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Market Auction Theory - backwards?
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Market Auction Theory - backwards?

  #21 (permalink)
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The idea behind auction market theory is that there are actually two auctions occurring at the same time. Most are familiar with the idea of a traditional auction where the auctioneer (seller) has some quantity of goods to sell and has assembled a group of buyers who have come to bid against each other for the purchase of those goods. So there is one seller and many buyers. In a market there are two auctions occurring simultaneously where the buyers and sellers each act as their own auctioneer. If there are more buyers than sellers and they are willing to bid up the price as they compete with each other, price will rise until there are no more buyers willing to lift the offer. At that point there will still be willing sellers but the buyers have receded to the point that there are none left. The buyers perceive that the price is unfairly high and if any more trade is to occur the sellers will have to reduce the ask before they can entice the buyers to buy. The reverse is true for sellers outnumbering the buyers and prices then falling.

Consider the simple case of a wheat farmer and a baker. Both have a business to run and need to plan for the future finances of that business. Obviously the farmer wants to sell at the highest price possible and the baker needs to pay a reasonable price for the grain so he can make a profit. The farmer will seek to lock in a price for his next crop when the current futures prices seem high enough that he can profit and before the opportunity is lost because of adverse price movement. The baker needs to lock in a price for his grain next year so he can plan for cash flow and other business needs. But at some point as the price rises he will judge that the price has become so high that he can no longer make a profit. The price has become unfairly high for him. At the low extreme the farmer will think that at the current price it is better for him to stand aside and wait because the price is unfair to his needs. At the lows there will be plenty of bakers that would be happy to lock in a buy for future use but no farmers eager to sell. Same goes for the farmer at the highs when no baker is willing to transact. At the center of the price range then there will be the bulk of the trading done as all the players who need to conduct their business find prices that they are able to do business at. The price that the most trades occur at is then considered the "Fairest" price by the market participants who collectively perceive market conditions as such at that time. So unfair highs are the absence of buyers at that level and unfair lows are the absence of sellers at that level.

Now, what if some new condition enters the market like a drought or a crop disease/pestilence. Players who have that information early might now perceive the unfair highs have become a buying opportunity and be willing to lift offers and raise the price to new highs. As that new condition becomes more widely known the baker who wasn't willing to buy at the unfairs might now conclude that he should go ahead and lock in at a higher price because a shortage of grain will mean even higher prices if he waits. And what of the sellers who were eager to sell not long ago? The farmer has already sold and can no longer add supply to the market. Speculators who are caught on the wrong side of the trade are now forced to puke up their losers as stops are hit. They are now buyers as they offset their shorts adding to the new imbalance between buyers and sellers. New speculators see an opportunity where none was before and add to the push. All of the sudden the unfair highs are now considered a strong buying opportunity so price leaves the old balance area and goes in search of new unfair highs where the buyers are satiated and sellers are once again willing to come into the market. Once that condition is reached price will fall and a new equilibrium will form around a new higher "fair" price.

Then, the drought fears are extinguished by late rains that will save the crop and the disease/bug problem turns out to be just a rumor. Now what happens? Eager buyers are trapped in losing trades as the price falls because market perceptions have suddenly reversed and the resulting stampede goes off looking for non-existant buyers.
The fall might be so one-sided with sellers that price goes completely through the old trading range before any buyers reappear, only to find support and eventually return to the old levels.

This simple example doesn't address the idea that what is considered unfairly high for a short term speculator might be a reasonable or even good price to a longer term trader or hedger. They can both transact at what is considered by each as a good price since it meets both their needs. The total volume of trading by all participants over time will naturally form a normal distribution and the tails of the distribution(profile) are considered as "unfair" simply because less volume traded at those levels, and the peak of the distribution is the "fairest" price since on average there was more business done there because more people thought it was in their interest to transact at those levels. Nothing particularly revolutionary about the idea. The utility of the theory is in understanding the patterns that price builds over time and using them to assess whether price is likely to rotate around an equilibrium point or break out and go in search of a new balance area.

Hope this helps

Last edited by nevadan; March 13th, 2014 at 01:46 AM.
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  #22 (permalink)
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josh View Post
It is not just you DT, but there is a straightforward way to reconcile this seeming paradox.

Agreeing on value must be true. After all, two parties are involved in the transaction and assuming neither is coerced, they each individually make the decision to transact.

But while they agree on value, as shown above, what they disagree on, assuming an outright speculation on both sides, is the future direction of the instrument.

One party happily buys at 500 (though he of course would be okay buying lower most likely), because he sees potential for appreciation. The counterparty happily sells at 500, having either realized a profit and seeing little potential for further appreciation, or selling short and seeing potential for downside.

So, value means the buyer and seller agree on a price, but chances are that they disagree on the prospects for the future.

This reasoning is no huge revelation, but it really is that simple.

+1 Well put Josh. Each particpant at a transacted price has a different expectation of what the "value" might be, both present and future. IMHO

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