Auction Market Theory & Invalidating Trades

Part II of Navigating The Wake of Choppy Selloffs

Auction Market Theory – Trading Principles

Before we hop into the core topic of this report, Finding Appropriate Exits and Accepting Losses, it is important to review Auction Market Theory (AMT), and the core principles that encompass it. In last week’s report, AMT principles were factors taken into account when looking at our example and entry criteria. It is important to be consistent with your methodology (consistency will be a common theme throughout this note). Therefore, AMT principles will factor into finding appropriate exits.

Simply put, AMT is a framework for observing and trading financial markets. It tries to define the market’s main purpose, and how market participants interact with each other, fulfilling that purpose.

A market achieves two main things:

• A market facilitates trade in a two-way process (auction, buy/sell, etc.)

• A market seeks the fair value of an asset (over time)

AMT looks at the market through the lens of supply and demand dynamics and the price discovery and auction process. A core tenant of AMT is that VALUE and PRICE are very distinct from one another. Tools used to visualize these concepts are Market or Volume profiles.

How is “value” defined in terms of financial markets? Outside of the market price of an asset, value can be defined as any type of data set, such as time or volume (think market or volume profiles). What is “fair value” of an asset? Within the AMT framework, “fair value” is synonymous with “value area”. To visualize this, the below graphic is a normal distribution bell curve, with 3 standard deviations from the mean. “Fair value” refers to ~68.3% of data occurring within 1 standard deviation of the mean.

At this point, the three components of AMT should b