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Discovery consists of seeing what everybody hasseen and thinking what nobody has thought.—Albert von Szent-Gyorgyi
I
n this chapter, we’ll discuss how the factors that influence marketactivity—information and the different timeframes that process andreact to that information—can be observed in a context that promotestransparency. We use the term “transparency” here because it means“readily understandable” while also relating to the clarity of your decisionmaking process. Even when something is utterly clear, if we lose sight ofthe larger context, we are liable to make significant errors in judgment.The Market Profile assembles the building blocks of market activity(time, price, and volume) by organizing the auction process into a coherentvisual framework. A market profile is an entirely objective organizationaltool that incorporates all information in a context that is free of bias, freefrom the conflicting indicators generated by an overwhelming number offacts, each influenced and surrounded by a diverse set of circumstances.In short, a market profile provides “transparent” information. That is, information that is available to all market participants on an unrestrictedbasis; information that is easily understood and available in a single coherent mechanism; and information that manifests ongoing market activity inthe form of recognizable shapes and patterns.Let’s now assemble the specific elements of market-generated information so that our decision-making process becomes transparent—and youcan start to develop an understanding of what key structural patterns mayindicate with respect to future market activity.41
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Historically, price has been the main piece of information that has promoted transparency. The Center for Research in Security Prices (CRSP) atthe University of Chicago provides years of price data for indexes, stocks,bonds, and mutual funds. Unfortunately, price without context is just anumber—for all intents and purposes a random event. A sequence of pricescan be entirely misleading as it leaves vital questions unanswered: Did aparticular price occur on higher or lower volume? Was a price sequencethe result of new business or old business (short covering and long liquidation are considered old business, as they don’t contribute to net new longor short positions)? Which timeframe was primarily responsible for thatprice? Which direction was the market attempting to travel at the time theprice occurred? As you will see, a market profile provides answers to theseall-important questions by giving dimension to price—dimension that isnecessary to achieve complete transparency.In Chapter 2, we identified the three fundamental elements that comprise the market’s auctions—time, price, and volume. We stated that priceis simply the auction’s means of advertising opportunity, with time regulating each opportunity, and volume measuring the success or failure of eachauction.These three auction elements can also be viewed as follows:Ĺ Price is a volatile variable and the fastest moving market element.Ĺ Time is the constant around which all auction data is organized.Ĺ Volume is also a variable, but it changes much more gradually thanprice (and volume represents the interaction of time and price).
THE SEARCH FOR VALUETo better understand how price, time, and volume create market-generatedinformation, imagine that you’re attending an art auction. Before the firstitem is introduced, you sit in the audience and ponder a question that hasbeen nagging you, recently: How does auction movement reveal the motivations of the market’s participants?The lights dim, a spotlight reveals a lovely oil painting center stage,and the auctioneer begins his rhythmic pitter-patter banter. The excitementin the room is palpable. “We start the bidding for this remarkable landscapeat nine hundred,” he says, “nine hundred . . . nine hundred? Do I have ninehundred for this beautiful work?”You stare at the painting and think it might make a nice addition toyour living room. No one has yet bid, and so the auctioneer lowers theprice, looking for that first paddle to rise: “Now eight fifty . . . eight fifty? Do
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I have eight fifty for this unique oil painting—I have eight fifty. Do I havenine? . . . .”Because no one responded to the initial price, the auctioneer quicklylowered the bid until he found a level at which participants began to respond. Now that the ice is broken and the auction is underway, the bidquickly exceeds the initial, unaccepted $900 bid: “I’m bid nine hundred. . .now nine and a quarter nine and a quarter. I’m bid nine and a quarter . . .now nine fifty, nine fifty, I’m bid nine seventy-five.”The bid races to a thousand dollars, and you feel your adrenaline surge,as you really like the painting. You lift your paddle and the auctioneer nodsand his patter speeds on, the price ratcheting rapidly higher as he createsexcitement with the intensity of his voice. Once bidding gets underway,it’s quite common to have bidding begin to build. Just like in the financialmarkets, very few individuals want to accept the risk of being first andbeing wrong, which might be seen as foolish by peers.The price of the painting climbs past $1,500, and you decide the greenof the fields might actually clash with your living-room rug. The auctioneer’s rapid-fire delivery continues unabated, sustaining the excitement inthe room. But being a careful listener, you note that he is beginning to addquite a lot of “filler” to his patter to make it appear that the auction is stillproceeding higher. This process continues until the last bidder bids, andthe rant is capped with a hearty: “SOLD at eighteen seventy-five!” You’reglad you didn’t get caught up in the hype, and you turn your attention tothe next piece being unveiled on stage.In the preceding example, there was only one item to be auctioned.If this were the everflowing process of a financial market, however, theauction would have begun again in the opposite direction once the upwardauction had discovered the last bidder. From the price at which the auctionfinally got under way—$850—there was only a brief price/time relationship because price moved quickly. As price began to climb steadily higher,“value” was established as multiple bidders actively engaged in the auctionat prices they believed to be fair. At the level where the price advance began to slow, and the auctioneer began to pad his banter in order to makeit seem as if the auction were still healthy, an extended price/time relationship developed; bidders in the top quadrant of the price range were mostprobably engaged in an overreaction to the momentum of the auction, finally purchasing above the value area.The value area, as we explained in Chapter 2, represents the rangein which approximately 70 percent of the volume of activity took place(one standard deviation of the resulting bell curve’s distribution). In the artauction, there was a lone bidder at the bottom and a lone buyer at the top,and of course the highest number of bidders in the middle; volume was highin this range because the auction process revealed an area of “fair value”
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HHHHHIGHIGHIBGHIBCGIBCGIBCDGIBCDGIKPBCDGIKLPBCDEGIJKLNPBCDEFGIJKLNPBCDEFGIJKLMNPBCDEFJKLMNPBCDEFJKLMNPBCDEFJKLMNBCDEFJKLMNBCDEFJLMNBDEJLMNBDELMDDD
OVERREACTION
EXTENDED PRICE/TIMERELATIONSHIP=VOLUME
UNDERREACTIONFIGURE 4.1 The value area and its relationship between price, time and volume.Source: Copyright ľ 2006 CQG, Inc. All rights reserved worldwide. www.cqg.com.
for the painting on the block. In a financial market, the value area at the endof the day represents the range within which most market participants thathad day-timeframe business to conduct were willing to enact that business.A review of Figure 4.1 reveals the value area in the center of the marketprofile. The top end of the profile was where price auctioned too high andbuying dried up, and the bottom of the profile was where price auctionedtoo low, cutting off selling activity.Our art auction example, of course, doesn’t represent the complexityof the auction process in financial markets. Daily markets are comprisedof several continuous two-way auctions that establish a range for the day,including a high, low, and value area. These indicators do not occur in anyparticular order—the high for the day can be established at the openingbell, right at close, or anywhere in between—and are not fully defined untilthe day’s trading is concluded and the market profile is complete. However, with enough training, concentration, and practice, you will be able tovisualize which profile patterns are most likely to develop, long before themarket close.
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As we begin to delve deeper into the confluence of various marketvariables, it is important to emphasize the value of a receptive mind; pattern recognition is only valuable if you can avoid wishful thinking andcontinually seek to understand market activity in the present tense. Thepatterns we are about to discuss are not set in stone. It is hoped, however, that they will serve to prepare you to recognize change ahead of yourcompetition—and before opportunity is lost.If you compare any given day in a market to the previous day, youwill observe that some degree of change has occurred. This change maybe very slight—almost insignificant, when a market is in balance. Or thechange may be pronounced when the market is trending, breaking out ofbalance, or in the midst of a short-covering rally, liquidating break, or otherunusual occurrence.Each day will also, to some degree, create a divergence between priceas it relates to value. As price attempts to move away from value, there areboth expected and unexpected responses. As price auctions higher, it isexpected that demand will dwindle and prices eventually trade back downtoward the daily mean. As the prices move lower, supply usually diminishesand prices auction back up toward the daily mean, or value area.Returning to our art auction example, we can demonstrate anotherphenomenon. Once the auction is underway, the price quickly surpassedthe failed early attempt to open at $900 and then proceeded upward untilthe auction slowed and the final bid was eventually cast. In some cases,however, higher prices, instead of diminishing demand, have the oppositeeffect. If this had been the case, the auctioneer would not have neededfiller to maintain a feeling of potential and excitement; you would haveheard him say (with some enthusiasm): “New bidder!” Higher prices couldhave served to attract increased demand, rather than shutting it off. Thiskind of activity tells us that the auction is far from complete. As we havesaid, all markets that are financial in nature operate in a similar manner,and this same phenomenon occurs in listed markets, as demonstrated inFigure 4.2.In Figure 4.2, price continued to auction higher throughout the day,with occasional pauses that served to communicate to new buyers thatvalue was being accepted higher.
Concept ReviewBefore we proceed, let’s review the salient concepts we’ve covered thus farin Markets in Profile:1. Structure, as revealed by the Market Profile, is developed through
a two-way auction process, and every day the auctions result
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NPMNPKLMNPKLMNPKLKLKLKKIJKIJKIJKIJKIIIIIIFGIFGHIFGHIFGHFCFBCEFBCEFBCDEBCDEBCDEBCDEBDBDBDBBBBBBBB
DAY ENDS WITH NEWBUYER DEMAND STILLNOT MET-NOOVERREACTION
HIGHER PRICESCONTINUE TOATTRACT NEWBUYERS
HIGHER PRICESATTRACT NEWBUYERS
EARLY UNDERREACTION OR LOWERPRICES REJECTED
FIGURE 4.2 Price auctioning higher and attracting new buyers.Source: Copyright ľ 2006 CQG, Inc. All rights reserved worldwide. www.cqg.com.
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in a range, value area, high, low, and comparative amount ofchange when measured against previous days (and weeks, months,etc.).2. By reviewing the resulting profile, we are able to observe the differ-
ence between price and value, so we can begin to assess whether pricemight return to value (see Figure 4.1) or might lead to value higher (seeFigure 4.2).3. The auctions, on most days, enable us to quickly see which pricesstrayed too far from value and were not accompanied by increased volume, resulting in a regression back toward the mean. In Figure 4.2, wesaw just the opposite—the auction explored lower prices early in themorning and established an overreaction low, which, after the auctiongot started, was never challenged again that day. The upward auctioncontinued to attract new bidders each time prices explored upper pricelevels, as witnessed by higher volume (acceptance of value).4. A market profile enables us to see structure as it develops in real time.
With receptivity, concentration, and practice, you can begin to visualize the final market structure prior to its completion. We will spendtime more fully developing this theme in later chapters.The practical side of what we have seen so far is as follows:Figure 4.1. The market is in balance in the day timeframe. If you arelooking to buy and the auction explores downward with the expectedresponse—lower prices slow down supply—then you buy at those lowerprices and so acquire your merchandise below perceived value. Marketgenerated information reveals that this is your opportunity. If you waitfor price to return to value, you can still make your purchase at a “fairprice” for the day (within the value area). However, buying as price explores the upper price levels—on a day in which the market is balancedin the day timeframe—means that you have acquired your merchandise atprices above value. And as a result, the odds are not in your favor that pricewill be able to raise value.Figure 4.2. Again, if you are looking to buy and enter the market duringthe early downward exploration, you would have successfully purchasedyour merchandise below value. Waiting for a return to value will, as in thelast example, still allow you to purchase merchandise at fair value. Anypurchase above the value area (on this day) still allows you to purchase atvalue or below, because price is leading value higher. If, however, you hadmerchandise to sell on this day and you sold at any time, the best you couldhave hoped for was to sell at value; more than likely you sold at pricesbelow value. Of course profits occur when you purchase below value and
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sell at or above value, but profits also occur when you buy at value and sellabove value.You should realize by now that not all prices are equal, nor are all opportunities. Buying below value in either of the examples above providedan asymmetric profit opportunity in which opportunity exceeded risk.Selling below value, in either example, also resulted in an asymmetric situation in which risk exceeded potential reward.The key, of course, is recognizing these developing patterns beforethey’re complete. Learning how to extract structural clues early in theday, or early on during an intermediate- or longer-timeframe auction, iswhat this book is ultimately about. Now, let’s continue to explore the waysin which market-generated information enables transparency around themarket’s everchanging motives.
KEY MARKET-GENERATED INDICATORSIn Chapter 1, we said we would show you how to use market-generatedinformation to identify and adapt to change before your competitors. Let’snow turn our attention to several key reference points that make it possibleto measure degrees of change. We have established the fact that the developing value area helps us observe the changing relationship between priceand value in the day timeframe. Taking a slightly longer viewpoint, valuearea comparison can reveal important clues about the movement of valueacross days and weeks. By comparing daily value areas and price ranges,the market’s proclivity to change becomes somewhat transparent.Each day’s initial balance is also part of the larger contextual understanding that we seek. Nothing more than the range a given security tradedwithin during the first two trading periods, the initial balance representsthe market’s open and initial auction explorations and can reveal vital cluesas to where the day’s activity is likely to occur.Range extension occurs when new auctions lengthen the market profile shape beyond the range established during the initial balance mentioned above. Range extension is an indicator that allows us to gaugebuyer/seller strength. If price auctions above the initial balance and resultsin new buying activity, it becomes clear that there is real buying strength;and when price auctions lower and gains acceptance, then it is apparentthat selling strength is materializing. Range extension elongates the profile,allowing us to visualize the aggressiveness of buyers or sellers. Returningto our art auctioneer, if price extends upward and higher prices continueto attract additional buying, then the auctioneer would constantly be announcing “new bids!”
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CDBCDBCDBCDBCDFBCDEFBCDEFGBCDEFGBDEFGBEGBGHGHGHHKHIKHIKHIKLIKLIJKLIJLIJLMIJLMILMIMNMNMNMNMNPNPPPP
B-C REPRESENTSINITIAL BALANCE
RANGE EXTENSIONBEGINS IN GPERIOD-SELLERSCONTROLREMAINDER OFTHE DAY
FIGURE 4.3 The initial balance and selling range extension.Source: Copyright ľ 2006 CQG, Inc. All rights reserved worldwide. www.cqg.com.
Figure 4.3 shows the initial balance—B and C periods—followed byselling range extension beginning in G period and continuing downwardthrough the end of the day.Let’s begin to synthesize these key indicators. If there is a lack of rangeextension, limited range extension, or range extension in both directionswith price returning to the value area, then the structural evidence suggeststhat the market is balanced—for the time being, at least. In Figure 4.4, priceexplored above the initial balance (B and C periods) in G and H periods,but new buying did not occur and price returned to the center of the marketprofile, which reaffirms that the market was indeed balanced.Now let’s further widen our understanding of market-generated indicators by examining a day’s value-area placement in relationship to the
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HHHLIMITED RANGEHEXTENSIONHIGHIGHIBGHIBCGIBCGIBCDGIBCDGIKPBCDGIKLPBCDEGIJKLNPBCDEFGIJKLNPINITIALBCDEFGIJKLMNPBALANCEBCDEFJKLMNPBCDEFJKLMNPBCDEFJKLMNBCDEFJLMNBCDEFJLMNBDEJLMNBDELMDDD
LIMITEDRANGEEXTENSIONFIGURE 4.4 Range extension during a balanced market (day timeframe).Source: Copyright ľ 2006 CQG, Inc. All rights reserved worldwide. www.cqg.com.
previous day’s value area. Figure 4.5 graphically displays some of thesepossible relationships.Starting with the relationship in the upper left of Figure 4.5, you cansee that the new day’s value area has developed clearly higher than theprevious day’s value area. We are far more interested in value than pricebecause value is far more stable and indicative of real market momentum.For example, there are frequently occasions in which price is higher, whilevalue is actually unchanged—or even lower. In the second example, in theupper center, the value area has migrated lower. The following two examples portray overlapping relationships, and the final two exhibit days inwhich value develops either outside of the previous day’s value or, in thelast example, totally within the prior value area.
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Value Area Relationships
Higher
Lower
Overlapping Higher
Overlapping Lower
Outside
Inside
FIGURE 4.5 Value-area relationships.
In Chapter 5, we begin to create a coherent whole out of all the analyticindicators introduced here; however, before we begin that process, youmust first understand the significance of volume transparency, attempteddirection, and symmetry.When we first began to employ the Market Profile in the 1980s, wecould be exacting with the horizontal axis, which represents time, and thevertical axis, which represents price, but volume had to be estimated byemploying the following formula: Price × Times = Volume. This proved tobe fairly accurate when compared to the daily volume breakdown at eachprice level reported after the close. Only a limited number of exchangessuch as the Chicago Mercantile Exchange and the Chicago Board ofTrade, which fostered the development of the Market Profile, reportedvolume in this manner. Today, an increasing number of exchanges, bothin the United States and overseas, have endorsed electronic trading,which captures volume instantly, greatly increasing transparency for allmarket participants. With electronic trading, time, price, and volume canbe graphed in real-time via Market Profile. Where electronic trading andinstant volume reporting is available, transparency is complete, and the
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playing field is level; all market participants have access to the same timelyinformation on actual order flow.Rising price on increasing volume reveals the fact that value is rising(“I’m bid nine hundred, now nine and a quarter. I’m bid nine and a quarter . . . now nine fifty. I’m bid nine seventy-five.”) The same scenario ondecreasing volume would be neutral at best, indicating that the auctionis losing momentum (“Do I hear nine fifty for this superlative example offifteenth century landscape?”). As markets conduct their business throughcontinuous two-way auctions, declining price on increasing volume is bearish, and decreasing volume is either neutral or bullish.The final analysis of any given auction or trading day is highly dependent upon the variance-from-mean volume. Remember, the principles wehave discussed are applicable for all timeframes. This can be extremelyconfusing until you learn to identify which timeframes are active. Forexample, if the markets are demonstrating intermediate-term balance, aswell as short-term balance, volume is likely to be of lesser importance tothe long-term trader. However, should the market approach or break outof either of the extremes of the intermediate-term range, the long-term investor/trader would definitely be concerned with volume.Most serious traders and investors are familiar with the term “regression to mean.” This simple concept is at the core of the currentdiscussion—attempted breakouts that result in decreasing volume arelikely to see price revert back toward the mean. Attempted breakouts thatresult in increasing volume, however, reveal that new, aggressive participants have entered the market. In these circumstances, new value areasare likely to be established for all timeframes.We have continually stressed the importance of context. The followingexamination of attempted direction is no exception. The first step in properly assessing the relevance of volume is to determine which direction themarket was attempting to auction when that volume was established—anassessment that can often be difficult. If the attempted direction cannot bedetermined, then it is not wise to make a volume assessment; the marketwas probably balanced, and the auctions rotated relatively equally betweenhigh and low. In Figure 4.6, for example, the market opened near the high ofthe daily range, traded lower, rotating several times above and below themidpoint, and finally finished near the highs for the day. In this instance,we don’t see any clear signs of attempted direction. For those trading veryshort timeframes, such as 5- and 10-minute bars, there may have beenclearly defined attempted direction. As your timeframe lengthens, however, determining attempted direction on this day became non-productive.In Figure 4.7 (see page 54), it’s relatively easy to observe that the day’sattempted direction was up as the market opened near the low and closednear the high. But let’s consider a more complex example, one in which
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GGCGPCDEFGPCDEFGPCDEFGPBCDEFGNPBCDEFGNPBCDFGNPBCDFGNPBCDFGNBCDGNBDGHJNBDHJNBHJNBHJKMNBHJKMNBHJKLMBHJKLMBHJKLMHJKLMHJKLMHJKLMHJKLMHIJKLMHIJKLIKLILILILIII
OPENING
MIDPOINT
FIGURE 4.6 Attempted direction in a balanced market (day timeframe).Source: Copyright ľ 2006 CQG, Inc. All rights reserved worldwide. www.cqg.com.
a stock rallies to new highs, breaking 100 for the first time. Experts go onrecord saying they’ll buy the stock on a correction. Most investors assumethat a “correction” in this context would mean a decline in prices after thestock’s rally. While such a dip could occur, the “correction” does not necessarily have to result in lower prices—new long-term buyers could enter themarket, buying from short-term sellers and keeping the price from falling.This activity effectively relieves holders of old long positions of their merchandise, replacing them with new long-term buyers.Without a flexible, well-prepared mind, this latter form of correctioncould take place without your ever having realized it. In fact, the marketcould exhibit clearly higher price and value—but with attempted direction
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NPMNPKLMNPKLMNPKLKLKLKKIJKIJKIJKIJKIIIIIIFGIFGHIFGHIFGHFCFBCEFBCEFBCDEBCDEBCDEBCDEBDBDBDBBBBBBBB
CLOSE
OPENING
FIGURE 4.7 Attempted direction in an upward trending market.Source: Copyright ľ 2006 CQG, Inc. All rights reserved worldwide. www.cqg.com.
down on decreasing volume, with prices closing on the low for the day.Without considering the larger context, price alone could confuse you, sothat you completely miss the next bullish move upward. Of course, thesame thing can just as easily happen on the downside.Attempted direction is an important element in compiling a holisticopinion using market-generated information. Like any task that requires
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skill, however, it takes time and dedicated practice in order to learn tomake the correct assessment of attempted direction on any given day.The final market indicator we’ll address in this chapter is symmetry.The market profile is not, as you have already surmised, always symmetrical, and that lack of symmetry can have very specific consequences. In hisbook The Mature Mind (New York: Basic Books, 2005), Gene D. Cohen,M.D., Ph.D., discusses the ways in which younger people tend to placemore emphasis on the left hemisphere of the brain—that hemisphere thatperceives the world analytically—in making decisions, while more mature(older) people tend to merge information from both hemispheres in theirdecision making. Not surprisingly, Cohen surmises that whole-brained decisions are better decisions. Words and numbers are the language of theleft hemisphere, while the right hemisphere is more capable of capturingthe world synthetically, parsing the meaning and import of images, models,and feelings.The market profile captures the market’s fundamental building blocks(price, time, and volume) in a visual graphic that enables us to see themarket’s structure. This allows us to evaluate market activity by using both of our information-processing modes—the analytic left hemisphere in conjunction with the synthetic right hemisphere. According toDr. Cohen (and everybody else), this should result in better decisionmaking.The profile graphic captures and displays a great deal of data in a simplified form, which enables us to better understand the complex relationships that exist between the multiple economic indicators and timeframeswe have discussed. A market profile that is symmetrical, within its timeframe, offers symmetric risk/reward opportunities on both the long andshort side of the market. Such a market in balance represents a situationthat is as close to the efficient market theory as is possible. A symmetricalmarket is waiting for new information before it makes its next directionalmove.Nonsymmetrical profiles identify markets that are imbalanced. In suchout-of-balance situations, the market profile helps identify advantageousinvestment opportunities, as well as situations that would yield poor odds.Nonsymmetrical markets occur under several conditions. The first develops when the market is trending, and multiple timeframes are acting inconcert; the resulting series of profiles will be elongated in the directionof the move. The second is a nonsymmetrical profile with a weighted upper end, which occurs when only limited timeframes are buying the market. A pronounced example of this phenomenon, shown in Figure 4.8, generally signifies short covering that is not accompanied by new long-termbuying.
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IIGHIFGHIJKLEFGHJKLDEFGJKLDEFKLDEFBCDFBCDBCDABCDABCABCAByAByAyAyAyAyzyzyzyzyz
NONSYMMETRICRALLY WITHLIMITED TIMEFRAMEPARTICIPATION
FIGURE 4.8 Nonsymmetrical proﬁle created by short covering.Source: Copyright ľ 2006 CQG, Inc. All rights reserved worldwide. www.cqg.com.
Similarly, a nonsymmetrical profile shape that is weighted to the downside represents selling by limited timeframes. Figure 4.9 demonstrates thiscondition.
PERFECTING THE ART OF VISUALIZATIONThe Market Profile is a simple tool that builds a graphic out of the market’s continuous auction process. As that graphic reveals itself over thecourse of any given day, there are key market-generated indicators thatcan reveal what the market is inclined to do—indicators like value area,initial balance, range extension, attempted direction, and symmetry. Anyone of these indicators, when taken out of context, can lead you down ablind alley; all market activity must be observed in the light of larger market context. In the following chapters, you will begin to learn how to usethe indicators highlighted here to make more effective trading decisions