Understanding Market Foundations and Auction Market Theory

Jun 10, 2024

Lecture Notes: Understanding Market Foundations and Auction Market Theory

Introduction

  • Importance of understanding market foundations for traders.
  • Many traders prefer following instructions over innovative thinking.
  • Core principles of market movements are crucial for developing trading strategies.
  • Conviction in trading decisions is necessary for success.

Key Concepts

Auction Market Theory (AMT)

  • Purpose of financial markets: Facilitate trade by auctioning prices from high to low and vice versa.
  • Trade facilitation: Similar to price adjustment in grocery stores to balance supply and demand.
  • Core concept: Markets move due to imbalances between buyer and seller aggression.
  • Fair value: Price level where trade is most facilitated and aggression is balanced.

Imbalances and Fair Value

  • Buy imbalance: Buyers are the aggressors, causing prices to rise until new sellers are found.
  • Sell imbalance: Sellers are the aggressors, causing prices to fall until new buyers are found.
  • Balanced market: Aggression between buyers and sellers is balanced, with prices trading in a tight range on higher volume.
  • Volume profile: 70% of total trading volume is typically used to identify fair value, akin to one standard deviation in a normal distribution (bell curve).

Market Behavior and Events

  • Market events: Can cause imbalances and drive price discovery.
  • Price discovery: Process where prices move to find new buyers or sellers and establish a new fair value.
  • Market cycles: Rotate from balance to imbalance and back through price discovery.

Practical Applications

  • Balanced markets: Opportunities for mean reversion strategies (fading moves away from fair value).
  • Imbalanced markets: Opportunities to trade in the direction of the imbalance, following trends.

Market Participants

Intraday Participants

  • Trade and provide liquidity within the day.
  • Aim to profit from smaller, repeated intraday moves.
  • Do not hold positions overnight; are always flat by end of the session.

Other Time Frame (OTF) Participants

  • Make decisions based on longer time frames (daily, weekly, monthly charts).
  • Hold positions overnight, influencing overall market direction.
  • Intraday traders act as middlemen, while OTF participants shape market movements.

Visual Exercise: Understanding Market Movements

  • Balanced Market Scenario: Interaction of intraday and OTF participants.
  • OTF buyer and seller aggression: Size of market moves and liquidity.
  • Intraday Traders: Overextension can lead to reversals or price breaks.
  • Market Discovery: Driven by OTF participant aggression and price reaching new levels of liquidity.

Conclusion

  • Auction Market Theory: Helps remove noise and doubts in trading decisions.
  • Application: Keep AMT principles in mind when learning new trading contexts, patterns, indicators, and developing playbooks.

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