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Auction Market Theory (Even in financial markets, the availability of an…
Auction Market Theory
Even in financial markets, the availability of an asset for a price (money) is limited. Moreover, the impact of time is much more in a dynamic market situation.
The primary function of any market is price discovery, that is finding of the almost true worth or value of an asset. If a market is not able to ration a good or service at a fair value, then it is not efficient.
In life, everything is economical. Time, money, goods, services, including love. Here economics does not mean business. It means using of a resource that is limited with optimal usage.
When it comes to a market, the impact or importance of economics on a good or a service is much more. Because time is limited always.
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In markets, price rations buyers and sellers depending on demand and supply.
Now, this price cannot be set by one person or one party. If they set, it becomes a monopoly or a duopoly at the maximum. If there is a monopoly or a duopoly, immediately sellers will get accumulated. Similarly, if there is monopsony (which means there is only one buyer) or a duopsony, immediately buyers will get accumulated.
In various markets, buyers and sellers are usually structured as "one to one", "one to many", "many to one", and "many to many".
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Most of the markets are usually auctions that are happening between buyers and sellers. An auction is a mechanism to ration or distribute the good or service between buyers and sellers in an optimal and economical way.
Based on this understanding of economics, a financial market or a market for trading of financial assets is also an auction. An auction for the inventory, that is cash stocks or futures or options.
However, this auction is a many to many auction. That means, unlike in other situations or markets, there is no one seller or one buyer. There are many sellers and many buyers interacting at various times of their preference with various amounts of good that they possess or require.
The trading market functions as a continuous (without breaks during the day) double-auction. Why? Because the price or quantity or time is being decided individually by the buyers and sellers.
When the market is rationing prices, it means that the good is being distributed from sellers to buyers at a better price. This price keeps on changing in the trading market, because new buyers and new sellers keep coming without intimation.
The market will keep adjusting to new buyers and sellers and their new requirements over time during the trading period of the day. That is the reason why stock markets move dynamically every minute.
Liquid markets move very dynamically while illiquid markets move rarely. However, when the markets move they will move very hugely, liquid or illiquid.
Price rationing is done by moving up and down dynamically in a stock market. Sellers move prices down or they come down to attract buyers. Why? Because they want to reduce inventory. Similarly buyers move prices up or they come up to attract sellers.
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Buyers go up in search of sellers and sellers go down in search of buyers for finding a fair price for themselves. That is the reason why a stock market is a dynamic, double-auction process that occurs every second it is open for trading.
In this setup, what is a fair price for you as a trader is determined by the capital you have, inventory you select, time you have and knowledge or information you have about the asset. That is how you get the fair value for yourself. Similarly, every player finds a fair value for himself or herself or itself (institution). Because institutions are good at it, our framework just suggests to tag them in identifying locations where they have advantage.