An auction market is a market where the price is determined by the highest price the buyer is willing to pay (bids), and the lowest price the seller is willing to take (offers). Bids and offers are matched for a trade to occur.
An auction market is a market where the price is determined by the highest price the buyer is willing to pay (bids), and the lowest price the seller is willing to take (offers).
The New York Stock Exchange (NYSE) is an example of an auction market.
A dealer market uses “market makers” to provide liquidity in the market.
How Auction Markets Work
Auction markets are an efficient way to connect buyers and sellers. The New York Stock Exchange (NYSE) is an example of an auction market. Trades on the exchange will be executed when an offer and bid is matched – think of it as an agreed-upon price between the buyer and seller. While negotiations are made in OTC markets, no negotiations are made in auction markets.
Historically, auction markets trades were executed via open outcry, where buyers and sellers would call out prices on the trading floor. Currently, trades in an auction market will be matched simultaneously and instantly and are executed electronically. If the bid is unable to be matched to an offer price, the order will remain pending until a corresponding bid and ask can be matched. In an exchange, the process is spread across many buyers and sellers.
Auction Market vs. Dealer Market
As formerly mentioned, an auction market trades directly between a buyer and a seller. A dealer market uses a middleman or “market maker,” who buys and sells securities to create liquidity in the market. The market makers are typically referred to as brokers and profit from the bid-ask spread.
As mentioned above, brokers are incentivized to create liquidity in the market through profits created from the bid-ask spread. A bid-ask spread occurs when a bid is higher than an ask, and a broker profits off the difference.
For example, if the ask is $99, and the bid is $100, the bid-ask spread would be $1 ($100 – $99). The bid-ask spread can also be quoted in percentage terms and equals the spread divided by the bid. In the above scenario, the bid-ask spread percentage would be 1% (1 / 100).
Example of Auction Market
Imagine a simplified scenario where three buyers are looking to buy shares in Company ABC, placing bids of $100, $101, and $102, respectively. There are also three sellers with offers of $102, $103, and $104. Here, only the buyer and seller with offers/bids of $102 will get their shares traded. The price of the stock at such a point in time will be $102.
Now, imagine a scenario where bids are $100, $101, and $102, and asks are $103, $104, and $105. In such a situation, all the trade orders will remain as pending until a bid and ask can be matched.