In What Types of Markets Can Technical Analysis Be Used?

Markets are simply meeting places of buyers and sellers. Markets can be categorized in many ways. They can be categorized by the assets being traded, the manner in which the borrowers and lenders meet, or the type of contract that is executed. Let us begin by dividing markets into categories based on how organized or integrated the market is. Using this type of division results in four different types of markets: direct search markets, brokered markets, dealer markets, and auction markets.

The direct search market is the least organized market structure. With this type of market, buyers and sellers must seek and find each other directly. For example, suppose that Elizabeth wants to buy a used washer and dryer for her new apartment. She might search the classified ads in her local newspaper or go to eBay or Craig’s List for a seller of a washer and dryer. Generally, low-priced, nonstandard goods are traded in the direct search market. This type of market is characterized by sporadic participation by the market players.

The next level of market organization, the brokered market, addresses the direct search market problem of the buyer and seller finding each other. In markets in which the volume of trading in a particular good is sufficiently high, brokers can specialize in bringing buyers and sellers together. One of the most familiar examples of a brokered market is the real estate market. Through specialization and economies of scale, the real estate broker is able to provide search and matching services to clients at a cost much lower than the clients’ private search costs would be. The broker is able to earn a commission by providing these search and matching services for the buyer and seller. Brokered investment markets work similarly, with brokers matching buyers and sellers of financial assets for a commission.

A third type of market structure, the dealer market, arises when the trading in a particular type of asset becomes sufficiently heavy. Unlike brokers, dealers trade assets for their own accounts. Specializing in particular types of assets, these dealers post bid and ask prices and stand ready to buy and sell at these prices. The Nasdaq is an example of a dealer market for stocks. The dealer offers to buy securities at the bid price and offers to sell the securities at the ask price. The dealer’s profit margin is known as the bid-ask spread. The dealer market saves market players search costs by providing readily available information about the prices at which they can buy and sell securities. The securities traded in dealer markets are usually substitutable and liquid, with the dealers standing ready to purchase or sell securities providing the liquidity. Thus, dealer markets generally have the characteristics necessary to use technical analysis.

The most highly integrated market is the auction market. In an auction market, all participants converge at one place to buy or sell a good. The centralized facility can be a location, a clearinghouse, or even a computer. An important aspect of the auction market is that all information about offers and bids is centralized, where it is readily accessible to all buyers and sellers. As all of the market participants converge, buyers and sellers need not search for each other, and a mutually agreeable price can be established, eliminating the bid-ask spread. Assets such as art, jewelry, and antiques are sold in periodic auction markets. The New York Stock Exchange is an example of a continuous auction market.

Some auction markets can be studied using technical analysis, whereas others cannot. For example, auction markets in paintings could not be subject to technical analysis because a painting is unique and not substitutable with another painting. The auction market for U.S. Treasury bills, however, can be analyzed with the tools of technical analysis because U.S. Treasury bills are highly liquid securities and are easily substitutable. Because organized exchanges are structured for continuous trading in liquid, substitutable assets, they are usually subject to technical analysis.

Source: Kirkpatrick II Charles D., Dahlquist Julie R. (2015), Technical Analysis: The Complete Resource for Financial Market Technicians, FT Press; 3rd edition.

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