Just keep in mind that this should be just a good introduction to the subject and not the complete theory. You should dive into this topic using the following books:
- J. Peter Steidlmayer - Steidlmayer on Markets:Trading with Market Profile
- James F. Dalton - Mind over Markets Power Trading With Market Generated Information
- James F. Dalton - Markets in Profile
If you decide to read just one, stick to "Mind over Markets", cause it is the best one of them. This was my bible for to study the subject. I read it twice and really study it´s concept simple because it made sense. Enough propaganda, let´s start the content!!!
The stock market is organized as an auction market, meaning the buyers will enter competitive bids and sellers will enter competitive offers at the same time. The price a stock is traded represents the highest price that a buyer is willing to pay and the lowest price that a seller is willing to sell at. Matching bids and offers are then paired together and the orders are executed.
The best way to understand how value is formed is using a simple auction example. This time we will auction a painting, instead of our usual Ipad. By using the paint example I make it harder to determine it´s value. Since the artist is fictitious you will have no reference to start with.
Here is how the auction will work:
- 11 paintings will be auctioned and they are numbered with the letters (just so we can differentiate them)
- The auctioneers will call the bids
- The players will be fictional, but we will add the complexity so value will be formed by "adding" the value of all players into one structure. They will be: the Collector, a Normal Person, the Artist Fan and the Art Retailer.
So our auction begins at U$50, the Retailer is the first one to bid, the Normal Person raise the bids to U$60, the Retailer comes back an raise again to U$70. Now the Collector comes in, we have new bidder, and raises to U$80. More people got interested in the auction. The Normal Person raises to U$90 and is the winner of the first auction (A).
Just keep in mind what we said about perception of value. Each player has a different perception of how much these paintings are worth. We will not focus on the reasons each one of them have. For example, the Retailer may have a costumer willing to pay U$110 for the painting, so he will not pay more than U$60 for it. The Normal Person might just want something to put in the living room and like the artist. The truth is you can not know everybody´s reason to buy or sell something and it does not matter.
Now the second paiting´s bids will start at U$90, as it was the last price (the reference we have so far). The Artist Fan decides to get involved and get in the game. Collector and the Artist Fan are the players now. It got too expensive for the other players. The Artist Fan, after a couple bids get the painting for U$130.
Third auction start at U$130. Artist Fan bids, cause he want another painting. Collector bids for U$150 and win this auction. Notice that in the first auction prices move from U$50 to U$90, second from U$90 to U$130 and this one only move U$20 dollars from it´s open bid. This tells you less people are willing to bid at this level and what happens next....
Forth auction start at U$150, no body bids. No more buyers at this level. The auctioneer has to drop the offer to U$140 than U$130... til he gets as down as U$90 where the Artist Fan buy the next painting.
Next auction no buyers at U$90. The Retailer get´s the painting for U$60 bucks. This game goes on until all the paintings are sold.
Do not worry who got more paintings at this point. We will take a look at the behave of prices during the auction process.
The auction is over and now think about this: the artist shows up and says he has more 10 paintings to sell and the players are still the same and nothing else has change. If we look the prices the at the last auction, what was the average price paid by the player? Here is the math behind it:
Avg Price paid = (90+130+150+90+60+100+140+70+120+80+110) / 11 = 103,63
So the next auctions´ prices would probably fluctuate around U$105. Since this is the reference all the players have now and no other information was add to the game, it is unlike that any off the players will pay a price too far away from U$105. Would you pay, for example, U$150 knowing the average price paid?
To be continued....
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