Auction Market Theory goes by many names, some call it distribution theory, and even Wyckoff Theory. Rather it would be seen more as a derivation of Wyckoff Theory, the principals remain fairly consistent with some twists.

Throughout this I will explain how Auction Market Theory works in the markets in relation to market participants moving the markets, being able to read and anticipate their movement and their sentiment and how to apply it to the markets. A strategy that can actually be applied and used.

The basis of a market is a two way auction, where buyers and sellers meet together to create a fair price for an asset.

Auction Market Theory explains how the financial market moves higher and or lower based on imbalances between buyers and sellers and their aggression. The difference between strong and weak handed market participants.

Price that is in balance wants to stay in balance and the price that is outside of the balance wants to stay out of balance.

Throughout this we’re going to go over:

1.Understanding Auction Market Theory
2.Market Participants
3.Market Structure
4.Market Profile & Volume profile (Tools)
5.Real world use & strategies

1.Understanding Auction Market Theory

a.The concept of Market Auctions
b.Role of Supply & Demand dynamics

Markets move based on the notion that there is a period of balance or fair value, where supply and demand are generally equal and the market creates a high volume range. This is where the market sits 70-80% of the time (compression). Then new information enters the market and the market becomes imbalanced, where either supply is greater than demand or demand is greater than supply causing a directional move or expansion. This turns into a period of price discovery where the market moves in search of new buyers or sellers and a lower volume move.

The area where price sustains the majority of its balance is the distribution in itself, this is where price finds its home, and generally speaking, we use the idea of a normal distribution to understand the concept better.

A normal distribution is a region that has the majority of its data points in the first standard deviation. This is to suggest, 67% of the data (mathematically) or in trading 70% of the data is the first standard deviation, then as we exit that area (either a ledge or a value area high/low) price gets imbalanced or “unfair”.

This might seem a little too distant from what we’re going to be using and how we’re going to lay out the understanding of auction market theory. This is something that we’ll dive into a little later.

First consider how prices move from balance to balance and understand that the balance is 70% of the volume.

The role of supply and demand in auction market theory allows us to identify when prices are in areas of balance and expected to hold or imbalance, and expected to hold.
When new information enters the market, we have the understanding that the market is expected to expand, this can be in the form of news, that is where supply and demand are no longer equal.

It’s an auction after all, think of the sale of a house and an auction. When we have greater demand than supply, we expect prices to go up, this would be triggered by a bullish event, when prices are holding stagnant and nothing appears to change the market information, we expect the price to stabilize, then when prices are affected negatively, the supply increases and prices drop.

2.Market Participants

The market participants in any market are extremely important and it will help us understand auction theory or as it’s commonly known as distribution theory better.

The market participants are most obviously the buyers and sellers, but we can dive a little deeper and split them into “strong handed” vs “weak handed” traders.

The buyers and sellers can be a part of either of these categories above.

What traders have to understand about buyers and sellers is the aggression at which they come into the market. Markets move based on imbalances as pointed out above, these imbalances are when buyer and seller aggression is one sided.

First understand strong and weak handed market participants then we’ll make sense of the movement and buyers and sellers.

Strong handed market participants:

These traders can be considered either institutional or retail, what’s important here is understanding that these traders move size. It’s a common misconception that there is something such as smart money that moves the market and only institutions can dictate price movement. Although they do dictate the majority of the movement they are not the only participants.
Strong handed traders get active in areas where they are able to create large pushes in the market, either up or down. Those areas are where volume drops off and into and through low volume areas or imbalances.

Meaning they get active at the ends of balances, and when the balance breaks through that imbalance to continue the move. When the move is deemed exhaustive, they step off the gas, and allow weak handed traders to come into the markets.

Take a look at the explanation below where we can identify where strong handed traders are most active in the markets.

Weak handed market participants:

These traders are late to the game, they too can be institutional or retail positions, most likely falling into the retail crowd. They get active at the end of the move, they are buyers into resistance and sellers into support. We can usually spot them at the tops of distributions buying and failing, moves either above the area slightly then clean rejection or just failures, the same goes for key support areas as well.
These are the market participants that we want to avoid, meaning we don’t buy into resistance or sell into support to start off. Those breakout trades are higher probability when you have order flow or other qualifications attached to it.

What happens to these traders is that they are getting trapped & stuck, this allows strong handed traders to come into the market when they see this happening and reverse the position, taking weak handed trader stops.

3.Market Structure & Auction Theory.

Market structure or price action is often something that traders associate with candlestick analysis, however we want to focus on volume analysis and how balance and imbalance play a role in market movement and direction.

Bring back the normal distribution, as is, we just get information from it, but if we flip it on it’s side and we think of it as a volume profile, you get a better understanding of its use and what it shows us as traders.

This is the idea of the normal distribution in terms of auction criteria, we have a balanced area, where price is deemed fair value. Under the principle that we have buyers and sellers relatively equal in this area, moves outside of this area, we expect to have unfair value.

This looks a lot like a value area for a specific period, with the extremes being outside of the value area highs and lows. The reality of the situation is that not each day is going to be this perfect, this is what it’s called a normal distribution.
Each value area and profile has generally different shapes.

As auction theory traders, we want to focus on where the bulk of the volume sits, what we would call the balance or the distribution. From here we can look at these areas based on any time frame. By time frame I mean the length of the volume profile.

When a market gets no new information, we range, and we form an area of heavy volume, when new information enters the market, we make a move outside of the balance and find new balance or prior balance.

This is the general movement of the overall market.

Here are structural rules that we can follow based on the market structure and movement of Auction Theory:

1.Price in balance, wants to stay in balance rejecting the bottom extreme and top extreme of that balance.
2.The extremes of a balance are created by strong handed traders getting active.
3.Price will escape a balance through an extreme caused by a strong handed trader, when that balance is broken, price would do well to stay outside.
4.The broken balance extreme is to be used as support or resistance structure to keep price out of balance.
5.A break of balance dictates direction (up or down)
6.The acceptance back into balance is a failed expansion which would dictate direction based on where price came from.

4.Market Profile & Volume Profile (Tools)

Auction Market theory can be further visualized using two main charts, this is how we can read auctions.

1.Volume Profile
2.Market Profile

The market is a 2-way auction where buyers and sellers come together to decide on the fair price for an asset, strong handed buyers and sellers dictate the strong directional moves and we can read balances and imbalances based on profiles.

The Volume Profile is the most basic form of Auction Theory where we can define balances and imbalances using high volume nodes, low volume nodes and typically value areas.

The common practice is to use a value area as the distribution of balance, because naturally this is the “normal” distribution where we have 70% of the value, however it’s not as symmetrical as we would like. You can still use some of this data day by day, but there is a way to get more symmetrical, larger data sets.

Meaning instead we can use the distribution blocks of cumulative profiles. Let’s say a 50-day cumulative profile, where the high volume nodes stack up to create a “Distribution”.

The image below represents a green balance arc, based on the 50-day volume profile & blue session arcs representing session value areas.

A volume profile has the following key metrics:

1.Value area (70% of the volume) in the images blue or green
2.Value area high/low
3.Point of control (POC) heaviest volume & blue coloured
4.Different shades of volume (red is the lowest value, blue is the highest value)
5.Low volume nodes (areas) which is a stream of red
6.High volume nodes (areas) a stream of blue and green.

Areas of heavy volume are seen in green and blue colors on the profile, naturally the POC will have an area of heavy blue coloring so it’s important to look at the areas that are away from the POC. These are areas of extremes where strong handed traders enter the market and can be seen as turning points in the market for following sessions.

The areas of low volume (red) if there is a stretch, this is what we would call an unfinished auction where the ledges are seen as key support/resistance areas, when the auction gets complete, meaning price moves back into the area, the current trend can persist.

In the image below the first session, we mark off the starts of the low volume areas, highs and lows based on the profile,price holds them as support and resistance, when we eventually run above, we complete the auction then get sent down slightly.
The heavy volume at the lows, where we have the blue arrow, is a region away from the POC where there is strong handed activity that causes an upside move, from here this area is expected to hold as a key support region, causing the most recent 40 point rally in the S&P 500 futures.

The image below highlights the specific value area highs and lows so we can compare them to 30-min moves.

1.We create the value area high and low, this is to be used in the coming sessions.
2.Auction Theory dictates that if we are in balance, we would want to stay in balance, if we move outside of balance, we are imbalanced and the price would want to continue in that direction. In this case, we exit the prior balance high and hold it as support and move higher.
3.Price opens within prior balance, it would want to stay there, rejecting the highs and the lows of that balance. We eventually make a move to the upside above that balance for a short bit before falling back within (meaning directional sell).
4.Price opens within the prior balance but doesn’t hold the extremes that well, but more loosely to stay within that balance.

Now look at the overall distribution on the 50-day profile for the same sessions:

Price opens within the main balance area on all of the sessions, and we hold the extremes of this balance. There is a headfake on the 3rd session above, but when price accepts back below, the sell side is eager to press lower. This is directionally bearish.

2. Market Profile

The market profile dictates similar things to the volume profile, however instead of being fully volume based, the profile is based on time spent at levels, each of the periods is denoted as a 30-minute interval.

Market Profiles split the 30-minute intervals into letters, the following times are based on EST.

(morning AM session):

A 9:30-10:00
B 10:00-10:30
C 10:30-11:00

And so on until “O” which is the final letter.

As in the image below from marketcalls.in.

The market profile has what we call the initial balance, which is the first hour of the trading session, or A & B period. This initial balance represents the period within which price can stay balanced or imbalanced.

Movement above the initial balance high would suggest either a selling tail on “C” period and further which is the first period that would allow for movement outside of the initial balance. Or it would dictate a directional move to the upside if accepted.
The same/opposite goes for the move below the initial balance.

The market profile has other criteria and qualities, like single prints and tails.

A single print in a market profile is the starting point within the session where there is no overlap of prior periods. (image below) The single print is represented by a dashed line. This shows you where the auction is extremely strong from one side of participants, they are emotional in this reading, incredibly confident in their move or just don’t have a choice.

These single prints can dictate trend days and be used as key support/resistance areas for trend continuations.

A tail in the market profile is a single print at an extreme, this where exhaustion really happens and weak handed traders get into the market while strong handed traders see this as an opportunity to reverse.

These tails can only happen outside of the initial balance and they have to be single prints not accompanied by anyone.

There is a difference between a trend move and these turning into buy or sell tails. The rejection back into structure allows us to use it as a reversal, better yet with qualifications like order flow or others.

In auction theory, the structural component, direction and trades levels are to be derived from the volume and market profiles and the information that they give you.

We would like to combine the information we get from all of these profiles to get a better read of the auction, something we’ll be exploring in the coming section.

The rules of thumb we like to trade and analyze by:

1.The 50-day cumulative profile will be the guideline for the main distributions you find in the auction. These large areas are not subject to only value areas. They’re large culminations of volume so they have freedom in finding the large distributions.
2.The second most important tool is the individual session volume profile, where you can identify heavy or light volume from past sessions as well as get an understanding of where the value area should be used in addition to the first point of large distributions. This is to help identify where key players in the market stand and their future positioning.
3.The final piece of the puzzle is the use of the market profile and individual parts in relation to the two above. This can help you solidify the direction in the market.

5.Real world use & strategies

Auction Theory helps us understand how volume is positioned to move price and how order flow has moved price in the past and how it expects to move it in the future based on heavy market participation, selling or buying.

This can give us a really good breakdown of how we can visualize the market and trade it.

We talked about 3 main moving parts and their concepts throughout this article:

1.Large distributions (50-day cumulative profiles) and where multi day balances and imbalances sit.
2.Individual session volume profiles, they give us their value areas, and heavy or light volume regions.
3.Individual session market profiles, where we see IB balance, single prints and tails.

First, we take the concept and understand that prices move based on balances, heavier volume that controls the overall move, and strong handed traders get active at extremes to push prices around.

Identifying the large balances, based on a 50-day profile is a good start, and how prices manage to move into that balance or out of it. This allows us to see direction.

Use the image below as a guide. From the large perspective, we have a distribution between 5065 and 5120 on the S&P500 futures. Those are the two key extremes where volume drops off the most into the ledges.

As long as prices open within the expectation for price to hold in the distribution, reject both the ledges to sustain. If price moves within from above, there is a bearish direction overall. If price moves above and fails to close above, there immediate bearish direction.
If we open outside, and above, we are expected to hold out the imbalance for the next leg. In this case the current prices and most recent days.

Meaning the most recent trading day, we start off with a move above the large balance, so price would want to stay imbalance there, prompting directional buy side.

If we add the next component, the individual volume profile, we get more information about the potential of the current day based on the days around.

Below we included the information of the individual session profit, the one with the green TPO (market profile) is the prior ETH session that trades on the overnight.

From here we identify:

1.The value area high and low (5145 & 5100 respectively)
2.The levels of thick volume: 5092, 5105, 5122.
3.The naked POC: 5134

The thickest of volume is at the bottom accumulated, meaning the potential for a leg higher from that low.

Price opens within the prior day value area, and at the tops, would do well to see a minor fade in prices from the area to come into areas of interest for the long.

The larger ledge that shapes up at 5134-5136 and the naked POC from the overnight.
Then the next thick area of volume, the start of the large distribution and heavy volume, 5120.

Here is how the day itself shaped up:

Move above the distribution into the open, run into the Value area high and large distribution ledge at the 5146-48 area, pullback to the 5134-36 for the longs, and up ever since.