The Dual-Auction Process
In this article we going to learn about The Dual-Auction Process and see how prices really move.
Table of Contents
let’s consider the financial markets. We now have what is know as a the Dual Auction Process (also know as Market Watch or Depth of Market– “DOM”)
Multiple buyers competing to buy into market, and multiple sellers competing to sell into market; all at the same time.
Anatomy of Dual Auction
As you can see DOM in the above image some even call it “Price Ladder” as price climbs up and down in the “Price Range” which can be seen in the center.
Bidding is shown in “Bid Column” in blue color and “Offers Column” also know as “Ask” are shown in red color. Their total is shown down below respectively as “Total Bid” and “Total Ask“.
The “Last Traded Price” aka LTP is Current Market Price which is now at the ask side as it is red color when LTP is at Bid side it turns Blue in color as in below image.
In the above image each bid or ask can be from and individual trader or numerous traders for e.g. in the bid column at the end there is 15 qty at ₹ 49.70 can be from 5 traders bidding 1 contracts each with remaining from 2 different traders bidding 5 contracts each totaling 15 qty.
So don’t just assume single traders at different price it can be any numerous ways. Also the above dual auction shows 5 bids and 5 ask at any given moment.
This is called as “5 market depth” or Level 2 data of volume. In India currently Zerodha is the only retail broker to offer “20 market depth” or Level 3 data to its clients. Want account with Zerodha broker click here.
As you can see in the above image all the bids and asks are Limit Orders. The bid column displays “Current Demand” or “Bullish Pressure” and the ask column is “Current Supply” or “Bearish Pressure“.
What moves the Price ?
To understand how prices move up and down just like the previous example we learnt from the 2nd Hand Mobile Auction just take a look at the above image.
On the bid side we have 25, 4, 3, 16 and 15 qty and bid price starts from ₹ 49.95 going down likewise we have ask price from ₹ 50.00 going up with 3, 21, 5, 4, 75 qty with LTP currently at ask side. As we know all these bid-ask are limit orders.
Now let me demonstrate what moves the price. Lets say in the above image the 15 qty bid were to cancel “Limit order” and turn it into “Market order“. Market order function is to accept whatever price the opposite side has which means this 15 qty bid will accept whatever the ask side has to offer.
This means that the 15 qty will fill the 1st qty i.e. 3 qty at ₹ 50.00 at which point the remaining qty 12 goes to 21 qty at ₹ 50.05 but only 12 qty gets filled so from 21 qty only 9 qty remains unfilled at 50.05. This happen in fraction of a second. As of March 2022 NSE has the capacity to process 300,000 orders per second and does 12 billion order messages a day, up from 2 billion.
In the above image you can see that the “LTP” jumped up from ₹ 50.00 to ₹ 50.05. This is how prices move with market order. If prices is going down its because sellers are using market orders and accepting any bid value.
Important Tip
Never decide whether to go Long or Short just by analyzing the “Total bids or Ask“. like for e.g. in the above image there are Total 98 bids and 141 ask so deciding to go short because ask total is more is stupid idea.
Because those are Limit orders total. Which can be canceled at any time to fool you. Remember that executed volume is always shown on charts and never on Bid-Ask (DOM). You can never find Buyers or Sellers in the volume because buyer and seller agree and the transaction takes place.
So in short “Limit Orders” are Passive and “Market Orders” are “Aggressive“.
Bid – Ask Spread
The bid-ask spread is a representation of the supply and demand for an asset. If the bid and offer prices are close together, it is considered a “tight market“, which means that there is a consensus between buyers and sellers on how much the asset is worth. If the spread is “wider“, it means that there is significant difference in opinion.
Spread is difference between ask & bid, so in the above image the tight market has 0.05 spread and in the wide market 0.20 spread. This spread should be you ideal difference when you enter SL and trigger value. You can see the Spread value in between buy and sell buttons in Status Line.
The Bid-Ask Spread Impacted By:
- Liquidity
- Volume
- Volatility
Liquidity
This refers to how easily an asset can be bought or sold.
As the liquidity of an asset increases, the bid-ask spread usually tightens.
Volume
This is a method of reporting the quantity of an asset that is traded daily.
Assets that have a higher trading volume will often have narrower bid-ask spreads.
Volatility
This is a measure of how much the market price changes in a given period.
During periods of high volatility, when prices change rapidly, the spread is usually much wider.
From the above we can tell that Tight or Narrow Spreads are best to trade where as Volatile Markets should not be traded or must be avoided.
Dual Auction Process w/ Price Chart
- Individual price bars are the result of the dual auction process operating within the time-frame of that price bar.
- Each price swing is the result of the dual auction process operating for the duration of that price swing.
- Over a period of time, when the demand is consistently greater than supply “price” will rise as it did in swings 1 and 4 (Image below).
- When the supply is consistently greater than demand “price” will fall as it did in swing 3.
The Sentiment in above chart as follows:
- Bullish sentiment leads to bullish order-flow resulting in price rising, as in swings 1 and 4.
- Bearish sentiment leads to bearish orderflow resulting in price falling, as in swing 3.
- Neutral sentiment leads to narrow range sideways price action, as in range action in 2.
As we learnt above we don’t have to see or use DOM as it is printed on chart. That’s all there is to The Dual Auction Process, in next article we gonna look into Supply and Demand.