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Auction Theory

And volume profile


In conversationsauction with friends, I have been discussing “auction theory.”  The initial purpose is to help non-trader friends understand how markets work, and see THROUGH charts.

Price charts represent the action of people, making choices to buy and sell things.

The deeper purpose is to develop a discussion of “auction theory,” that can serve as an introductory part of a Trading Primer. Here the goal is help me and other traders to think through, rethink, and clarify what is actually happening in markets, behind charts, in order to improve our trading skills.

trading floorAuction theory is simply how auctions work.  Most people have been to an auction, or seen one on tv.  An auction for livestock, or cars, art work or antiques.  It’s a familiar process.

And yet, when people look at a chart, be it the price action of a stock, like Apple, or the price of Gold or corn, it sometimes looks random and disorderly.  They don’t automatically think of it as an auction.  But that’s what it is.

And even if we know what an auction is, we may not have considered the mechanisms by which market participants value products in an auction.

How do auctions work?

In a nutshell, how and why does an auction create a “flag.”

A flag is probably the most basic chart pattern.
Basically, price moves quickly in one direction, pauses, goes sideways
for a while…often it looks like a pennant flying off a flag pole.
The expectation is that it will continue in the same direction.

flag

There are lots of places people can find basic chart pattern ideas like
this.

What I have been endeavoring to do, is explain WHY markets do that.
In particular in my “market anatomy” chapter, I do that.  But it is peppered
throughout my blogs, and parts of the “Trading Primer.”

But I still need to discuss it more in terms of “auction theory,” and “volume
profile.”  It’s not a theory, really, but the way auctions work.

Think of an auction.  You are selling anything.  A car, a cow, a painting.
Let’s say it’s a brand new thing, a thingamajig.  You have 1000 thingamajigs
to sell, and you have no idea how much they are worth.

You open the auction at $15.  No takers.  You offer it for $14.  No takers.
Price slides all the way down to $9 with no buyers.  Suddenly someone bites.
You sell one at $9.  You and the rest of the audience perceive this as the base
price.  There is only one print (sale) there.  You quickly rise the price to $10, and
someone quickly buys a second thingamajig.

Some excitement starts to build in the audience, and everyone starts to realize
there is interest in thingamajigs.    You raise the price to $11, and 2 people buy
one before you can raise it further.

You start raising the price as quick as you can, and buyers are buying as quick
as they can.  there are 2 sold at $12, 2 sold at $13, 3 sold at $14, 12 sold at $15,
24 sold at $16, 120 sold at $17…then, suddenly, there are no takers at $18.

So it auctions back down a bit, and 70 sell at $15, then another 100 at $16…then
price stalls again.  But each time it goes lower by a buck or two, buyers perceive a
deal, and buy it back up.  The biggest amounts sell at the highest prices, around
$15-17.  Very few sold below $15.  There were just a few sales as price rose
rapidly from $9-15.

$9-15 is the “flag pole,” and $15-17″ is the flag.

If you look at the volume of thingamajigs sold, on a vertical chart, you see there
is a big blob at $15-17, and a little tail below.

This is like half of a bell curve, standing horizontally.  Or like the letter P.
This is also known as a “poor high.”

A “completed auction” should look like a vertical bell curve of volume of thingamajigs
sold.

Just as the market rejected prices below $15 as “too cheap,” normally, it will want
to explore above the value range that the market has established, to find out what
is “too expensive.”  If all these people will buy thingamajigs for $15-17, maybe you
can get more.

Everyone else starts thinking that too, and some of these buyers start thinking they
might resell theirs for a profit.

As soon as someone buys the first one for $18, it’s game on, and there is another
buying frenzy, that drives the price higher.  People buy as fast as they can.

A perfect bell curve of volume would be formed if price went up $6 more, the exact
length of the low volume tail from $9-15.  So the perfect top would be $24.

If price rose to $24, while less and less buyers were found, so there was, say,
250 thingamajigs sold at $18, 120 at $19, 25 at $20, 12 at $21, 8 at $22,
4 at $23, 1 at $24….then price stalled, and rapidly fell back down to the commonly
accepted value of $15-17….that would be called “a complete auction.”

If the price of thingamajigs, on the other hand, rose rapidly, and started selling more
and more at $22-26….then you have another flag, another incomplete auction, and it
again looks like it wants to explore higher.  This is the anatomy of a trend.

This is how Apple would have looked, day after day, for weeks, months, and so on,
as it climbed.

Volume profile

Looking at price action in auctions according to the volume traded at each price is known as Volume Profile. 


Here is a textbook picture of a Bull Flag, in ES, futures of the SP500

bull flag in IRT

The volume that traded at each price, during this overnight session, is represented by bars on the right.  And on the right of those, by the exact # of contracts traded at each price.

The idea with a bull flag is that it “should” go higher, to complete the auction.  A completed auction looks like a bell curve.  There should be a taper on either side, with the biggest amount of volume traded in the middle.

Here’s a textbook type example of a completed auction

bell curve

This is a statistical phenomenon.  It is a bell curve, also known as a Gaussian distribution.

We can flip this chart on its side, so that the price axis is horizontal, and time is falling vertically down, and we’ll see the more familiar bell curve on its side.

Gausian profile

More statistics terms:
When the shape of the bell curve is perfect (as in a completed auction), it is “leptokurtic.”  It has greater kurtosis than usual.

The point of the statistics terms is to point out that price action in auctions is literally a mathematical, statistical phenomena.

When you look at price charts of stocks, bonds, futures, etc. what you are seeing is an auction.  The purpose of the auction is to explore value.

The market explores value when people actually buy and sell products.  Price charts represent surveys of the market, about the values of products.

People cast their votes about the value by actually buying and selling them.  So you can believe they are honest about their responses!

Price discovery and Price acceptance

In a when price moves sharply in one direction, leaving a tail, as in a bull flag, it is called “price discovery.”  The market is saying the value of that product has changed, and it’s seeking the new value.

When price goes back and forth and makes a bell curve, or volume blob, it is called “price acceptance.”  The market is saying that for now, it finds this a fair range of value.

Notice that the flag part of the bull flag is a little bell curve.  It’s only when you look at it in context, and you see the tail, that you realize the product recently repriced from a different value area.

Moving targets

Why does the market move around?

Because the values of products are moving targets.  Companies change value.  Commodities change value.  Everything that has value is constantly being re-evaluated.  Value is never a static thing.

When we look at volume within a day time frame, price action seldom forms a perfect bell curve, or a bull flag (although it often forms little bell curves or bull flags throughout the day…tiny fractal auctions.)

What the auction strives to do is always to create the perfect bell curve.  This can take minutes, days, or weeks, or years.  And smaller auctions are little parts of larger ones.

A bull flag on one day may complete up the next day, and then fall back down in to the main volume area.  That way, the two days, taken together, form a bell curve.

And other times, this happens over a much bigger time frame.  We can then draw a volume profile around the larger time frame action.

So, for instance, looking at the SP 500, in its move up, during the summer of 2016, starting 6-27, we can see that, the first part of the move created a bull flag.  And then from there, we got another sharp move up, which created a second bull flag.

8-17-16 ES composite

We can see this, more or less, in the bar chart, even without the data about how the volume traded.

History and composite volume profiles

Since most products have a history, they are in territory they have covered before.

(The SP500 is not, currently, in the chart pasted above. This is new territory, all-time highs.  This auction very probably wants to explore higher prices at some time.)

But when price is zig zagging back and forth through places it has already historically traded, it can be helpful to have a composite of all the volume that has ever traded at any price.

In that case, what we get, is peaks and valleys of value.  Each of the peaks is the peak of a bell curve, and the hill around it is a Gaussian profile.  We call that a “high volume node.”  (HVN).

And each of the valleys is an area where price historically moved quickly through, as in the stem of a bull flag.  The areas where price traded the least volume, we call a “low volume node.”  (LVN.)

Here is a composite histogram of all the volume traded in the SP500, between 1700 and 2193.

8-17-16 ES composite histrogram

Price moves in characteristic ways around these hills and valleys of volume.  And all this movement is based on the principles outlined above, when looking at a bull flag, or a bell curve, on a specific day.

More recent price action is prioritized over older price action, naturally, since it represents more recent values of products.

But all prices at which a product ever traded are relevant.

Areas of high volume are areas where value was accepted.  Areas of low volume are where value was rejected.

Price tends to move quickly through areas of low volume, where it moved quickly before.  And price tends to slow down, and trade more, where value was accepted before.

If you look at the big jagged histogram on the right, which represents all the trades over the past few years in the SP500, and realize, what the market is trying to do, is form a bell curve, it helps to clarify the action.

In the never ending process of trying to “complete,”

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