Market Auction Process

Almost all electronic financial markets trade based on an auction market. Understanding how financial auction markets operate is paramount for anyone interested in becoming a successful trader. In traditional auctions an auctioneer conducts the auction process. Typically the auctioneer will start the auction process at an open price. If the open price is perceived as reasonable value, auction participants respond by accepting it. The buyers acceptance of the price will prompt the auctioneer to raise the offered price. The auctioneer will continue to move the price higher until there are no more buyers willing to buy at that high price level. At that point the auctioneer will quickly pronounce the item sold to the highest bidder.

If there are no buyers interested at the auction open price, auctioneer will bring the price down until one of the auction participant shows interest. The dynamics of the auction market may quickly change based on what is perceived as value. Consider the following property foreclosure auction. Initial open price for a million dollar home started at $650K. No one was interested in the property at that price. The auctioneer dropped the opening bid to $600K. There was still no interest in the property. He continued to drop the bid lower to $550K, then to $500K and so on until a buyer finally stepped forward at $300K.  At this point other bidders start to participate in the auction and the price began to go up. It moved from $300K all the way up-to $600K . This example shows how quickly things can change in any auction and how prices will adjust to supply and demand.

Financial markets use the same auction theory and principles as traditional auctions even thou the mechanics of the auction are quite different. Financial auction market is continuously responding to the available orders in the market. Once the market opens for an instrument like stock, there are usually large number of orders already placed in the Order Book.  The price will move up and down in a price ladder to facilitate trade and fill as many orders as possible. The response of the market participants determine the direction and pace of auction activities.

The Order Book is an important element of the financial auction market.  There are 3 levels of access to the actual Order Book for any instrument. Level I provides number of bid and ask orders at the current price. Level II offers a larger but still limited view of the bid – ask spread. Level III offers an open view of the entire Order Book. Level III access is only available to market makers and dealers.

Level II Order Book

Level II Order Book for ES

The Order Book is the roadmap for the financial auction process. The number and size of the orders in the book determines the direction and speed of the auction process. Market participants that are interested in buying place their orders on the bid side of the book and sellers will place their orders on the ask side. Sellers will offer to sell to the market at the ask. The ask is the price seller is demanding from the buyer to make the sale. Sometimes the ask is also referred to as the offer. On the opposite side buyers present a bid price to sellers. Bid price is the amount buyer is willing to pay to the seller to make a deal. If the bid and ask prices are not equal, no transactions will take place. The difference in price between the bid and ask price is known as the spread.

Supply and demand is perhaps one of the most fundamental concepts of economics and it is the backbone of a market economy. Demand refers to how much quantity buyers are willing to buy at a certain price. The relationship between price and quantity demanded is known as the demand price relationship. Supply represents the quantity sellers are willing to sell at a particular price. The correlation between price and quantity offered to sell is known as the supply price relationship. Price is a reflection of supply and demand.

The law of demand states that, everything else remain the same, the higher the price of a good, the less amount of people will demand that good. In other words, at higher prices lower quantity is demanded. Conversely at lower prices higher quantity is demanded.

The law of supply states that, all factors remain the same, sellers are willing to sell more at higher prices. In other words, at higher prices, more quantity is available for sale. Conversely at lower prices, lesser quantity is available.

Clearly as we can see from the law of supply and demand, there is a problem with quantity, supply and demand and price. At higher prices, more quantity is available for sale but demand is lower. At lower prices, demand is high but lower quantity is available for sale.  The higher and lower ends of the supply and demand curve is known as price extremes. The mid point where buyers and sellers are equal are known as the equilibrium price or value.


Price movement at any point is a mere exploration of value. Market is in constant discovery of value. Buyers and sellers battle it out until they agree on value and start consolidating. Based on the external stimuli, the process will start over and over, creating a trending or ranging market.
A successful trader is one who sees the shift in supply and demand, identify initiative and responsive activities and positions himself alongside the trend of the market based on his trading timeframe.


Posted in Market Internals