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Auction Market definition

How Does an Auction Market Work?

An auction market is a market where there are willing buyers and sellers entering competitive offers at the same time. The buyers place competitive bids, while the sellers submit competitive offers. A deal is done once the bid submitted by the buyer is accepted by the seller. Stock prices represent the current market price at which buyers and sellers are willing to trade. This price typically represents the highest price that a buyer is willing to pay and the lowest price that a seller is willing to sell. When a competitive bid by a buyer is presented on the market, and a willing seller is prepared to accept that price, the transaction is concluded. Only once matching buyer bids and seller offers are paired up, are transactions processed and orders executed.

There are many examples of auction markets operating around the world. These include the most iconic auction market of them all, the New York Stock Exchange (NYSE). In order for a trade to be concluded, bids and offers must be matched. Note, that at any given time, any number of bids or asks will be presented to market. Only where they overlap is it possible for a trade to be executed. If negotiations take place over the counter, in OTC markets, it is not necessary for auction markets to negotiate. In the past, open outcry – a method of physical trading in the pit on stock exchanges – would bring buyers and sellers together. Nowadays, there are instant and simultaneous matches taking place with electronically executed trades. Orders will remain in a pending status if bid prices and offer prices do not match.

How Does the Auction Market Differ from the Dealer Market?

Auction markets bring willing buyers and sellers together simultaneously. Back-and-forth takes place until a price point is reached at which time a trade can be conducted. The maximum price that a buyer is willing to pay is matched against the minimum price that the seller is willing to sell. In a dealer market, a market maker is used to facilitate the trading. In other words, a middleman will buy and sell securities in order to generate liquidity in the markets. Market makers are otherwise known as brokers. They make their profits from the bid-ask spread. This occurs once the bid price is higher than the ask price. The broker (middlemen) then makes a profit from the difference.

An example can help to the clarify the bid-ask spread:

If the bid is currently $110, and the ask is $108, the bid-ask spread is the difference between the bid price of $110 – the ask price of $108. In this case, it is $2. In percentage terms, it is the spread value divided by the bid value. Here, it is $2 /$110 = 1.8%. Therefore, the calculation for the bid-ask spread is simply the Bid – the Ask. In an auction market, the calculation might work differently. Assume that there are multiple buyers looking to purchase shares in Company XYZ. They may place bids of $110, $111, and $112 respectively. Now, in order to facilitate a trade, there must be willing sellers. In this example, there might be sellers offering shares at a price of $112, $113, and $114. Now, only 1 of the buyers will be able to transact with the seller at a price of $112. The other buyers do not find willing sellers.

Since prices change in a dynamic fashion with stock markets, it is possible that other buyers and sellers will transact when the market price of the underlying financial instrument is reached. The remaining orders may not be immediately executed until such time as the bid price and the ask price overlap. If no matches are found in a trade, the trade will not be executed.

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