we did previously. Adjusting our parameters to fit these new developments isnot difficult; knowing that the adjustment is necessary ismore difficult, especially for the new, developing trader.Fixing the gate isn't very hard; recognizing the need to doso is harder.
BASIC PRINCIPLES OF MARKET PROFILE
Let's start by laying out three operating principles that arebehind Market Profile and LDB.•68-
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READING THE MARKET PROFILE CHART
In the Market Profile chart, prices are arranged along thevertical axis, with the highes t price at the top and thelowest price at the bottom. Trading activity at each priceis then graphically displayed on this chart. The trading dayis divided into half-hour periods — a convenient, thougharbitrary choice; some other time period could have beenselected instead. These periods are labeled alphabetically,starting with a letter for the first trading period of the day,then progressing alphabetically. When a trade occurs at aparticular price during a particular half-hour period, theletter for that period is displayed at the appropriate pricepoint on the chart. As the day passes, and trades occur atvarious prices during different half-hour periods, a uniqueMarket Profile for that day and that product is developedby using a bell curve.The Market Profile presents a number of basic elementsof the market in a rapidly-understood graphic form. Thesmallest possible unit is the time/price opportunity — a single letter representing a trade occurring at a given priceat a given time. This is a direct descendent of John Schultz'sminimum trend concept, the starting point for my thinkingabout markets.Prices that occur often during the day, usually with thegreatest volume of trade, are represented by a large horizontal bulge. Prices that occur less often are representedby the thinner parts of the profile. In most cases, the mid-,die of the profile represents the area of fair price, wheremost of the trading occurs; the top and bottom representrelatively unfair prices, high and low respectively. By noting how widely dispersed the high and low excesses areand how far they are from the fair-price area, we can also70
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see the relative unfairness of the day's high and low prices,presenting some degree of imbalance.In most cases, the Market Profile resembles a normaldistribution curve, which, äs statisticians have found, isthe most common organizing principle in nature. Sincemarket behavior is human behavior, it is logical to expectthat prices would follow the same statistical patterns thatgovern other human groups.Note, too, that the normal distribution form of the Market Profile also reflects the market phenomenon by whichparticipation drops off äs prices move higher or lower. Justäs bidders in an auction market drop out, one by one äsprice increases, so the Market Profile curve tails off at theupper end of the price ränge; and, at the lower end, thecurves tails off äs sellers drop out of the market. This represents the declining volume of trade at these extremeprice levels.Another way of looking at the normal distribution presented in a Market Profile is through the concept of theStandard deviation, also drawn from the science of statistics. The Standard deviation is a way of measuring how farthe values in any group of numbers vary from the mean,or average, value in the group. In any normal distribution,values within a given number of Standard deviations fromJthe mean will occur with a predictable frequency. Normally, about two-thirds of the values will fall within oneStandard deviation from the mean; 95 percent of the valueswill fall within two Standard deviations of the mean (seeFigure 6-1).Now that you understand what you are seeing when youlook at a Market Profile, how can you use this informationin analyzing market activity? Let's look at some details onhow Market Profile reflects the development of a marketäs it happens.• 71 •
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The purpose of the day structure is to find and maintain afair price. This allows the market to do business because
no one intentionally trades at a price they know to beunfair. This activity of the market in seeking and maintaining a fair price needs to be explained in its relation tothe day structure.We begin our study of the day structure with the firsthour's price ränge — the ränge represented by the first twohalf-hour Segments. This is defined äs the first balance areaof the day. Accumulated trades in this area represent abeginning fair price for day time frame traders, for theyusually make up most of the volume during the first hour.This is all well and good for them, but other traders sooncome in to take advantage of that price. These are beyondthe-day traders. Their activity upsets the delicate balance,and, naturally, price has to move to make an adjustment.If they give the market only a little nudge, price will notmove very far; if they give it a big push, price will moverather dramatically.There is, then, a spectrum of possibilities, ranging froma small influence by long-term traders to a major influence.Let's consider some definitions that will help you understand how this spectrum works.First, there is the non-trend day. On a non-trend day,long-term traders exert little or no influence on the market. The market exhibits no or almost no extension of itsrangexrf prices beyond what is seen in the first hour. Lookat the Market Profile for October 31 in Figure 6-2; this isa good example of a non-trend day. The first hour's pricesare represented by the y and z prints in the profile (because this market opened at 7:20 A.M.); note that the rängefor the day was extended by only one tick beyond the firsthour's ränge (during the D period). This makes the day anon-trend day.The next possibility is a day in which the market gets aslight push from the beyond-the-day traders, usually re-
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Figure 6-1.
A normal distribution, with the first three Standard deviations in each
direction indicated.
The skill of reading Market Profile can be broken intotwo parts. The first deals with the individual day, the second with beyond the day. It is the interaction of these twotime frames that creates the conditions of opportunity. Weneed to examine them separately and then together todevelop a good working understanding of Market Profile.DAY STRUCTURES: FIVE TYPICAL PATTERNS
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sulting in a slight extension beyond the original ränge. Wecall this a normal day. On a normal day, outside or longterm activity represents about 10 to 20 percent of the trading activity for the day, and it produces a ränge extensionof about 15 percent beyond the first hour's ränge.Figure 6-2 shows normal day s: October 28 and November 1. Note that October 28 actually shows no ränge extension beyond the first hour's ränge. This is because theinitial ränge was so large that it precluded any ränge development; instead, the day continued trading in the middle of the initial ränge. Thus, a normal day isn't invariablycharacterized by ränge extension.Note that on either a normal day or a non-trend day,the first Standard deviation of volume will be in the middleof the ränge, with the second and third Standard deviationsabove and below.The next type of day we call a normal Variation day. Ittakes place when the long time frame traders represent 20to 40 percent of the activity for the day. As a rule, on anormal Variation day, the day's price ränge is about doublethe size of the first hour's ränge. In Figure 6-2, the profilefor November 2 is a good example of a normal Variationday.Next, jw^fliave a type of day known äs a trend day. Ona trend day, the outside traders represent about 40 to 60percent on the market's activity. On a trend day, the market moves dramatically away from its opening price ränge.It normally closes within 5 percent of the extreme in thedirection of its movement during the day.In Figure 6-3, the profile for October 31 illustrates atrend day. The market opened at the top of its ränge forthe day and closed near the bottom. Notice that the profilecontains two patterns resembling the bell curve. Theserepresent two distributions that occurred during the day,74
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separated by a low-volume area near the middle of theränge (highlighted by the line across the profile).The fifth and final basic classification of days is the neutral day. This is a day in which the long-term traders exerttwo opposite and approximately equal influences. This causesboth an upside and a downside ränge extension, nettingout to no change for the day äs a whole.The new opportunity time frame created by the adventof 24-hour trading has had the greatest effect on the neutralday, äs illustrated in Figure 6-4. This figure shows twoneutral days. October 27 is an "old-style" neutral day, in
MARKET PROFILE (R) COPYRIGHT 1V84 CBOT.CÜPYRIBHT 1987' CQ6 INC.
Figure 6-4. A three-day Deutsche Mark profile, illustrating two neutral days: anold-style neutral day (October 27) and a new-style neutral day (October 28).
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which the market closed near the middle of the ränge forthe day, creating a basically balanced profile.By contrast, October 28 is a "new-style" neutral day,influenced by the 24-hour trader. The day started in muchthe same way äs the preceding day, but when the marketfailed to make a substantial new low in a period, opportunity time frame traders rushed in to buy. As a result,the market ended up, with an unbalanced profile. Thus,the rule of thumb stating that neutral days usually closenear the middle of a ränge needs to be reconsidered inlight of current changes in the marketplace.Almost any trading day will fall into one of these classifications — non-trend day, normal day, normal Variationday, trend day or neutral day. Each involves a differentset of likely ränge parameters, produced by a particularimbalance between short-term and long-term traders. Ifyou can make the correct classification äs the day develops,you will understand how far the market is likely to move.
We know that the beyond-the-day trader will be buyingor selling at different price areas in the market; and weknow, from experience, that long-term traders do not tradewith one another but almost always with the day traders.So we need to be able to look at the ränge and development of our Market Profile and extract from it the longterm trader's activity. The long-term trader will be activethroughout the profile, so we need to examine the profilein its entirety so äs not to miss any information.Let's start by defining some important terms that willhelp us understand the long-term activity. The first term
is an extreme. An extreme is activity at the top or bottomof the price ränge, represented by two or more time/priceopportunities (prints on the profile) by themselves at theupper or lower end of the profile. An extreme cannot occurin the last time period for trading because there is nofollowing trade against which to test it. By definition, anextreme is a price which the market has tested, then movedaway from.Figure 6-5 contains some examples of extremes, together with some patterns that might resemble extremesbut which don't really fit our definition.The elements labeled l, 4, 6 and 10 in the figure areextremes. Each is a series of two or more time/price opportunities that the market moved away from äs an unfairprice. On the other hand, the portions of the figure labeled2, 3 and 7 are not extremes; since they occurred duringthe last time period for trading, these prices were not testedby any succeeding trade. The prints labeled 5 and 9 arenot extremes either; each shows trade at the given priceduring more than one time period. Finally, the print labeled 8 is also not an extreme; only a single tick at the lowend of the profile is involved. An extreme, by definition,must have two ticks or more.Another important term is ränge extension. This is, simply, any extension in the price ränge for the day that occursbeyond tKe first hour of trading. In Figure 6-6, the firsthour's trading for each day is represented by the D and Eprint^ The point at which ränge extension occurred eachday is represented by the circled print. In each case, thiswas the first time/price opportunity for the day locatedbeyond the first hour's ränge.One more important term to understand is the TPOcount. This is a useful indicator of market activity. To findthe TPO count for any given day, first locate the price with
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BEYOND-THE-DAY ACTIVITY
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the greatest number of time/price opportunities (TPOs)nearest the middle of the ränge. Then count the numberof TPOs above and below this line. The result is the TPOcount.Figures 6-7 and 6-8 give two examples of the TPO count.As you can see in Figure 6-7, on November l there wasa greater number of TPOs above the center line than belowit — 22 to 16. (The TPO count is shown in the box at thebottom of the profile.) This means that the day was, onbalance, a selling day in this area of the ränge.In Figure 6-8, by contrast, we see that the ratio wasalmost reversed; on November 2, there were 19 TPOsabove the center line, 22 below. This means the day wasa buying day in this area of the ränge.By monitoring extremes, ränge extension and the TPOcount for any developing market, you can gain a sense ofwhat long-term traders are doing. As long äs the activityof the beyond-the-day traders is unbalanced, the price levelwill tend to maintain itself or move directionally. For instance, five consecutive days of activity with ten buys andthree sells will mean that the market should hold its price,if not move higher. Conversely, if there were three buysand ten sells, we would expect to see prices either remainthe same or fall.As you can see, then, combining your understanding ofthe day and beyond-the-day disciplines, the lever that causesmarket activity to increase or decrease is the raising orlowering of prices. A large day time frame influence pushing prices down creates a good opportunity for the longterm trader to enter the market. By the same token, toolarge an imbalance of buying that ends a long-term marketspree usually creates a good opportunity for the day tradersince it will probably cause an excess in the marketplaceonce it moves away.•82-
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Price cannot simultaneously serve two masters. This isthe basic principle that creates opportunity for you äs atrader.
EXCESSES
INITIATINC VS. RESPONSIVE ACTIVITYUnderstanding and distinguishing between these two typesof activity are difficult for many traders. In this section,we'll give some tips that should help you deal with themconceptually and practically.First, let's consider initiating and responsive activity ästhey relate to the previous day. Use the previous day'svalue area äs a reference point. This is defined äs the firstStandard deviation of volume, äs calculated by the ChicagoBoard of Trade in its Liquidity Data Bank volume release.Next, reference the market activity of extremes, rängeextensions and time/price opportunities (TPOs) äs theyevolve in the newly developing day. The key is to trackmarket activity above or below value. When today's activity is buying below the previous day's value area, this isresponsive activity. So is selling above the value area.By contrast, buying above the previous day's value areais initiating activity; so is selling below the value area (seeFigure 6-9). Market activity directly opposite the previousday's value area is not given a name in this definition.The concepts of initiating and responsive activity canalso be related to developments within the day. Simplyrefer to the first, second and third Standard deviations ofvolume for the developing day. The market is describedäs initiating when it is in the second or third Standarddeviation of volume; it is responsive in the first. This isillustrated in a later chapter.•90*
Excesses can occur in many fashions; they are a useful toolin reading the market, both short-term and long-term. Goodfloor traders learn to recognize excesses instinctively; theyare usually characterized by fast, unanswered price movements in the market. Excesses become areas that constitute barriers to further price movement, and therefore makeexcellent reference points for the trader.Figure 6-10, which shows the daily bar chart for December 1988 live cattle futures, includes two excellent examples of excesses. As it happens, I was teaching tradingclasses that included analysis of live, on-line market activity during each of these excesses.The first (point 1) took place at the end of May. Themarket opened about 20 points higher and immediatelydove. It was clear that this represented an excess that wouldbe a barrier to further trade on the high end for some time.The second (point 2) occurred late in September. Themarket opened, broke sharply, then rallied within threeor four minutes. This established an excess on the downside. In/both cases, it was the rapidity of price movementthat signaled the excess.Figure 6-11 is another example of a classic bar chartexcess. On the day indicated by the arrow, the marketopened, went lower and then closed around the middle ofthe ränge. This established a barrier to be traded againstfor the immediate future.
MARKET PROFILE AND SPREADSThe same kind of Market Profile, with similar referencepoints, is available for the various spread relationships that•91 •
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exist between different commodities. (As you know, a spreadis a combined long and short position on two closely relatedcontracts. A trader can profit from a spread depending ona change in the difference between the two prices.) If youare an experienced trader who likes to use spreads in yourtrading strategy, you'11 find that you can use Market Profileto find profit opportunities in spreads äs well äs in anyindividual commodity or other contract.Figures 6-12 and 6-13 are Market Profiles for two different spread relationships. Figure 6-12 depicts five daysof the spread between the cash S&P 500 and the S&Pfutures contract. There was relatively little movement during this period. Figure 6-13 illustrates a much more volatile spread, that between platinum and gold. Note thatthe profile for this spread on October 28 was a nearly perfect normal curve, while the other days were unbalancedin one direction or another. As you'll learn in a later chapter, these unbalanced profiles are examples of a specialtype of distribution which I call the Steidlmayer Distribution — an important new concept in trading, and one thatis increasingly relevant in today's volatile and fast-movingmarke ts.Market Profiles can also be created and used for tradingindividual Stocks, commodity options — anything traded onan organized exchange. Since the profile reflects the underlying nature of markets, which does not fundamentallydiffer from one market to another, the same basic methodscan be applied no matter what contract, commodity orproduct is being bought and sold.
Liquidity Data Bank (LDB) is a volume report put out bythe Chicago Board of Trade after the market closes. Itsrelevance lies in helping you determine whether a continuation or change in market activity is likely. The underlying assumption is that market behavior—mass humanbehavior—within the structure of the auction market is lesslikely to change on high volume than on low.To illustrate this assumption, let's look at the volumeprofile shown in Figure 7-1. Notice the imbalance in volume between the upper and lower portions of the profile:There fs relatively more volume at the higher price rängethan tne lower. Since large volume activity does not —cannot — change very quickly, the lower prices occurringeafly in the next days profile represent a price oppositehuman behavior.
READING THE LDB REPORT
The best way to explain LDB is to examine the sampleLDB printout shown in Figure 7-2 and explain its features,point by point.•92
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MARKET PROFILE (R) COPYRIGHT 1984 CBOT.COPYRIGHT 1987 CÜC 'MC.
Figure 7-1.
Market Profile and volume profile for November 1988 Major Market
Index futures. Note the imbalance between the volume of trade at the upper and lowerends of the price ränge. The next day the market would stay the same or continue basedon use of market by participants.
The first column of the printout shows a ränge of pricesin ascending order. The second column shows the actualvolume of trade at that price for the Session. (To be moreprecise, it actually reflects just about 75 percent of thevolume for the day; this is because the data are derivedfrom the second run from the CBOT clearinghouse, dueto time constraints. However, this is a very accurate sample of the entire day's trading.)94
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The third column shows the percentage of trade occurring at each price äs related to the entire day. The fourthcolumn contains what we call CTI codes, which reflect thecommodity trader Identification breakdown. These codeshave the following meanings:CTI-1: Local trader s.CTI-2: Commercial traders trading for their own houseaccounts.CTI3: Members trading off the floor, or having othermembers fill and order for them.CTI-4: The general public.The CTI-2 category designates the commercial traderwho is Clearing trades at the CBOT or who is a memberof the exchange. It is possible for a person in this categoryto move a trade into CTI-4 if he wants to hide it. CTI-4also includes many commercial firms that are not membersof the exchange and are mainly making hedging trades.These trades, which don't show up in LDB äs commercialtrades, really belong in that category. Nevertheless, theCTI-2 category has proven to be a reliable indicator ofcommercial activity.The last column is the volume profile that visually summarizes all of this data.The bottom horizontal line of the report in the left-handcorner shows a calculation of the first Standard deviationof volume, provided by the CBOT. This represents thevolume value area for the day. As you proceed toward theright, the various percentages in this area of the printoutreflect, first, the overall volume value area (70 percent plusbreakage) and then the percentage for each of the fourtrading groups. The last line of the report gives the totalvolume for the day for the contract in all contract months.
Figure 7-3 shows the volume profile for the same dayin the market seen in Figure 7-2, together with the following day for comparison purposes.
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STEPS IN INTERPRETINC THE LDB REPORT
As we've said, the primary purpose of the LDB report isto help you determine the likelihood of continuation orchange in the market. Here are the steps to follow in making this determination.
1. Try to determine in what direction the market wastrying to go during the Session. Was it trying to go higher,lower, a mixture of both —or is it impossible to teil?Don't be embarrassed to put a question mark here —sometimes it's difficult to determine.2. Having made this determination to the best of yourability, check whether volume was higher or lower thanthe previous day. More volume, coupled with a cleardirection for the market, means continuation; lower volume means change.3. /N ext, look at the extremes of the column showingvo ume percentages. Depending on the size of the day'sränge, count off three or four ticks from the top andthree or four ticks from the bottom. Find the total percentage of trade in these two areas. The comparisonbetween the two numbers may be significant. For example, if we had 9 percent of the day's trade in the topfour prices, and just 4 percent in the bottom four prices —and the market was higher on the day —this would indicate continuation on the up side. Conversely, if we
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had 4 percent on the top and 9 percent on the bottom —and an up market — this would be a contraindication forcontinuation on the up side.4. Compare the ränge of the volume value area for theday to that of the previous day. Is it larger or smaller?If it is larger and the market is up, it is a positive signfor continuation; if it is smaller, it is a negative sign forcontinuation.5. Compare the volume value area to the TPO valuearea, which is the part of the price ränge containing twoor more time/price opportunities. Note the spatial relationship of the two, with the volume value area havinggreater significance. For instance, if the volume valuearea is toward the bottom of the TPO value area, andthe market is higher, that is a negative for continuation.Conversely, if the volume value area is toward the topof the TPO value area —or even extends a tick or twobeyond it —that would be a plus for continuation. Thisprocedure is something like finding the "specific gravity"of the market; it suggests the direction in which themarket appears to be weighted.6. Find the volume in the top half of the ränge andcoimpare it to the volume in the bottom half of the ränge.ConSpare this ratio to the trend for the day —higher orlower—and the result will be either positive or negativefor continuation.
The Wxt step in analyzing the LDB report is to moveon to the commercial activity section. Again, we'll operateon certain basic assumptions. The commercial trader doestwo types of trading: he trades for the day and for beyondthe day. And the commercial trader is the closest thing toa purely responsive trader.98«
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For example, the commercial trader may be in somebusiness which requires him to consume a certain amountof grain every day. As a result, he must do some businessfor today. At the same time, he is doing forward business;for instance, he may have made a deal with some foreignbuyer for six months down the line. Both the day needand the beyond-the-day need must be covered in the marke tplace.Our assumption or definition is that the commerciarseveryday trades usually take place within the volume valuearea, while his new, long-term business falls outside it.This is because, in general, his customers are people whoare shopping for good prices. He may buy one millionbushels of corn in the value area to cover his daily needs;but if the market breaks three or four cents a bushel, thecustomer may decide that this is a good price and buy itfrom the commercial trader, who, in turn, must buy thecorresponding amount of grain in the market. So the commerciars activity is mostly responsive.This doesn't mean that the commercial never makes initiating trades; he does. It would be unusual activity, whichshould be noted when it does occur.It is important to note, then, the amount of commercialvolume that takes place within the volume value area. Didthe commercial trader do more business here today thanyesterday? There is a Standard figure in every market. Inbonds, for example, the Standard is about 13 percent inthis area, meaning that the commercials, on average, doabout 13 percent of the bond trading that falls in the volume value area. Compare this with today's figure; if today'sfigure is higher than the Standard, it is a positive sign forcontinuation.Then, determine the commerciars outside activity — is itnormal or abnormal? To decide, make the following cal-
culation. Take the ränge of prices above and below thevolume value area. Add the total percentages of commercial trading at these prices and divide by the number ofprices. This gives you an average percentage, which iseither higher or lower than the percentage of activity withinthe volume value area. If lower, disregard it. If higher,assume that the commercials were trading responsively. Ifyou note a large amount of buying activity in your profile,assume that the commercials were buying.These, then, are the basic disciplines for analyzing LDB.Using them, you'll find that, about 70 percent of the timeyou can determine accurately whether the market will behigher, lower or unchanged the next day. This can helpyou to be patient, or conversely, can reinforce the needto make an immediate trade promptly, depending on otherfactors.In trying to determine whether to anticipate higher, loweror unchanged values, don't just add up the pluses andminuses. Instead, learn to select and focus on the mostimportant factor. This will vary from time to time. Generally, the most important thing to determine is the tradefacilitatjon direction. The second most important is whethervolum^ is higher or lower; the third most important is theränge [ of the volume value area; and the fourth most important is the spatial relationship between the volume valuearea and the TPO area.Finally, if commercial activity is abnormal — either buying high or selling low —this may be the most importantfactor in the market. However, if you find the commercialaspect of the analysis confusing, drop it for now. It can bequite helpful, but you may need to work your way into itgradually.Let's refer back to the T-Bonds example (Figure 7-4)and go through the exercise in detail. This will familiarize
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you a little better with the steps in interpreting the LDBreport.1. Trade facilitation direction — the market tried to gohigher early (periods A through D), then went lowerlater (periods E through L) on apparently greater volume. On balance, it appears that the market was tryingto go lower.2. Total volume was greater than for the previous day.This would be an indication for continuation.3. Volume on the extremes — counting off three ticks atthe top and three ticks at the bottom, we find that volume in the top three prices was 5.1 percent of the day'svolume, äs opposed to 5.8 percent at the bottom. Thisisn't a great enough difference to be a meaningful indicator.4. The volume value area ränge ran from 9031 to 9107,and it was smaller than the previous day. This would bean indicator of change.5. Tjte TPO value area ranges from 9029 to 9114. Whenwe/compare this to the volume value area, we find thatit AS on the low side, which is an indicator of continuation.6 The volume in the bottom half of the ränge is greaterman in the top half of the ränge — another indicator ofcontinuation.
NoW we'll analyze the commercial activity for the day.First, note that the total volume in the volume value areais greater than normal —14.4 percent äs opposed to thenormal 13 percent. This indicates that prices are stimulating trade by the commercials, which is responsive trading.Next, look at the amount of commercial trading aboveand below the volume value area. On prices below 9031,commercial trading volume ran at an average of 15.5 per•103-
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cent. On prices above 9107, commercial volume ran at anaverage of 17 percent. The conclusion would be that commercials sold early in the day, stopping the first attemptto rally. They then probably bought on the break, sincethe market bounced late. Thus, commercial activity is normal. Overall, we would look for unchanged to lower activity based on higher volume and the normal nature of thecommercials' trading.The key in this analysis is not to be absolute in yourconclusions but rather to try to get a feel for what is goingon. In this case, indicators 2, 5, 6, and the commercialanalysis teil us to look for continuation, while indicator 3is non-committal and indicator 4 looks for change. Consequently, we would expect the market to be lower orunchanged in ränge on the following day. This would beour expectation in our first approach to the market, untilwe noted some change or detected some error in our analysis.This is not an especially clear cut example. Most marketsare like this. When a market is unusually clear, you'11 notice the difference.
Its main value lies in its ability to help you determine thedirection the market is trying to move in if the day is tobe a two-part day —that is, one with two distributions.Suppose that during the first part of the day the marketwas trying to go higher, and 75,000 contracts were traded.During the balance of the day, the market was trying tomove down, and 200,