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What is Market Profile?

Each day the market defines a Market Profile (MP), a Value Area (VA) and a Point of Control (POC), all of which are invaluable to trading the following day. Similar market-derived data over longer time frames is also of great value to day traders and other time frame (OTF) traders. Before I expand on this subject, let's back up and define the various terms we will use.

The sole function of any market is to facilitate trade. Over time a profile of the nature of the trading develops and levels of perceived value become established. By the end of the trading session, a structural profile for the period has been established. This is referred to as Market Profile (MP).

Definitions You Should Know

Market Profile (MP): The MP organizes price on a vertical axis and time on the horizontal axis. A price/time relationship is established. A convenient way to evaluate demand at any given price and time is to use tick values, which are immediately available. Subsequently a bell curve of price - volume distribution over time is created.

The basic time period used in MP analysis is the thirty minute time frame. The half hourly tick volume is organized by alphabetic code starting at 8:00 A.M. Letters of the alphabet are assigned for prices that occur in each half hour. The period 8:00 to 8:30 is A; B is 8:30 to 9:00; C is 9:00 to 9:30, and so on. .

Value Area (VA): The "Value Area" (VA) is one standard deviation (70%) of a normal bell curve of the time/price distribution in a given period, commonly each day, i.e. the volume of trade as well the cost of trade is included in the computation of the VA numbers.

Value Area High (VAH): The upper price limit of the Value Area.

Value Area Low (VAL): The lower price limit of the Value Area.

Point of Control (POC): Is the price at which most trade is conducted during the period under study. It is that line of TPOs that makes the very apex of the bell curve of distribution. It is the statistical mean of the price, time, and volume relationship.

Responsive Selling?

If perceptions do not change as prices move away from the upper VA level, prices quickly run out of buyers and start attracting sellers who return prices towards and into the value area. This is also true at the other end. As prices move away from the lower VA level, prices quickly run out of sellers and start attracting more buyers who will bring prices back to the value area. This phenomenon is referred to as responsive selling or buying, respectively.

On occasion, the migration of prices above or below the VA extremes, rather than attracting responsive buyers or sellers, attracts the big money who (for whatever reason) now considers the VA extremes as unfair. The big money responds by initiating buying at this previous extreme. Once this happens, the upside breakout is likely to gather momentum as short sellers quickly cover their losing trades. Prices are likely to trend strongly for the rest of the session, or at least until the big money considers a new upper limit of value has been reached. This is also true at the lower VA level (VAL). Normally when prices reach this area, they cause traders to respond by buying. But occasionally the big money will have reevaluated value at this VAL and consider it overvalued and initiate selling. This will attract further selling and a downtrend is likely to continue into the close, or until fair value is perceived to have been reached.

Keep notes on trades you liked but didn’t make.What held you back? Do you notice any patterns causing you to miss opportunities? FIX THEM!

The Value of the Value Area

The VA of the day is of great value to traders the following day. The opening of the Chicago regular trading hours (RTH) relative to the previous day’s VA can be above, below, or within the VA. Opening price, if outside the VA, may or may not pull back into the VA. All these possibilities have significant implications for the ensuing day's trade. Markets frequently rotate through value and only occasionally trend. So VA extremes offer opportunities to enter fading the extreme or trading the breakout. Knowing which to trade has obvious implications for your financial survival.

The POC's Daily Implication

Similarly the POC of the previous day has great implications for day traders. Being the level of the greatest perception of value, and the price at which the greatest volume of trade took place, it is likely to offer significant support on downside pull backs in an uptrend, or resistance on an up-side correction in a downtrend. The POC will then offer opportunities to fade the pull back. However, failure of these normal expectations as prices test the POC would amount to a break out of sorts, and fading the POC could be a costly mistake.

VA and POC Insight

Similarly, VA and POC studies of longer time periods offer great structural insight to the market for day traders and other time frame (OTF) traders who are usually the big money looking to initiate, or hedge positions for the long haul. But as James Dalton says in his book, 'Markets in Profile,' "Even OTF traders are day traders when they put on a trade."

Use of the VA overlay charts over a 5-, 10- and 20-day period can be a great aid in identifying potentially low-risk trade placement and setting reasonable targets for price movement. These are of use to day traders and swing traders.

*PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS.

VA Overlay Chart Day-by-Day Analysis

Chart 1 shows the VA Overlay Charts after the close Friday July 23, 2010. It illustrates and defines VA areas of distribution for the previous 5, 10 and 20 days.

In the previous 5 days, we see that there were two well-defined VA areas between 1096.00 - 1100.00 and between 1059.00 - 1094.00. The VA area for the previous 10 days was a tad larger, 1056.00 - 1100.00. The 20-day distribution covered two distinct areas of VA distribution, 1012.00 - 1047.00 and 1056.00 -1099.00. The POC of the previous 5 and 10 days was in the 1090.00 area. The longer 20-day period had its greatest volume of trade in the 1074.00 area. This was the picture going into Monday of the following week.

Monday, the RTH session gapped up on the opening above the Friday close and the previous 5 and 10 day VAHs. This was not an opportunity to fade the opening. It was a day to buy the breakout and profit from the trend day that followed.

The next day, Tuesday, the RTH market opened at 1116.50, substantially higher than Monday's close (1109.50) and well above the VAH for Monday which happened to be 1109.75. So was this an opportunity to fade the opening or an opportunity to buy another breakout and enjoy another uptrend day?

The former was the trade du jour. After the opening prices moved up to 1117.75 in the first fifteen minutes, the high of the day was in. Once prices broke below the opening, the game was up for bulls and the sellers swooped in to join the responsive sellers attracted by that early over-valued high, an unfair high price to the big money players. These responsive sellers were quickly joined by early longs covering their losing positions and later in the session by blindsided "long only" fund managers caught on the wrong side of the market. The session closed at 1111.00. Our 5 & 10 day VA overlay chart suggested that no real support could be expected until prices reached the 1100.00 area.

So Wednesday when the RTH session opened below Tuesday's close (1111.00)and below Tuesday's VAL (1108.25), one was left with the dilemma of buying or fading the opening (1108.00) and the VAL for the day which was 1108.25, fading or buying the POC (1110.25), or fading the Tuesday close (1111.00) or selling the break back below Tuesday's VAL. The correct trade(s) turned out to be fading any or all - i.e. the Tuesday close, the break back below the POC, and the break back below the VAL. The expectation was that 1100.00 would be tested and the possibility that even the 5 & 10-day POC would be the ultimate test of support. That day the low was 1099.25 so a profit was realized at the target area. That still left the possibility of the 5 & 10-day POC in the 1090.00 area being tested before this down side correction was over.

Thursday the RTH opening was a tick off Wednesday's close and above the VAH after Wednesday's trade. Again one had the dilemma of whether to fade the VAH or the POC, if touched, or going short if those levels of potential support failed as such. In the first hour, prices edged up to a tick above the VAH after Tuesday's trading. This was the high of the day and so shorting that three-day VAH was the ideal trade to enter for the day. The target was once more the 1100.00 area with the real possibility of declining further to test the 5 & 10-day VAL, in the 1090.00 area. The low of the session was 1088.75.

Friday, Thursday's low was tested but the break below the 5 & 10-day VAL could not be sustained so buying the 5 & 10-day VAL was the trade du jour and prices steadily moved higher from that key reference area, the high of the day being 1103.50, a little above that other key reference area, 1100.00. This apparent break out could not be sustained and prices eased back to close at, you guessed it, 1100.00.

VA Overlay Chart Day-by-Day Analysis - Chart 2

Chart 2 is the 5-, 10- & 20-day VA overlay chart after the close Friday July 31, 2010. The key reference areas are shown and are offered to help you in your trade, this first week of August.

Before Monday's opening, this chart was sent out to a few friends with this note: If Friday was a reversal day, and I believe it was, we should see prices move up to at least test the 1113.00 area, even the recent correction high at 1115.75. A new high in the 1120.00 area or a test of the June high, 1129.50 cannot be ruled out. If the breakout is unsustainable, we are likely to see a correction that could bring prices back to test the 1090.00 level.

VA Numbers for Monday:

VAH @ 1100.75

VAL @ 1093.25

POC @ 1097.75

*PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS.

I'm not being sly in the Chart 1 presentation of the value of VA Overlay Charts. The good stuff you learn about trading VAs in my courses and the use of Market Delta "footprint" charts makes decision making at these key reference areas easier than you might think. "Volume leads price" was the mantra of market technician Joe Granville who popularized On Balance Volume as an aid to investing.

Volume is key to unraveling the fade/breakout trading dilemma. Using the technical indicators that over 90% of traders use, all set at the same default values, is far inferior to understanding market structure. It is no coincidence that over 90% of traders fail at this zero sum game called day trading. I teach market structure so that Value Areas are easily defined, and their relevance in any situation can be quickly deduced.

Larry Levin
[email protected]

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