Understanding Market Auction Theory: A Comprehensive Introduction

What Is Market Auction Theory?
Auction market theory is a framework popularized by J. Peter Steidlmayer in the 1980s to understand why a market moves the way it does. Put simply, it’s a way of interpreting whether the price of something “makes sense” based on prior prices and all the available information.

Market auction theory can apply to anything with buyers and sellers, such as consumer goods, houses, or, in our case, securities.

How Does It Work?
Market auction theory is based on the assumption that the price of something will usually gravitate towards what is known as “fair value”—the area where buyers will generally agree to buy, and sellers will generally agree to sell.

The fair value of something could be an exact price—$0.25 for a piece of gum from a gumball machine, for example—or, as is usually the case, it could be a range of values. If Stock ABC is consistently trading in a range of $10-12 over a prolonged period, that range represents its fair value.

The 3 Elements Of Auction Market Theory
Auction market theory takes into account three elements: price, time, and volume. All three are measured within the context of each other.

For example, if a stock trades at a consistent price for a long period of time with consistent volume, it’s understood that the market is “balanced”—all three elements are in sync, and the market is working efficiently. The benefit of a balanced market is that the stock is priced at an area the market deems “correct,” so while you will likely get a fair price for whatever you want to buy or sell, there are also limited opportunities to capitalize on inefficiencies.

For example, for the entirety of 2017, Twilio (TWLO) traded between $27-34. That tight trading range let the market know that TWLO was in a balanced market, and it likely wouldn’t break out of that range without a) a new piece of fundamental information or b) a significant amount of volume to carry it higher or lower.

In situations where the relationship between price, time, and volume break down, that’s known as an “unbalanced” market. This would happen if the price of a stock wildly fluctuated for a short period of time or if certain prices coincided with significantly higher or lower amounts of trading volume.

In an unbalanced market, there is no clear trend and the potential for increased volatility. This can lead to more opportunities to capture market inefficiencies but can also make it harder to buy or sell at fair value.

Take Tesla (TSLA), for example. From Nov. 25, 2019, through the end of the year, the stock rose 30% to new all-time highs on no fundamental catalyst. Though there was significant volume during this period, the stock’s significant price volatility meant it was in an unbalanced market. There was no “fair value” for Tesla during this period.

The Purpose Of Market Auction Theory
Most traders with at least some experience will have built a natural understanding of auction market theory without even realizing it.

The purpose of market auction theory is to help you understand where a stock is trading at now, and where it could trade in the future. If a stock is trading at fair value, we can logically assume it will continue to trade there until the market gets new information. If a stock is not trading at fair value, it’s likely in a period of price discovery.

Market auction doesn’t tell us where a stock will trade, but it does tell us how a stock has traded. And having this understanding can be incredibly useful when trying to determine whether your bid or offer is a fair price.

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