Auction Market Value Theory
Capital Market Theory (CAPM), as reported by Sharpe [CX-1], starts with
the assumption of a stochastic (gaussian) market with daily high-lows
(returns) forming the distribution. Other assumptions for CAPM, explicit or
implicit, are that investors are rational, markets are efficient, value is
firmly grounded in expected return, the one-price rule (no arbitrage) holds
and volatiltiy (risk) is the variance of the returns. These rules are
admittedly imperfect, but it is often proposed that CAPM is correct because
it has predictive value (much of this through econometric analyses).
Since 1970 economic researchers have disputed every assumption of CAPM. Thaler,
Kahneman and others have shown that investors are not rational, price varies too
fast and too much for an efficient market, at times arbitrage dominates the
stock market (program trading) and common sense argues that the variance
of returns cannot be solely risk since opportunity derives from the same
source.
Most devastating to CAPM is the work of the econophysicists who prove
the market is complex and non stochastic. This finding throws all results
derived from CAPM into question. According to the econophysicists, financial
markets are a complex, self regulating process driven by feedback. Further,
there is probably no distribution function that can be found to describe
market behavior in general [CX-5].
Auction Markets and Value
Complex processes are met everywhere in life. The climate, ocean movement,
traffic flow, tornados, one's interaction with others, airflow over a finite
wing, even the motion of coffee being stirred in a cup, are all complex.
Often a process will have two phases: non-complex and then, under certain
conditions, a transition to complex behavior at some point. For example,
airflow over a wing at low velocities (laminar flow) is well understood and
easily modeled. At high velocities turbulent flow sets in. Financial
markets similarly display quiet periods that are straightforward to analyze
and project (econometrics works), followed by agitated periods that are not.
The quiet periods are characterized by balance, where the high-low price
range of the period is constrained within limits. Active periods are normally,
but not always, associated with the directional phase of price movement.
A key to analyzing complex financial markets involves a change of variable.
Price, the obvious choice, must be transformed into value. The catalyst is
time. Price over time translates into value. A seller wants the highest
price possible, a buyer, the least. Jockeying for the best deals in an auction
market produces a range of prices over time. The highest prices will have
few buyers. The lowest prices will have few sellers.
In between prices have more activity, with most trading occurring around
the middle. A price-volume plot of a day's trading will show a
quasi-bell shape, thickest around the middle prices, tapering down to
the small volumes at the highs and lows. Assuming that price over time defines
value, the price-activity display shows the preferred prices; those prices
that market participants perceive as revealing value. A price-volume (or price-
activity) plot is a raw picture of market feedback.
The concept of measuring market feedback to determine value was proposed
by Steidlmayer in 1985 [CX-2]. He defined value as the price range of the
middle seventy percent of volume in a trading day. This definition was
limited to Chicago Board of Trade futures since the CBOT Liquidity Data
Bank (LDB) was the only source of volume at price. This methodology can be
called LDB - Volume Jones, [CX-4], devised a
methodology using price - time occurrences (TPOs) as a surrogate for
volume, thus making value calculations available for all futures.
The new methodology (Tick - TPO)
relied on quoter or tick data and thus is available in real time.
In 1988 Jones [CX-3] extended the
day model to multiple days via the Overlay Demand Curve, identifying the
market's condition (balancing or directional). A balancing market has
unchanging value (value is a range, not a single price). Directional markets
are those in which value is changing. The value approach is inductive;
mesurements are made, data is analyzed and sorted and conclusions are drawn.
The methodology offers an understanding of markets and market dynamics. There
is no general formulation, e.g. the gaussian distribution of CAPM is not applied
and there is thus
less opportunity for prediction. The value approach depends on actual market
measurement, effectively bringing financial economics onto a scientific basis.
Market Profiles were originally applied to one day's market, but any representative
time period may be chosen. For most purposes one day is adequate, and will be
used in this report. There are two types of profile: Market Profile comes from
the CBOT Liquidity Data Bank and Meta-Profile is built from tick data. Both
find value and for purposes of this discussion, are equivalent.
Market Profile/Meta-Profile is the fundamental method of
auction market analysis, the basic building block. Overlay Demand Curves use
a collection of
Profiles, linearly adding activity for the number of days chosen.
A market will be in balance so long as the market feedback decrees.
When the balance phase gives way
to directional movement, that too may last an arbitrarily long time; from
a part of a day to many days. If the Overlay covers enough profiles the
entire cycle from balance to directionality and back to balance is
displayed. Thus market condition is an observable directly connected to market
activity and its feedback.
Overlay Demand Curve integrates Profiles
to analyze the longer term market, revealing market condition.
Market condition developed by the overlays rely on no preconditions;
no assumptions are made about fundamentals (e.g. interest
rate change). Market activity, what is observed, rules in auction value
analysis. The same is true in most physical experiments.
Basic Elements of Markets
The Profile is the fundamental element
of auction market analysis, measuring local demand (short term value).
Overlays integrate profiles to find longer term demand. The market unit is
the basic element of market structure, found from Overlays.
The foundation of auction market value theory lies in the set of
Profile, Overlay Demand Curve and market unit.
Profiles, Overlays and market units provide a powerful platform for
investigating markets. Items as diverse as market equilibrium,
volatility and market opportunity will be studied as applications of
value theory.
This report on Auction Market Value Theory is broken into sections. Each
can be studied separately or in order.
Market Profile History
The Market Profile/Meta-Profile
Overlay Demand Curve
****put in webserver
Link: Market Unit
The Market Unit
Link: Noise
Noise Traders
Link: Pulse
Pulse
Link: Opportunity
Opportunity
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Link: Profit
Taking Short Term Profits
Link: Volatility
Volatility and Stops for Daytrading
Link: References
Auction Market References
CX-1 Sharpe, W. (1970) (2000). Portfolio Theory and Capital Markets, MCGraw Hill
CX-2 Steidlmayer, J. (1985). CBOT Market Profile Manual
CX-3 Jones, D. (1988). Overlay Detection of Long Term Market Condition, The Profile Report, Vol 2, Oct. 1988
CX-4 Jones, D. (1987). Determining the TPO Value Area, Market Logic School, Al. Ltr. V1-#3, Apr 13
Jones, D. (1987). Estimating the Market Profile Value Area for Intra-day Trading, S&C Sep.
CX-5 Sornette, D. (2003). Why Stock Markets Crash, Princeton
Johnson, N., P. Jeffries, P. Hui (2003). Financial Market Complexity, Oxford
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