Auction Theory: How prices move in stock market

This is one of the fundamental concepts in any market. How securities will be priced depends upon this basic principle. Understanding this will give you a better view into the market and some advanced methods like order flow analysis will be easy to understand. In fact, a form of trading that uses the data of auction directly from the terminal is called ladder trading. I am assuming that this article will be read by someone who is a beginner and hence I would make it as rudimentary as possible. I will state some facts that might be known to some people and hence start with the section you think you know from.

Fact #1: The buyers and sellers at any price will be equal at any moment in time.

It was important to state this fact right now as in some circles the common saying will be like

-" Prices move up when there are more buyers than sellers."

or

"Prices go down when there are more sellers than buyers."

Please understand that a price at a moment is determined when both buyers and sellers agree on the price and are ready to exchange the security( in stock market it is mostly shares). Every buyer needs a seller for the transaction to take place. If a single share is exchanged at a price then that price will be recorded for that moment. The type of buyer and seller for prices to go up or down is different. This will be well explained in the next section.

Fact #2: Prices move up or down basis the aggressiveness of buyers or sellers respectively.

First try to understand how the aggressiveness is expressed in stock market. In stock markets, there are two types of order:

Market order:-This order contains only quantity and no price. In buy scenario, when this order is placed the specified quantity will be bought at lowest price possible till all quantity is bought. This order will be filled instantly as once the sell quantity at lower prices gets exhausted it will move up and buy the remaining quantity. This will go up till the complete quantity is bought.

Limit order:- This order contains qty and the price. In a buy scenario, when this order is placed the required qty will be bought at the specified price or lower. If the sellers are not there at the specified price or below, the remaining qty will be left for buying until the price again reaches the same level. There is no guarantee of prices reaching the same level again and the left over qty might not get filled at all.

The vice versa is true for the sell side orders.

Look at the table below. This shows the limit orders at one moment in time. Lets assume that 100 was the last price that was traded. Bid is the price that the buyers are willing to pay through limit orders. Ask is the price sellers are willing to sell one share for.

The movement of prices happens when market orders are placed. For market buy orders, exchange will start to allocate units from the lowest prices available. This comes from the logic that any buyer would like to buy the shares at lowest possible prices to make the maximum profits. Let's try to understand this with the help of few examples.

Suppose from this point market buy order for 2 units is placed. Then the price would have been 101.(exhausted units are stricken down in picture below, please zoom in case it is not visible)

If 4 units market buy orders are placed the prices would go to 102.

If 1 unit market order is placed the price would be still 100.

The same mechanism would be applicable from the sell side. If 5 market sell orders are placed the prices would go to 99.

If 12 unit market sell orders are placed the prices would go to 98.

As one can see that market orders show aggressiveness. When aggressive buyers punch market orders, prices will go up and when aggressive sellers punch sell market orders, the prices will go down. If the participants think that there is chance that their quantities will not be filled as the prices might not come back at these levels, they might prefer punching market orders.

Now imagine a scenario where there is a very bad news in the market and it is trending down. The limit order sellers might think that the price might go further down and their sell orders will not be filled. They might prefer selling it through the market order. If a large enough participants are aggressive then large market orders will rapidly move prices down.

Limit orders will be able to move prices if the limit order is placed above the present price for buy orders and vice versa. So for this case, if limit order of 5 units at 102 is placed then the prices would go up to 102. However, this is not the case most of the time as limit orders are to ensure efficiency in buying and selling.

This process is executed throughout the day in exchanges and the prices for each moment is being recorded. Based on this the candlestick and other charts are being drawn. Reading live auction data is difficult and order flow data is being used to see how the prices were reached in the past. The details of order flow data will be coming in a separate article. Thank You!