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announcing the inevitable rally. But if such a rally were really imminent, thepoint of control should have been rising, not falling. Volume, as revealedthrough the Market Profile, was indicating a consensus that said somethingaltogether different than what the “experts” were predicting.
DEMYSTIFYING MARKET BEHAVIORThe Market Profile is a powerful tool for capturing the structure of the market as it is being built. While Figure 2.1 resembles a normal bell curve, Figure 2.4 reveals a volume that skews toward the bottom of the profile. Pricealone cannot distinguish between a market in which movements away fromvalue will be retraced, versus a market that is transitioning from bracketingto trending or from trending to bracketing. Sophisticated traders—definedas those that survive and prosper over the long haul—quickly adapt to different strategies depending on the bracket/trend bifurcation. Investors thatincorporate market-generated information effectively increase the oddsthat they can determine whether the current market action is occurringwithin the context of an intermediate or longer-term bracket, or as partof a trend. The strategies for each of these two types of markets are quitedifferent, which we will discuss at length in later chapters.In order to identify change early enough to act, you must be creative,flexible, and innovative when you process information. You have to be ableto interpret the fundamentals of market activity in a way that keeps yourhead clear of the deluge of conflicting information. Any individual or organization that hopes to be consistently successful must continue to learnand develop fresh approaches to investing, always questioning the statusquo, reviewing standard practices, and extending their knowledge base.The Market Profile, which is entirely process driven, provides an objective, visual structure to market activity that reflects the embodiment of theactions of all timeframes and market participants. Once you have learnedto read and interpret this profile, it becomes possible to demystify marketbehavior. You can gain a significant advantage over the competition by better understanding and capitalizing on the market’s reaction to fundamentalinformation—before the market reacts and opportunity is lost.
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Timeframes
Knowledge is little; to know the right context ismuch; to know the right spot is everything.—Hugo von-Hofmannsthal
hange influences market participants of every type, from the daytrader to the long-term portfolio manager. Chapter 2 established thatwe are all affected in varying degrees by the evidence—or lack ofevidence—that is revealed as time passes and our decisions are cast innew light. The next step in developing a more holistic market understanding is to explore the significance of market participants’ timeframes and thedistribution of volume among those timeframes. You are better equippedto assess market risks and opportunities when you understand the waysin which various timeframes coexist and intersect and how this interaction results in volume distribution that reveals the motivation of each timeframe within the evolving market landscape.To illustrate the importance of volume distribution, we’ll look at theautomotive and housing industries. General Motors is a “long-timeframeproducer” of automobiles, and we, the general public, are “long-timeframepurchasers.” (When we use the term long-timeframe, we are referring tothose market participants whose actions are the result of a long-term commitment.) Of course, we generally don’t buy cars directly from GM—rather,we go to our local independent dealer, who operates in the “intermediatetimeframe” (those market participants whose motives and commitmentsare shorter term in nature). Let’s examine the role volume plays when thesevarious timeframes interact, as the resulting analysis applies equally wellto all markets that are financial in nature.
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GM sells a car to the dealer, and the dealer sells the car to an individual. In this perfect scenario, all participants are satisfied. In the real world,however, transactions are never so simple. Let’s expand the scope, andsay GM sells 50 cars to the dealer, but only 34 of them are purchased byconsumers. The dealer’s inventory begins to build, and he is forced to offermore aggressive discounts in order to attract sales and balance inventories.When the dealer sees his lot overflowing, he reduces the orders that heplaces with General Motors. If dealers all over the country are experiencingthe same slowdown in sales, GM will also experience inventory build-up.In order to keep sales and production lines moving, GM will begin to offerincentives to both the dealer and the individual purchaser.It is worth noting that over the years a substantial number of wellknown researchers and economists have failed to recognize the importance of volume distribution among timeframes—as well as the relevanceof the very existence of different timeframes. For example, a respectedeconomist recently suggested that it is obvious that there is “a buyer forevery seller and a seller for every buyer.” While it may be obvious that every sale comes with a corresponding purchase, what many fail to grasp isthe relevance of which timeframes are behind the buying and selling. Thispowerful piece of knowledge unlocks key information about the potentialfor future directional movement.In our automotive industry example, it is true that overall volume remained constant—for every seller there was, in fact, a buyer. However, thetimeframe that was holding that volume had everything to do with pricemovement. Because the dealers and GM were holding the majority of inventory (volume), price had to move lower to attract long-term buyers.A review of the housing industry over the past five years also servesto highlight the importance of timeframes and volume distribution. As interest rates fell, driving mortgage rates to historic lows, more families(long-timeframe buyers) began to purchase single-family residences. Asthe real estate market began to heat up, builders like Toll Brothers Inc.(long-timeframe sellers) built both on contract and speculation, confidentthey could sell into the hot housing market. Talk in the media, among brokers, and in coffee shops consistently described the real estate market asa “seller’s market.” The combination of a poorly performing equity market,attractive mortgage rates, and rising home prices caused investors to beginto view real estate as an attractive investment alternative. By 2005, following several years of consistently rising home prices, nearly 25 percent of allindividuals (intermediate-term timeframes) held second homes.Let’s look a little closer at the different timeframe participants inthe housing market and how their actions drove the auction process.Initially, there was a reasonably close balance between the long timeframe buyer and seller. As the market continued to heat up, however, an
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imbalance developed between them; builders (sellers) couldn’t meet demand and so price began to auction higher seeking a new balance. Withprices rising (advertising opportunity), more and more local builders entered the market place, building homes both on contract and for speculation. Among the last to enter the foray were the inexperienced individual investors, just as they did at the height of the tech bubble just fiveyears prior. Individuals with no real estate experience whatsoever werebuying second, third, and fourth homes with “no money down,” hopingto flip them three to six months later at a huge profit. Essentially, a newbreed of short-term real estate “traders” was born. But finally, as in allauctions, the imbalance of demand shifted and the housing market became over supplied, which lead to inventory being held by the shortest oftimeframes.The real estate example is similar to the GM example, even thoughthe industries are completely different. Our position has always been thatall markets that are financial in nature—whether they are comprised ofstocks, bonds, commodities, futures, currencies, real estate, automobiles,or any other goods and services—operate in a similar fashion: they all involve an auction process of some form that facilitates the involvement ofparticipants operating under different timeframes.The market’s auction process serves to fairly distribute bids and offers.In Chapter 4, we explore in greater depth how the market’s auction processalso serves as an important information-discovery mechanism, traveling(via price) up and down to uncover and accommodate the needs of bothsupply and demand. By observing this auction process unfold via the Market Profile tool, we can begin to assess the attitudes and interactions ofthe different timeframes. Just as in the GM and real estate examples, imbalances in the securities markets occur among different timeframes andthe markets adjust to accommodate. However, unlike the automobile andhousing markets with their slow-moving inventories, the securities markets enable extremely fast build-up and liquidation of inventories, whichmakes it extraordinarily difficult to continually assess market conditions.It is precisely for this reason that market-generated information and theMarket Profile are so valuable.
BREAKING DOWN MARKET TIMEFRAMESThe concepts in this book are built on an understanding of the way thevarious timeframes coexist, intersect, and interact. To establish a foundation for this understanding, we must first define the different market timeframes, as well as the general motivations of each.
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ScalperThe scalper lives by the minute hand, continually buying and selling in order to take advantage of fleeting discrepancies in order flow. Scalpers maymake as many as several hundred trades a day, comprising thousands ofcontracts. The classic image of a scalper portrays an individual who shouts,shoves, and survives on the exchange floors. But advances in technologyand mobile communication now enable the scalper to conduct his or herbusiness from virtually anywhere.Scalpers rely on intuition. They buy from and sell to all timeframes,and their ability to respond to the immediate needs of the marketplaceprovides essential liquidity. As you may have guessed, this, the shortestof timeframes, tends to be utterly detached from longer-term economicthinking; fundamental information is far too slow and cumbersome. Thescalper’s world is that of bids and asks and order-flow depth. I rememberwhen a friend and comember of the CBOT called to tell me that one ofthe most successful local traders wanted to come up to my office for achat. Just before we hung up, my friend said, “Don’t mess this guy up withtheory—he knows nothing about the inverse relationship between bondprices and yield. He’s just a master of reading order flow.”
Day TraderThe day trader enters the market with no position and goes home the sameway. Day traders process news announcements, reflect on technical analysis, and read order flow in order to make trading decisions. They also haveto deal with long- and short-term program buying and selling, brokeragefirm margin calls, mortgage banker’s duration adjustments, speeches byFederal Reserve governors, and “important pronouncements” by politicalleaders and influential portfolio managers. Anyone who believes marketsare rational should spend a day trying to digest and react to the landslideof conflicting data day traders must wade through to make a decision.This group focuses on large quantities of technical information; theylove numbers and levels and hype. Like scalpers, day traders also provideliquidity for markets, although very often at great personal expense.
Short-Term TradersShort-term traders often hold trades longer than a day, but usually notlonger than three to five days. There is no scientific evidence to supportthis view, but I observed this timeframe’s behavior when I ran a discountbrokerage firm in Chicago in the late 1980s. Short-term traders, such asday traders, have to contend with a huge quantity of data. But they tend
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to pay more attention to technical and economic fundamentals. Short-termtraders generally focus on multiple days of overlapping prices, attemptingto buy the lows and sell the highs while watching for breakouts. They usemarket-momentum indicators and monitor trend lines and trading channels to time their buys and sells. They are not out to influence market behavior but to be flexible and adaptable enough to react to and capitalize onevents that trigger short-term market movements.
Intermediate Traders/InvestorsThe difference between intermediate traders/investors and short-termtraders is simply that they operate from a longer point of view. Participants of this timeframe are often referred to as “swing traders” becausethey look to trade the tops and bottoms of intermediate-term ranges suchas the one illustrated in Figure 3.1, which illustrates the S&P market fromNovember 11, 2005, through February 16, 2006. Intermediate traders bankon the fact that markets, like pendulums, travel only so far in one directionbefore changing course.
O= 129120H= 129140L= 120020L= 120000∆= −250
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.- 5 16 Feb Location of third
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swing trade as we are workingon "Markets in Profile"
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MayApr13 20 27 03 10 17 24 01 06 16 22
Jun01
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FIGURE 3.1 Intermediate-term trading ranges: S&P 500 daily bar chart, November 11, 2005, through February 16, 2006.Source: Copyright ľ 2006 CQG, Inc. All rights reserved worldwide. www.cqg.com.
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Within the range defined in Figure 3.1, consolidation areas developedthat provided shorter-term traders with fertile fishing grounds. The pointhere is that the intermediate timeframe relies on distance traveled, nottime, to influence trade decisions. Within consolidation areas, volatility canbecome quite extreme because combinations of these shorter timeframeinvestors and traders are often active at the same time—and in oppositedirections.The intermediate timeframe uses both fundamental and technical analysis, and normally has no desire to break new ground, choosing insteadto operate within historic trading ranges. However, they do pay close attention to momentum and will quickly jump on board a trend when thelongest timeframe begins to move prices beyond the containment levelsof the intermediate-term market. When this activity occurs, multiple timeframes are acting in concert and longer-term trends often develop.The weekly bar chart of the S&P 500 in Figure 3.2 shows severalintermediate-term trading ranges. Notice that the market tends to spendmuch more time in overlapping ranges (brackets) than it does trending.This is typical. Notice also that there are several smaller trading rangeswithin the intermediate-term brackets, and that these brackets (at least
0= 129120H= 129140L= 120020C= 120000−250∆=
131500131000130500130000129500129000128890128500128000127500126990126500126000125500125000124500124000123500123000122500122000121500121000120500
17 Feb 060= 129120H= 129140L= 120020C= 120000501 03 15 22
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2006Dec01 12 19 27 03 09 17 23
Feb01
13 21
Mar01
AprMay13 20 27 03 10 17 24 01 03 15 22
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FIGURE 3.2 Shorter-term trading ranges contained within intermediate-termbrackets: S&P 500 weekly bar chart, April 2002 through February 2006.Source: Copyright ľ 2006 CQG, Inc. All rights reserved worldwide. www.cqg.com.
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OHLLA-
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Jun0112 19 26
FIGURE 3.3 Day-timeframe auction, shorter-term timeframe and a swing trade:Daily bar chart, 30-year U.S. treasury bonds.
in this case) held for eight months to a year. The shorter-term tradingranges within well-defined, intermediate-term brackets are the focus of theshorter-term traders we discussed earlier. In the last several chapters ofthis book, we offer tactical trading guidance for day traders, short-termtraders, intermediate-term traders, and longer-term investors.Figure 3.3 shows: (1) a day-timeframe auction; (2) a nine-day, shorterterm auction; and (3) and (4) the start and end of a swing trade occurringin the U.S. Treasury bond market. With the exception of the day timeframe,it is important to understand that the remaining classifications are definedin general terms and vary depending on both market activity and how eachindividual trader/investor visualizes the market. For example, while someinvestors see long-term trades in terms of years, others in the money management industry consider “long term” to be a much shorter duration.
Long-Term InvestorsLong-term investors are far more attached to the securities they own. Theyhave a stronger tendency to buy securities and put them away for some
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0= 129120H= 129140L= 120620C= 120000−250∆=
100000128890127500126950125000122500120000117500115000112500111000107500105000
All timeframes are acting in concertThose timeframes that haven't figuredthis out don't survive.
10250010000097500
Trend
950009250090000875008500082500
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FIGURE 3.4 All timeframes active to produce a strong upward trend: S&P 500weekly bar chart, January 2002 through February 2006.Source: Copyright ľ 2006 CQG, Inc. All rights reserved worldwide. www.cqg.com.
time, with holding periods from months up to several years. When they areactive, they tend to deal in large positions that are very visible to the market. Intuitive shorter timeframe participants understand that when the longtimeframe enters the market, their purchases are likely to be large and possibly ongoing. With the size of money management firms these days, individual trades—even partial trades—can result in huge orders. In fact, someshorter-timeframe traders research what the long-term investors alreadyhold, so that when they sense them selling they can take advantage of theresulting price movement. When the longest timeframe becomes active, itis not uncommon for all other timeframes to join in a large movement thatcan result in a major trend. Figure 3.4 shows just such a movement occurring in the S&P 500 during the latter half of 2003. Those traders who fail tograsp transitions of that magnitude will not survive.When we take an even longer-term perspective, we can more clearlysee how the various timeframes coexist, act in concert, and merge overtime. Figure 3.5 shows:1. All timeframes are acting in unison, resulting in a longer-term upward
trend.
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0= 129120H= 129140L= 120620C= 120000−240∆=
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117500115000112500111000
4. Long-term remains upSwing and intermediate-termare sometimes trading counterto long-term and sometimesto each other as well.3
107500105000102500
Trading range low
1000009750095000925009000087500850008250013 Feb 060=129710H=129250120000L=128890C=∆= 122172.191
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FIGURE 3.5 Coexistence of multiple timeframes: S&P 500 weekly bar chart, January 2002 through February 2006.Source: Copyright ľ 2006 CQG, Inc. All rights reserved worldwide. www.cqg.com.
2. The longer-term trend tops out (temporarily) when the market begins
a series of intermediate timeframe auctions as it balances and seeksequilibrium. Here, longer timeframe buyers provide support to the market, while the day, shorter-term, and intermediate timeframes facilitatethe auction process from both sides of the market. As a result of thisauction process, long-term value is established at higher price levels.3. After the period of balance, the longer-timeframe buyer auctions priceabove the balance area and the longer-term trend continues.Long-term investors, as we’re defining them here, are responsible forbreaking new ground, starting trends, upsetting the status quo. While thisinvestor timeframe doesn’t necessarily account for a large portion of market volume, it is generally responsible for large directional moves in themarket. Why? Because the shorter timeframes primarily exist to facilitateliquidity, while the long-term investor is placing substantial orders in onedirection. In other words, long-term money is much “stickier.”Long-term investors tend to look at the fundamentals of a company,the quality of their earnings, cash flow to book value, P/E multiples, talent,
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new ideas, pricing power, industry strength, and so on. They might not evenconsider the technical information that drives many shorter timeframe decisions.What is important about the preceding discussion is the idea that market activity is influenced by a wide variety of participants operating undera wide variety of timeframes and motivations. The way each of these participants combines and employs information is different:Ĺ Scalpers are aware of key market reference points, but rely primarilyon intuition and order flow.Ĺ Day traders depend almost exclusively on market-generated information, because fundamental information is usually too cumbersome andcan actually be counterintuitive for the process of day trading.Ĺ Short-term traders supplement market-generated information with anawareness of recent fundamental information and the effects it canhave on market movement.Ĺ Intermediate-term traders rely on a balanced mix of fundamental andmarket-generated information.Ĺ Long-term investors tend to follow fundamental information first, followed by market valuation, finally looking to market-generated information to supplement their understanding of market activity and individual securities. They also keep an eye out for trims and adds, andinflow and outflow of funds requirement.It’s not easy to comprehend the nature and interaction of the differenttimeframes. And it’s extremely challenging to detect their everchanging influence to implement a successful trading strategy. That’s why it’s essential that you understand the fundamental nature of each timeframe beforewe build on that knowledge with new concepts—concepts that may initially appear contradictory. We structured Mind over Markets around thefive steps of learning (the path from novice to expert), and it is worth noting here that in order to take your market insight to the next level, you’llhave to unlearn some of the rules that got you where you were before. Butonce you have jettisoned concepts that may be limiting the breadth of yourknowledge, you’ll be better able to comprehend and integrate the myriadrelevant pieces necessary to understanding the broader paradigm of market activity.In real-time trading and investing, the timeframes are far more difficult to distinguish than the neat descriptions above might suggest. Whilewe have identified them separately, all timeframes coexist, intersect, andinteract with one another in a constantly shifting tapestry. It is the study ofthis coexistence, intersection, and interaction that will comprise your real
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learning. And, in one way or another, it is largely the topic of the balanceof this book.As you continue to observe market activity, you will begin to recognizecombinations of timeframe patterns over time. Trading requires a greatdeal of mental flexibility, because once you have learned to recognize a certain pattern, it may soon be supplanted by another, more-relevant pattern,which itself will eventually perish. The point being that traders who integrate discipline, emotional control, and an agile market understanding aregenerally able to let go of prior patterns and habits that are no longer working. To be successful, investors must recognize the confluence of evolvingfactors that will eventually lead to a changing market atmosphere.
YOUR TIMEFRAME IS YOUR STRATEGYCORNERSTONEIf you can correctly identify which timeframe is in control of market activity, and you have a good understanding of how the individual timeframesgenerally behave, then you are in a stronger position to trade, invest, andeffectively control risk.Throughout the course of this book, you will not only learn how toidentify which timeframes are active and in control at any given moment,but you will also begin to learn to identify your own timeframe; that is, thetimeframe that suits your investment personality best. This is vital, for ifyou don’t have an accurate idea of your timeframe and how it behaves inthe context of all other timeframes, you are setting yourself up to be confused and misled by conflicting information. For example, it’s easy to beright in the short term but wrong in the long term—a position which can beextraordinarily costly. Once you have clearly defined your timeframe—andhow it coexists, intersects, and interacts with the others—you will be moreconfident and better disciplined, and therefore less likely to break strategywhen the market acts contrary to your expectations. You’ll also be morecognizant of the larger context, which will enable you to improve yourtrade location—and good trade location is the key to managing risk, in every timeframe.
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