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yyyAyzAyzAyzAyzAyzAyzAyzAByAByABBBBNONSYMMETRICBBBREAKWITH LIMITEDBBCTIMEFRAMEBCPARTICIPATIONBCGBCDFGCDFGCDFGLDEFGHJKLDEFHJKLDEHJKLDEHIJKDIJKDIK
FIGURE 4.9 Nonsymmetrical proﬁle created by long liquidation.Source: Copyright ľ 2006 CQG, Inc. All rights reserved worldwide. www.cqg.com.
As in any endeavor that involves complex associations, an actionableunderstanding of the market’s developing auction process can only be perfected through extensive observation and study. The world’s top chessplayers are not merely “intuitive,” but have spent considerable time pouring over patterns and potentialities, searching for that elusive advantageover the competition.
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Not everything that counts can be counted, and noteverything that can be counted counts.—Sign hanging in Albert Einstein’sPrinceton University office
hapter 4 focused on isolating key indicators revealed by the auctionprocess. The art auction we described was extremely simplified—aone-time event geared only to facilitate the sale of a single item.In the financial markets, this process is continual, with multiple timeframes influencing market behavior and multiple items continually beingbought and sold. As a result, the indicators we defined never occur inisolation—they must always be considered within the complex, everchanging context of which they are a part.To use an everyday analogy, consider the act of picking up a cup ofcoffee. On the surface, this process may seem so simple it needs no explanation. But the brain must first interpret the reflection of light off the cup’ssurface, and then send dozens of impulses to a variety of muscle groupsthat must work in perfect synchrony. Now think about the astounding number of simultaneous processes that must coincide flawlessly to enable abaseball player to hit a fastball moving at 90 miles per hour.The same is true with trading: the process is complex. Markets arecontinuously influenced by news, multiple timeframe participants, buyingand selling driven by wildly varying objectives, short covering, liquidatingbreaks, and on and on. When information compounds upon other information, it gets exponentially more difficult to sort out the “net effect” ofthe current auction and to keep the activity of the different timeframes
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straight. As we have said before, it takes an incredible amount of practiceto become an expert trader, one who is capable of observing, understanding, and deciphering—in the present tense—the flux of constantly evolvingmarket indicators.
AUCTIONS IN ACTIONNow, let’s attempt to integrate many of the concepts that we’ve discussedthus far by reviewing Treasury refunding, a relatively short-timeframeauction. Currently, the Treasury sells bills in 3- and 6-month month maturities; notes in 2-, 5-, and 10-year maturities; 30-year bonds; and Treasury inflation-indexed securities. The auction process begins with a publicannouncement by the U.S. Treasury that includes which security is to beauctioned, the amount of the issuance, maturity of the security, and theamount of cash to be raised, a portion of which will re-fund maturing debtwith the remainder funding new debt.Bids are accepted up to 30 days prior to the auction; however, theprimary dealers—the financial institutions that have been recognized bythe New York Fed—purchase most of the inventory, generally submittingbids at the last possible moment, often just moments before the auctiondeadline. There are two kinds of bids that can be submitted: competitivebids, normally submitted by primary dealers, and noncompetitive tenders,which are generally submitted by small investors and individuals. The primary dealers submit bids for both themselves and their customers, andmost of the securities they purchase will later be resold—to other dealers, companies, banks, individuals, and the like. The fixed-income market often “backs up,” or “sells off,” prior to the Treasury auctions as thedealers attempt to create a spread, so that the securities they buy canbe resold at a profit. In this sense, they’re similar to the automobile dealers and home builders that we discussed in Chapter 3; the government isthe long-timeframe issuer of the securities, and individuals, pension funds,endowments, and foundations are among the long-term holders. If everyone guesses correctly, the newly issued securities pass from the Treasurythrough the dealers that make their markups and into the hands of otherfinancial institutions that either hold them for their own accounts or resellthe securities to long-term, “sticky-money” investors.Just as we discussed in the automotive example, it doesn’t always happen this way. Sometimes the dealers get stuck with inventory that isn’t immediately distributed to long-timeframe investors. To balance their inventories, the remaining securities must be priced (auctioned) lower, whichincreases their yield and makes them more attractive to long-term buyers.The auction continues lower until balance is restored in the market.
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Of course, the auction can also be extremely successful when there aremore bidders than securities to go around. When this happens, it’s not uncommon to see a strong upward auction begin immediately when biddersrealize that they’re not going to get their hands on the securities that theyhad hoped to acquire. These bidders may have been short, needing to buyin order to cover, or they might have simply been trying to meet their ownquotas or the demands of their clients.The point of this discussion is that auctions are everywhere—the auction process is the cornerstone of all business transactions. By being a consumer in a market society, you have an intuitive understanding of how thisprocess works. Every time you go to the store you encounter auctions inaction. When you decide to pay a higher price for a gourmet frozen pizza,the auction might not be immediately interactive (unless you have to fightthrough a crowd to get to the freezer), but the long-term effect is the same:if the pizzas fly off the shelf, then prices rise. Conversely, too many pizzas left on the shelf results in prices “auctioning” lower in order to balance inventory. This fundamental understanding—so simple it’s taken forgranted—will serve as a foundation for developing a more holistic understanding of the financial markets’ compound-auction process.
THE COMPOUND-AUCTION PROCESSMarket-generated information—data that results from the auctionprocess—is real-time and constantly evolving. The underlying messagehere is that investment ideas based on past findings can often block newinsights, which can lead you to favor preconceptions over fresh observations. As a result, you can easily set yourself up to make flawed investment/trading decisions. Combine that tendency with the natural humaninclination to focus on solutions rather than the process that leads to solutions; and you’ll be incapable of understanding the true nature of real-timemarket activity. In the investment-management business, the tendency bymany investment professionals to study only surface indicators has costlegions of investors untold fortunes; if the process is flawed, then you canbet the solution will be flawed as well. If your goal is to be a top-quartilecompetitor, then you must immerse yourself deeply in the process—themarket’s compound-auction process.The art auction we referenced was a useful paradigm to identify anddiscuss a few individual market indicators, but the same process occurs,with greater complexity and virtually simultaneously, when there are manymultiples of an item to be auctioned. For example, once a new auctiongets underway, multiple participants bid for supply. At lower prices, only
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a few bids may be filled—the auction rises quickly if prices are perceivedas unfair (below value) for sellers of a certain timeframe. As price auctionshigher, more bids are accepted and some bidders drop out as prices exceed their idea of fair value. From there on, only those that must buy tomeet demand, or those caught up in the auction frenzy, continue to purchase inventory as price climbs higher. Once market participants sensethat prices, for their timeframe, have auctioned above value, and that demand is waning, then offers begin to exceed bids and an auction beginsin the opposite direction. Hence, the compound-auction process is an ongoing, multidirectional progression that draws in participants of differenttimeframes, depending on the direction and significance of each interstitialprice movement.Traders and investors who operate on an intraday basis—which includes short timeframes that can range from minutes to hours—may experience several such rotational auctions in a single day. Shorter-term tradersmay see their trades last for several days or weeks; intermediate-term participants may find that auctions relevant to their timeframe last months;and long-term auctions can last months or years. Recognizing where youare in the auction process determines your risk/reward relationship. Youcan begin to understand where you are in the current auction process byinspecting bar charts, which enables you to essentially “speed read” theauctions, starting with the longest-term auctions and working toward thedaily auctions, where trade location is ultimately secured.
THE EBB AND FLOW OF BALANCEThrough studied observation, you will notice that long-term auctions don’tgo from bull to bear, or bear to bull. Rather, long-term trends first transitionto balancing ranges before either continuing in the original direction orbeginning a new long-term auction in the opposite direction. To illustratethis principle, observe Figure 5.1, which displays the S&P 500 market forthe period October 1998 through May 2006. (The time period and marketare irrelevant, so long as the period is sufficiently long to include a longerterm auction.)In this case, the S&P 500 trended upward until March 2000 and thenbalanced through September of that same year. In October 2000, after balancing for seven months, the S&P began a sustained, long-term downwardauction that bottomed out and began to balance in October 2002. In May2003, the market exited this balance area and began a new long-term upward trend that remains intact as this is being written (May 2006). If youlook at the two periods marked “Balancing,” you will observe that the
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55000500004500040000
1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013
FIGURE 5.1 Long-term trends transitioning to and from balance: S&P 500monthly bar chart, October 1998 through May 2006.Source: Copyright ľ 2006 CQG, Inc. All rights reserved worldwide. www.cqg.com.
market began the balancing process several months prior to the completion of the absolute highs and lows for the respective long-term trends.Often, it is not until the balancing process is already underway that yourealize the long-term auction is ending and the market is coming into equilibrium.As you gain experience studying auctions, you will begin to recognizethe beginning of this balancing, or bracketing, process. The two balancing periods noted in Figure 5.1 are examples of intermediate-term auctions(which we’ll cover in more depth in the next chapter). Long-term auctionsare comprised of several such intermediate-term auctions, and provide important context without which trade decisions can get lost in day-to-dayinformation overload.Figure 5.2 looks more closely at the S&P 500 activity shown inFigure 5.1 by focusing on (1) the start of the balancing process in July 2002,which marked the end of the downward trend that began in March 2000; (2)the upside breakout from the balancing period in May 2003; and (3) two ensuing intermediate-term auctions that are incorporated in the longer-termupward trend that continues as this book is being written.
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FIGURE 5.2 Breakout from balance as a catalyst for a longer-term trend: S&P 500monthly bar chart, July 2002 through May 2006.Source: Copyright ľ 2006 CQG, Inc. All rights reserved worldwide. www.cqg.com.
WHERE DO TRENDS END ANDBRACKETS BEGIN?(Authors’ Note: The following sections are written in the first person tobetter convey the personal experience of James Dalton.)The question I’m frequently asked is, “Why did you pick a certain period to designate the beginning or end of a trend or balance area?” I confessthat it isn’t a science. But after looking at a wide variety of markets overmany years, the signs of transition begin to intuitively make sense. For example, Figure 5.2 reveals two distinct lows for the S&P 500, the first at
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9,290 and the second a little over three years later at 9,390. May 2003 waschosen as the “upside breakout” because the market had given up probingbelow these significant reference points. Following the upside breakout,the market again balanced—or “bracketed”—for 11 months before continuing onward.Brackets arise out of the market’s innate need to balance. When price isperceived to be away from value, the market auctions in one direction untila new value level is found. This happens within the day, day-to-day, weekto-week, and longer timeframes. As observers, we only know that a newvalue level has been found when two-sided trade begins to take place; themarket begins to auction in both directions with relatively equal strength,always pulled back to a central value, known in statistical circles as “themean.” The tighter the extremes of the bracket, the closer the perceptionsof value between buyers and sellers of all timeframes. The farther apart,the more differing opinions are in play.Another way to illustrate this concept is to think of a trend as a marketthat is “unfair” to one side. For example, in an upward trend, the marketis telling us that prices are too low—unfair for the seller. In a bracketingperiod, the market is expressing its belief that prices are once again fairfor both the long-term seller as well as the long-term buyer. The resultingactivity is a relatively well-defined area of price containment, often characterized by overlapping value areas. As long as the bracket holds, and participants are in agreement regarding value, market activity on the bracketextremes will be met with responsive selling at the top, and responsivebuying at the bottom. “Responsive,” in this sense, refers to participants responding to the advertised opportunity of price above or below value, orthe mean.Auctions that occur near bracket extremes provide significant information about the odds of the bracket holding. For example, if an auctionthat pushes toward the upper extreme occurs on heavy volume, the oddsare high that the bracket will not be able to contain the upward movement.Conversely, if low volume accompanies an auction at a bracket’s upper extreme, then it is likely that higher prices are effectively cutting off activity;higher prices are not being accepted as “fair,” the bracket’s extremes areaffirmed, and more balancing activity can be expected.A common reaction to this definition of brackets is this: Brackets areeasy to identify in hindsight. But how do you identify them as they are developing? The art of distinguishing real-time bracket activity is more thana matter of drawing neat lines on a chart. It takes time to acquire this skill,just as it takes time to learn to read an X-ray or master chess. With practice, however, you recognize the signs of balance and imbalance—perhapsthe most essential element of successful trading. Markets communicatetheir need to balance via declining volume, thus the same information that
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reveals the likelihood of bracket containment is also helpful for identifying when a new bracket is beginning to form. One auction isn’t enough tomake this determination. As you become familiar with the auction process,however, you’ll begin to fortify your ability to make this assessment.From a trading standpoint, accurate bracket identification provides important perspective; not only does it better equip you to take advantageof well-defined moves within the bracket (a trader’s paradise), but it alsohelps you identify when the market is once again coming out of balance,indicating that a new trend may be developing.
CLARITY IN THE MAELSTROMIt’s easy to lose yourself in short-term minutia, which can cause you to losetrack of the longer-term auction. We recommend that you print out a longterm chart at least once a month and a weekly chart every Sunday. Postthem somewhere highly visible to help you keep the “big picture” in mindas you continually assess your long-term strategies. Any time the marketdeparts the boundaries of one of these charts, immediately reprint them.To illustrate how different market activity appears when viewed in thecontext of different timeframes, Figure 5.3 displays a weekly bar chart forthe S&P 500 for a portion of the same time period shown in Figures 5.1and 5.2.I have been amazed over the years by the money managers whomI have reviewed who pride themselves on the fact that they have absolutely no charting capabilities in their research facilities. I recently reada newsletter produced by a top research firm that discussed a vital indicator they missed in their analysis of the Japanese markets over the pastseveral years—they stopped paying attention to what Japanese policymakers were doing. And they weren’t alone: Japan’s deflationary period simplylasted longer than the attention span of most investors. A periodic reviewof long-term bar charts could have alerted savvy investors (and investmentfirms) to the fact that change was taking place, and with change comesopportunity.The attempt to remain as objective and honest with ourselves aspossible about what is actually occurring in the markets—not what wehope to see or need to see in order to justify our positions or pastpronouncements—is a natural, ongoing challenge for even the most experienced traders and investors. This may sound obvious; but we know fromexperience that when multiple people are given the same set of facts, theywill invariably arrive at different conclusions. Why? Because our decisionmaking process is always influenced by our past experiences, and it goes
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Upside breakoutMay 2003
July 200208 May 060= 132810H= 133080L= 132700C= 132720 2002
2003
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FIGURE 5.3 Shorter-timeframe perspective for a portion of the same time periodshown in Figure 5.3: S&P 500 weekly bar chart.Source: Copyright ľ 2006 CQG, Inc. All rights reserved worldwide. www.cqg.com.
without saying that everyone has a vastly different background. The pointis that it’s possible to check your inclinations by frequently referencingthe market’s long-term auctions, which should support your decisions. Forexample, the research firm that was negative on Japan should have lookedfor confirmation of this opinion in the form of lower volume during upwardauctions, with no upside breakouts from the long-term balance. A cursoryreview of the longer-term auction should have revealed—if their conclusions had been correct—that upward movement was not straying far fromthe lower balance area. Instead, just the opposite was occurring, but thefirm’s analysts stopped looking and lost sight of the bigger picture.One way to identify the beginning or end of a longer-term auction is byobserving the market’s balancing periods. To reiterate, markets rarely perform an “about face,” moving from one sustained directional movement toits opposite. For long-term investors who manage large portfolios, learningto recognize when long-term auctions begin and end can be absolutely vital. And fortunately, the balancing process can take several months, forthe long-term auction, which allows time to reposition even the largestportfolios. Failure to make use of this time, however, has destroyed many
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solid track records—track records that can take years to rebuild. Once themarket leaves a balance area, price often moves rapidly (at least initially)in a nonlinear fashion, liquidity shrinks and opportunity is lost.It is worth noting here that a financial market is different than a physical system like a motor. A car’s engine eventually wears out, but it remainsthe same “system” no matter what is done to it. Conversely, a market isconstantly evolving based on the actions of its participants; cogent patterns are eventually eliminated by those within the system acting upon it,which explains trends and why they come to an end.Enter Market Profile, a simple visual manifestation of market activitythat changes constantly, objectively reflecting the evolving attitudes of allparticipants in the present tense. Part of the beauty of the profile—its elegance, even—is the simple fact that it records change. It is this liquiditycapturing aspect that makes Market Profile such a vital tool for interpretingmarket activity.The word liquidity generally refers to an individual’s ability to executean order, Here we use the term to address the constant flux of funds intoand out of the market.That’s worth reiterating: Market Profile is different than most trading approaches because it is wholly liquidity driven. Market fundamentals and technical patterning may be accurate or misleading, may evolveand become anachronistic, but the fact remains: If funds are flowinginto a market—whether it’s an individual security or a sector or an artauction—then the market eventually auctions higher. If funds are flowing out, the market eventually auctions lower. There’s nothing new here,just the primal law of supply and demand made manifest in a simple visual graphic that portrays the developing relationship of price, time, andvolume—a graphic that enables whole-brained investors to visualize whena market is both in and out of balance.The resulting profile enables us to capture complex relationships sothat it’s possible to better understand what is actually happening in themarket in the present tense. The long-term bar charts presented in thischapter serve a different function; because they only portray price, theydon’t capture all the additional complexities and behavioral attributes incorporated by Market Profile. They do, however, provide crucial long-termperspective when reviewed in conjunction with daily profiles, which addthe dimensions of time and volume.
THE BIG PICTUREI use long-term bar charts to speed read the market’s “big picture” before Inarrow my focus on more granular, daily detail. For example, the bar chart
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S&P 500 futures10 May 2006
14 March 2006
42-day tradingperiod
FIGURE 5.4 Longer-term price perspective provided by bar charts: S&P 500 dailybar chart, March 14, 2006, through May 10, 2006.Source: Copyright ľ 2006 CQG, Inc. All rights reserved worldwide. www.cqg.com.
shown in Figure 5.4 shows price for the identified time period, and Figure5.5 shows the same period represented in a long-term Profile graphic thatdisplays time, price, and, by inference (price × time), volume—the threeessential ingredients to understanding the health of the auction process.With the proper quote system, it is possible to create a Profile that covers
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FIGURE 5.5 Critical value and volume perspective provided by long-term proﬁles:S&P 500 long-term proﬁle, March 14, 2006, through May 10, 2006.Source: Copyright ľ 2006 CQG, Inc. All rights reserved worldwide. www.cqg.com.
any range of days you want to examine. The significance of the longer termProfile graphics will be discussed more fully in Chapter 6.Figures 5.4 and 5.5 represent the same time period: March 14, 2006—May 10, 2006. Figure 5.4, a daily bar chart, does not enable you to see, at aglance, what is evident in Figure 5.5:1. The three distributions (the broad areas of the profile, where most
trade, i.e., volume, took place).2. The mean of each distribution. Based on the discussion thus far, it
should be clear that volume measures the success or failure of eachauction; higher prices either cut off activity or, in strongly trendingmarkets, attract more activity. When higher prices cut off activity, pricegenerally reverts to the mean.From another perspective, imagine that volume represents force. Fora market to successfully auction away from a fully developed distribution
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area with a well-defined mean (where buyers and sellers have agreed uponvalue), the auction would need to have excessive force to overcome the“gravitational pull” of that value area. If price exploration does not haveforce—volume—then the expectation is that price will be pulled back tothe established distribution value area.Peter Steidlmayer said that markets are not “efficient,” but that theyare “effective.” By “effective,” he means that price has to auction too highbefore the market realizes it’s too high, and too low before the marketrealizes it’s too low. In effect, what happens is that price auctions higheruntil there is a lone bidder; when higher prices cut off activity, then theauction has gone too far.Price is simply an advertising mechanism. Some advertisements aresuccessful and attract new business, while others are unsuccessful, serving to shut down activity. As we observe, via the market profile, a marketauctioning away from an established distribution area, the question we’realways trying to answer is this: Will a new distribution (value area) be established or will price be pulled back to the prior distribution area? Again,it takes the force made manifest in volume for the establishment of a newvalue area to be successful.While we have discussed long-term trends for a broader market, thesame concepts are applicable for sectors and individual securities as well.Figure 5.6 shows the monthly bar chart of UBS (Union Bank of Switzerland), a global financial services company, from May 2000 to May 2006.UBS traded within a range of approximately $35 to $59 for three years;long-term trends generally begin and end in just such intermediate-termauctions. Notice that UBS traded within a very tight, approximately fivedollar range for four months prior to the upward breakout from the threeyear bracket. Figure 5.6 shows this narrow balance area occurring justbefore the start of an upward trend that, as of this writing (June 2006),carried the stock to a high of $122. During the four months prior to thebreakout, it would have been easy to disregard UBS, as there appearedto be limited trading opportunities and extremely low volatility. Once thetrend got under way, however, it exhibited all the characteristics we havepreviously described—it began to trend, balanced from January to November 2004 and then resumed trending upward, balancing again from December 2004 through October 2005. In November 2005, UBS again began toauction higher.Any breakout from a balance area signals that a reevaluation ofvalue is occurring. Intermediate- and long-term timeframes may disregard short-term balances; however, traders and investors of all timeframesshould pay careful attention to long-term breakouts, as they include participants from all timeframes and can result in large momentum shifts.Failure to recognize this principle can result in major losses and missed
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