Market Profile: Auction Market Theory

All right, guys, what's going on? This is going to be the first part of our order flow roadmap series. We're going to be talking about the auction market theory. So after learning this theory, it's going to be hard to just consider it a theory. It's going to seem like the most practical or pragmatic approach to markets. It just completely makes sense. It boils everything down to the bare bones. You know, the interaction between buyers and sellers in an auction. Right. To, you know, to identify what the fair value of an asset will be. Okay, the purpose of a market, Right. A market is a place where this exchange happens between buyers and sellers. And the purpose is to identify what the fair value of an asset will be. So this is the auction market theory 101. And I'm going to try to keep this short and sweet and strictly to the point. So understanding the auction. So trading is very much like an auction. The market has two jobs. So obviously it has to facilitate trade. So it needs to provide a place where buyers and sellers can interact, rather come together, and where buyers can submit competitive bids and sellers can submit competitive offers at the same time. All right? And again, this helps price find its fair value. All right? And fair value is a concept that we are going to be talking a lot about. You'll see me talk about the fair value area on something like a volume profile. We'll talk about the value area high and the value area low. And hopefully these areas will now make a bit more sense. So when prices are too low, they're below fair value and demand will press them upward. Okay. On the other hand, when prices are above their fair value, they will come back down. And you have to think about this fair value as the mean. Okay? So when prices are above value, they come back down, and when they're below value, they rise up. Okay. And this is. This is through the interaction between. Essentially, this is supply and demand. So this is the interaction between buyers and sellers to determine the fair value of an asset. And this is based on supply and demand. So you have to think of an auction. So in this case, think of the auctioneer, so the person heading the auction, coordinating the auction, whatever, and so forth.

Henceforth, so forth. It sounds funny. So the auctioneer will start the auction by naming one price. If at that price he doesn't get a response, what does he do? Okay, he will initially lower the price of whatever he is auctioning. And what happens when he lowers it? The room starts to get a little louder. He basically finds by lowering his price where that sweet spot is essentially, demand picks up and then the room does the rest of the job. So one bidder after the next is trying to outbid the other. And what happens to price? It goes up. So price initially drops to find buyers and then it rises to find sellers. So when price rises, what happens in an auction? The auctioneer will continue to yell out a number. Let's say starts off at, do I have 50, do I have 50? No one buys initially. He drops it down to do I have 45? All right, no one buys, do I have 40? Okay. And then he gets some response from the room. So what does he do? Okay, do I have 41? Buyers start bidding it up. Okay, do I have 42? Do I have 43? Suddenly, what do you know? The initial price started off at 50, went down to 40, and then now it's bid up all the way to, you know, random 60. $60. Right. So he'll keep rising, okay. Rather raising the price, okay, until it exceeds where the demand is. So it'll reach a point in which it is above fair value. It's above the value area. Okay? And this is just consider this as if it's expensive. So what will happen? It'll stall out. And when it stalls out, there'll be, in this case, consider like excess supply. And the price will drop to meet the demand again. All right, and what happens? Price might drop a little bit at first, might not really find any demand. I drop a little bit more and then the same pattern will occur. The room will rise up again. You'll hear volume in the room. I want you to think about volume as the responsiveness on part of buyers. So just think of it that way. When you're imagining the market volume increasing, imagine the volume in the room increasing as the price becomes more attractive, right? So price will rise and fall, seeking out buyers and sellers. Okay? Just as in an auction, again, volume will confirm interest and acceptance of prices. So acceptance is going to be important. We're going to talk about acceptance. You're going to hear me refer to the concept of acceptance. Rather, when we look at certain things like footprint charts, order flow charts, volume charts, volume profile. And when we're talking in regards to, or rather about devalue areas, the value area high and low being broken, whether or not something is accepted or not, meaning buyers step in and continue to push it up. So volume comes in. So typically reverse or rather, when I'm referring to acceptance, more often than not, what I'm referring to is an increase in volume to really stand behind the move. And the opposite of that would be when price comes up through an area and there's a failed auction, okay? And say price goes above the value area high, for example, and buyers don't continue to prop it up and it's a failed auction because it'll eventually come back down into the range.

In a second. We're going to talk about how this value area works within a range. Just trying to keep this as simple as possible. So this is a very basic drawing that I did and this is what it looks like. Imagine this being a volume profile and this being price. Now if you notice, this looks sort of like a evenly distributed bell curve, alright? So if you look at a bell curve, the one standard deviation would be where 68.8% of the values were within, rather 68.8% of the values took place between one standard deviation of the average. Alright? So that's what's considered one standard deviation in a normal distribution. So this is kind of similar to how we set up our value area when we're making.

Calibrating the settings for our volume profile. So we'll put it around 68 or 70%. And what it will do, it'll include where 70%, or rather it will highlight where 70% of the trading volume took place. Or in the case of, if you. 68, right. Now remember, it's not a normal distribution. It doesn't always look very balanced. But you know, in the case of just for this example, we're looking at a very balanced volume profile. So just imagine this is very balanced, this is a very even distribution. And these lines right here are what would be considered the extremes of one standard deviation. Okay, so imagine this is the average. And so this is, I believe this would be 34% to the top, 34.4 and then 34.4, right? And that would include what is considered within one standard deviation of the average. So not to over complicate things, but it's just worth pointing out. So this is very balanced. So this would be, all right, the side profile of an auction. So imagine this as the auction as we were just talking about. Okay, so price starts here, comes down, all right? Looking for buyers, looking for buyers, okay? It falls below value immediately, it's bid up, it's bid up, okay? Again, maybe it exceeds that demand initially, comes back down, finds demand, comes all the way up. Again, it's bid all the way up, okay? Buyers bid it up to the point where it's above value. No one's interested in buying anymore. So what happens it comes down, comes down, meets demand again. No one's interested in selling anymore. Now, in this case, no one's interested in selling, but buyers are interested again. So it's bid up, okay? And this process continues. And again, what happens? It comes above value, and no one is interested in buying anymore. So think of the auction. Prices raised too high. There's no more interest in the room to buy at this price. So what happens? It comes back down, and it eventually settles into its fair value area. So just imagine this is a very balanced range. So when we talk about balanced range, it'll have this very even distribution. So if we're looking at a volume profile, point that out in a second. So this is just price moving within a range. And we'll see that it'll go below value and it'll immediately revert back to the mean. And it will spend most of its time between what is the value area high, okay, and the value area low. So. So there's two types of auctions. So there's a ranging bracketed market. Not many of you have likely heard it referred to as a bracketed market. It's a little bit older, that goes back to market profile, but this is basically a range. Price is just ending a period of trending behavior, and it's now consolidating. So basically, whether it's the beginning of a trend or the end of a trend, price will consolidate and it will form a balance between buyers and sellers in this auction. So it gets auctioned from lows to highs. No indication of who will ultimately gain control in the near term. This is where a lot of the times you'll see traders and investors looking for outside information to determine what direction the next move is going to take. But the moves between here, so from low to high to low, these are basically just rotations. So when we call something a rotation, just think about it like that. So it's a rotation from the lows to the highs back. So we're just considering from value area low to value area high, basic rotation within the auction. Again, no clear indication of what side will win out. Usually it's the one who runs out of ammunition. And this can occur after a trend up. And what we'll see is the market will typically consolidate before continuing. But for continuation, what it needs to do is show an increase in buying. Obviously, eventually buyers have to accept this at a new value area. And that takes us to the trending market. So trending market is essentially a series of fair value areas moving in one direction. Whether this is upward or downward over time. So imagine if this is a very balanced auction, what happens? Price is very balanced out between buyers and sellers. And then eventually price will breach an area, let's say that it's come above the value area high multiple times, eventually breaches it. And in this case, when it comes, all right, when it comes above this area, rather buyers step in, okay, that volume comes in and then this fair value area that was right here has moved to a new location. It might just continue in a new range here. But nevertheless, what we see is in a trend, it's a period of, or rather a transition from a value area, rather a fair value area, to a new price range and then to a new price range and so forth. This fair value just keeps getting brought to new locations. And what happens in a trend, this brings in all market participants, typically from all time frames. So if you're a scalper and you're just operating on a five minute chart, then you have your swing traders that are looking to take advantage of range to range. They might be looking to swing from one range to the next. You have your position traders. When a market is trending strongly, it draws all of these participants in. So everyone will enter into the trend. This usually sucks all participants in. So in the normal range, we have what is called, as I said, the fair value. This forms the low and the high. And this is again where most of the trading volume takes place. We just went over how when it comes to the highs, buyers are not necessarily as interested, sellers become more interested and this process will repeat. So lack of volume, or rather lack of buying volume, increase in selling volume above these areas and a lack of selling volume and increasing buying volume down below these areas at below value. Okay? And again, breakouts of ranges are confirmed to be accepted and supported when we have an increase in volume. So just imagine the room right when the prices are raised to a new point, okay. Or whether they're lowered, the interest is found with volume. So if price comes above a certain area and no volume comes in, that's what we typically see when we have something like a fake out. So this is again, this is why this is such an important way to look at the market. So if you could just imagine that auction room. So those, you know, participants with their paddles or whatever kind of auction they're in, whether it's corn cattle, you know, you name it, how they respond about prices or rather to prices that they're interested in. So this is what a ranging market looks like. Okay? And we talked about that balanced looking Volume profile. So here's an example of volume profile, alright? And this is a pretty evenly distributed volume profile. And you can see that it's a little blue here and a little gray there and then gray up here. And so the blue delineates where the value area high and lower. So where this was in this case, 70% of the trading volume took place between here and this volume profile. Actually, for the case of this entire range, this is a higher time frame chart. Okay. This was only brought to this point. So I just wanted to give you an example of how this will extend moving forward. Okay. How we can likely more often than not on the higher time frame when we're forming a range, a range. Rather extrapolate this moving forward and consider these highs, okay, Value area highs and value area lows to be areas where we could potentially look for some type of reversal. So this is where it ended. Meaning that from this point moving forward, this was not created yet. So here's your value area high. What happens when price comes below value, dips below. Okay. Spends a little time below and then comes right back into fair value area again, Breaks out above. There was no volume here though. Okay, Fakes out test liquidity up here, Falls back below. Okay, Again comes back above the value area high. Falls back below. Above, falls back below. We see a lack of buying volume up here until prices are auctioned lower. Okay, Falls below. Nope. Buyers are interested. Okay, Falls below. Nope, no more selling interest. More buying interest. Picks it up again. Right, so this is a very balanced range distribution. Okay? So this is your bracketed market. This is your very even balance. All right, so when we refer to coming out of balance, that is what we're talking about when we're looking for acceptance to come out of balance and to form some type of breakout or some type of new range. Onward and upward into new areas. Whether it's onward and upward, onward and downward. So then acceptance outside of a range. All right, so here's your balanced volume profile for this period. Right here. You can see again, comes down below, Right in this case, it spends a little bit of time down here. This is a lower time frame chart actually. So in this case, lower time frames, more chop. Comes down below, comes back above the line is where majority of the volume took place. So this line right here, point of control, bounces off of that, comes back below, comes back above. Now finally, what do we see with this volume distribution though? We could see just in this area, there's more interested sellers than there are buyers. Okay? So price comes up, buyers are not interested in bidding this up anymore, comes back down some demand, but again comes up, spends a majority of its time in the lower portion of this distribution, indicating that buyers are not interested up here. So what will likely happen, it falls below its value area. Value area down here falls below. And this is definitely accepted. You see one of these large candles. If we had the volume on here, you'd see that there was an increase in volume, then acceptance, and then backside confirmation is when we come up and retest this area and then fail. So this is your acceptance. If we look at a volume chart right here, you'd see a ton of volume indicating acceptance. If we're looking at a footprint chart, you'd see a ton of volume in the candles indicating buyers, or rather buyers stepped away and sellers were very interested in selling at this point. So again, remember the sellers in the auction too. So in this case, price tries to reclaim this area. It's not able to reclaim this value area back to its previous fair value. So what happens? This forms a trend that ends up resolving downward. These are.

Your two types of market conditions. You have your ranges and your trends, your brackets and your trends. Trends occur when you get acceptance out of a range and you fall out of balance and you begin to form a new range. It's a very simple concept, right? So that's why I want to start this series off on the auction market theory. Because once you're able to look at the market like this, it demystifies exactly what is going on. You're going to look at the market like an auction. You're going to look at the higher time frame, like a higher time frame auction. You're going to look at the lower time frame, like a lower time frame auction. All right? That's all it really is. Okay? Even though we have charts that have historical prices going back to who knows when, and if we're having it on a logarithmic chart, it looks like a crazy auction. Most things will just look like this nonlinear growth period of new value area to new value area, especially looking at the S&P 500, right? But there are certain markets where this just is perfect. It's a perfect approach. If we're trading commodities.

If we're trading things that are, I would say, less fundamentally based, alright? This is perfect for trading cryptocurrencies, perfect for trading bitcoin. All right? A thorough understanding of this, all right, will set you up so that you can have success moving forward using order flow to base your trades around. So that's that guys this has been a pleasure. As always. Exercise proper risk management and trade effectively.