key price levels that creates the transitional structures noted in our discussion of market cycles.

Our next step will be to extend this auction model to multiple timeframes, so that we can see how auctions proceed among different classes of market participants. In our next post in the series, we will see that, what we call a market, is actually many markets comprised of different participants with different expectations and time horizons. The interplay of these participants creates the patterns that recur across markets, from intraday to very long term.


Note: An excellent introduction of auction theory is Jim Dalton's "Mind Over Markets" and his followup volume "Markets in Profile". Jim and colleague Terry Liberman offer training and education in auction-based trading via their site, where the books are also offered for sale. Bill Duryea conducts an online trading room based on auction market principles; see the Institute for Auction Market Theory site.