ayer distribution, with significant volume at the high end of the priceränge. If you were long copper, you'd like the low-volume number at 14600 to hold ästhe trading Session continued and you'd like a new distribution to begin to the upside.
distribution developed in the Order of first Standard deviation, second and then third, ending at the higher end ofthe price ränge. The second distribution developed in theorder of third Standard deviation, second and then first,ending at the lower end of the price ränge. Thus, thetrading day äs a whole contained one up distribution andone down distribution, resulting in a basically balancedoverall picture.In Figure 10-6, the profile for November 2 shows ratherclearly two Steidlmayer distributions. In this case, bothare down distributions.
After putting on a trade, it is very important to be able torecognize the kind of market activity you are getting anddescribe it with volume. The key to reading on-line volumeis to note äs soon äs possible any single price that is accumulating a large amount of volume. This is a strong indication of a responsive Situation or the likely presence ofa first Standard deviation of volume.
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On the other hand, a series of small, almost equal pricevolumes with a correspondingly large ränge means that themarket is in a second or third Standard deviation, seekingto find the first.In analyzing on-line volume, then, the most importantnumbers to look at are the high-volume number and thelow-volume number because these will be relatively hardto change. But they do sometimes change, particularly whenyou are working with a small sample size early in the day.Under those circumstances, one large trade or a singleinflux of trades can change the Situation dramatically.Changes of this sort are essential to note, and their meanings must be analyzed for any possible impact on yourtrading position (see Figure 10-7).On-line volume is not available at the present time formany exchanges; tick volume may be substituted for it.Volume figures released after the close by the ChicagoBoard of Trade in its Liquidity Data Bank, äs well äs thepartial releases during the trading session, provide valuable information relating to continuation or change.The extension of availability of on-line volume data willbe the most significant and beneficial development in theindustry over the next several years. As exchanges becomeincreasingly aware of the importance of their role äs sourcesof market information, and äs traders come to realize thebenefits of trading with volume and using volume to describe market activity, there will be a natural evolution ofvolume information brought on by demand.
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The key to reading the market is knowing and understanding the basic structures of market development: the negotiation process and the distribution process.
THE NEGOTIATION PROCESS AND THEDISTRIBUTION PROCESS
The neigotiation process Starts the market; developmentfollows.l The procedures of the negotiation process itselfare familiär to all who work in and around markets. Thereare three crucial points in any negotiation process: thetrade price and two outside reference points. These pointsevolve together into the development of the market, almost like an egg growing into a chicken.This development includes six important elements orreference points: the starting price; the current price; thetwo boundaries of the day's ränge (that is, the current highand low for the day); the recurrence of prices used (thatis, the accumulated trade area); and the relationship amongthe elements. These six elements may develop in any order; they may also change in any order. These elementsand their interrelationships evolve in a continuous, forward-rolling process throughout the trading session. As the•139-
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data build and the sample size becomes larger, the reference points become more stable, or, in some cases, moreclearly defined.Any single reference point may be used or studied separately, but it is better to use it in relation to the others.For example, a reference point that is greatly out of proportion to the other indicators may not mean much byitself; but once the comparison to the other reference pointsis made, its significance becomes clear (see Figure 11-1).All this activity takes place in a distribution or ränge forthe day.To begin reading market activity, try to place the variousreference points into the different thirds of the market'sränge for the day—that is, the the top third, the middlethird and the bottom third. Of course, once the tradingsession is over, you can easily see the top, middle andbottom third of the ränge. What you want is to be able todo this on-line, in the present tense — or äs close to this äspossible. For instances, being just a half-hour late in reading this information would be a high Standard of accomplishment, and one that would enable you to trade veryprofitably in most cases. As you trade, you'll find that you'lltrade well when you've been reading the market accuratelyin the present tense; when you trade poorly, you've beenunable to do this.Having developed this activity to some degree, the second key is to realize that all market activity takes placewithin a distribution. Therefore, you must relate the rängeyou are looking at to the ränge of the distribution. Furthermore, you must give consideration to more than onedistribution when looking at the ränge of the day. In otherwords, in order to read the market, you must read thecurrent distribution along with all the distributions undertaken by the market during the current session—or, at•140-
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least, be prepared to modify and correct your idea aboutthe number of distributions äs the day develops.Notice the contrast between today's markets in the late1980s and those in the 1960s. When I was first trading, atypical day would have only one quarter of a distribution;that is, it would take four or even five days for a distribution to complete itself. Today, during a volatile Session,we may experience three or four distributions in the samemarket, usually all in the same direction. This certainlyillustrates the change in volatility that I've experiencedsince I started trading. Based on our currently availablemeasurement tools this trend appears likely to continuefor the near future and even accelerate, although it is sureto peak out eventually.
EMERGING AND DEVELOPING MARKET ACTIVITYIIARKE:T PROFILE (R) COPYRIGHT 1984 CBOT.COPYRIGHT 1987 CQ6 INC.
We can classify the market's initial development into twoparts. The first part is emerging market activity, coveringthe immediate development of the market. It is concernedmostly with the degree of ränge distribution äs the marketdevelops.Next comes what we call developing market activity.This is the price/volume relationship äs it takes shape during the development of the distribution. Understanding itcalls for placing price activity into either the first, secondor third Standard deviation (see Figures 11-2 and 11-3).The price/volume relationship yields time and places pricelocation äs to potential development.Last, we need to place these two forms of activity withinthe Steidlmayer distribution, so that we can read whenthis initial distribution is ending, and perceive the begin-
To bring this process to life, let's follow a real-life marketäs it develops on-line during the course of a single day.Figures 11-4 through 11-11 will profile December 1988gold futures äs they unfolded on November 3, 1988. Studythe profiles and our commentary, and you'll gain some
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igure 11-2. Two-day profile for November 1988 soybeans. Emerging market acwith a distribution evident on November 2, though not on November 3.\
ning\and ending of other possible distributions during theday. ^
ONE DAY IN THE MARKET
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MAKKET PROFILE (R) COPYRIGHT 19£14 CBOT.COPYRIGHT 1987' CQG INC.
Figure 11-3. Two-day profile for January 1989 soybeans. On November 2, the market opened with a distribution; it was possible to place the early prices within the thirdStandard deviation. On November 3, with no distribution, we place price within thefirst Standard deviation. Note that volume confirms this.
insight into how an experienced trader can trace a marketäs i t develops.Figure 11-4 shows the profile for the four preceding days(October 28 through November 2) and for November 3 äsof 8:00 A.M. Chicago time, about an hour after the marketopened. Our reading of the emerging market activity teilsus emphatically that there has been no distribution in themarket. (Compare this with the profile for October 28, onwhich there was a large distribution at the opening.)144
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Note from the tick volume chart that we have two verylarge numbers, representing a high percentage of tradeoccurring at two prices; so we can comfortably place thisprice area within the first Standard deviation of volume. (Ifall the volume bars had been small and approximately equal,we couldn't make this assumption.) So the market is likelyto remain in this price area for a couple of hours.We can also see that the market is barely higher thanthe previous day, which had a major rally; so we can expectthe market to trade within the value area of the previousday since there is no distribution either up or down.Figure 11-5 shows the market äs of 9:30 A.M. Chicagotime. The market has basically remained within its originaldistribution ränge; it made a new high, but then wentnowhere. We have deliberately ignored volume in thischart in order to follow and test our first reading. After thefirst half hour, you should have the developing activity inhand; learn to trust this reading. As of 9:30 A.M., we don'tknow any more than when we started out —but we don'tknow any less, either.Figure 11-6 brings us up to 9:51 A.M. Chicago time.Again, we have left volume numbers off the chart. Nowthe market is beginning to take shape äs an emerging Steidlmayer distribution — note the familiär fishhook shape. It'sapparent that we may have completed the first distribution. We don't know the volume, since on-line volume isn'tavailable; tick volume could give us a distribution of volume, but not a total. And we can teil that we are at thebeginning of a possible new development. Having testedthe high side and having gone nowhere, the market shouldnow test the down side.We have some slight support at the 423 area, wherethere is a point of inflection (a tiny one), labeled 1. Thereare three points altogether at which we can expect support:•146-
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423 (point 1), 420 1/2 (point 2), and 418.8 (point 3). We'vebeen expecting the market to trade within the value areaof the previous day, so it's important to have our referencepoints within this area, not far outside it. (Note that wehave no resistance areas on the top side; we'd have to lookat data for the past month to find them.)Now we're prepared for what we think is going to happen: a new development. Let's see what our next chartshows us.Figure 11-7 shows us the market äs of 10:21 A.M. Wehave now completed our first distribution — a weak distribution to the upside —and started a new distribution, beginning with the D period in the profile. The market heldthe first support area, a sign that the market isn't veryweak. This attempt by the market to break marks the startof/the new distribution./Tick volume data describes this new distribution. Notetpat there is no low-volume number between the first andsecond distributions; rather, the volume number third fromthe bottom of the volume distribution is actually ratherlarge. If the market were going to have a significant distribution, it would be trading well below a low-volumenumber. That number would become a point of inflectionbetween the two distributions and a resistance point thatthe market would have to get through in order to resumethe uptrend.In the absence of this pattern, the probe of the downsideappears to be äs weak äs the earlier upside probe. Weassume that this D-period distribution will prove to be theequivalent of the yz distribution we observed at the startof the market; we have a high percentage of trade at justa couple of prices, giving us much the same Situation. Weconclude that the market should remain in this price areafor some time.148
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We pick up the market in Figure 11-8 äs of 11:19 A.M.,and our reading seems to be holding correct. However,we are now building, in a long time frame, a large firstStandard deviation of volume. We should move out of thisby the end of the day to complete the larger-time-frame,day distribution of first, second and third Standard deviations. We expect the market to move out of this area, toeither the up or down sides, sometime during the last hourof trading.An aside for Market Profile traders: this is a neutral day.It is balanced, with about equal distribution on both sides,and the market is currently around the middle of the ränge.Had the opportunity time frame traders been active whenthe market failed to rally or break, and had they thoughtit was the best opportunity they were likely to get for thenext several days, they could have driven the market disproportionately away from either extreme.Figure 11-9 shows the market äs of 11:59 A.M. We attempt to organize the market into distributions since wethink there will be movement out of the first Standarddeviation. Thus we break the market at what we think isthe top and bottom of the responsive part of the first Standard deviation of the distribution that occurred during they through D periods. This gives us a beginning distributionin E through 77 periods, which has all the earmarks of afirst Standard deviation, much like what we saw at theoutset of the market.Figure 11-10 shows the market äs of 12:54 P.M. We cansee that in the last hour of trading (the 7 and / periods);the market did in fact complete its second distribution andmoved down through the first support area. The 7 periodstopped at 4232, the support level we mentioned earlier.Its target now is the next support area, around 420 1/2.152
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As the market distributed during this last hour, the volume percentages at the last six prices were all small andbasically equal. This gives us the possibility of having apoint of inflection between the first and second Standarddeviation of volume in the second distribution. Now wehave the market trading between 424 and 4188 for tomorrow's activity.Figure 11-11 is the finished profile for the day's activityin this market. The profile has deflnition in that it displaysa fair value price area, balanced activity toward either extreme, a ränge extension up and a ränge extension down,making this a neutral day. It also illustrates that the onlynet form of market activity was time/price opportunity selling in the fair value area, which was visible to us all daylong.c Although this market didn't do much, it's a clear exarnple of why I now recommend the natural form of marketinformation äs pure, fast and indisputable. The day's prome is one of normal distribution from 424.80 —from thenktural viewpoint it was two distributions that we couldfollow and note development. It is the strongest basis fora solid understanding of market activity in the present tense.YouV Market Profile information, of course, is a fine adjunct to it.
NATURAL INFORMATION FLOW AND THESUCCESSFUL TRADER
The successful trader today is a highly individualistic creature. You don't trade in a group but äs an individual. YourPersonality, methods, time frames, needs —all are uniqueto you and cannot be shared by anyone eise.154
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The successful trader absorbs market activity and Information by participating fully in the markets. He perceivesopportunities äs they arise and makes distinctions amongthem, discerning which are more valuable, which less. Thegood trade doesn't escape him. He can turn his ideas intomarket opportunities because he has worked to learn, notlearned to work.Today, the trading environment is changing; it is expanding to different time zones in the new, growing, globalmarketplace. The trader cannot function in this new environment in the old, familiär ways; he has physical limitations, like the need for sleep and mental refreshmentthat would make this impossible. So the trader must learnto do the same things that have made him successful inthe past, but in a new manner./Now the trader can generally build his knowledge basepy observing the time frames of market activity that he has/missed in the past. But these observations fall short ofgiving him what he needs for his own, highly individualyzed data absorption program, from which the experiencedtrader is accustomed to deriving perceptions and opportunities. He needs to be able to break down market activityajnd define it with volume, just äs it developed during thetime frames when he was not personally available. He needsa way to participate without participating.The solution is a data base with all the elements that thetrader needs to play back the missing time zones in a manner familiär to him. The data base needs a highly flexibleformat to reveal the structure of the market —not accordingto rigidly fixed parameters but flexible ones — so the tradercan arrange and format the data to meet his own needsand fit his trading style. He begins with the base unit ofmarket activity — a distribution.
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As data of this kind becomes increasingly available, itwill provide a base for industry growth and help festerworld trade in a fair and competitive environment.
A BACKWARD GLANCE ... A LOOK AHEAD
In Part III of this book, we have discussed the naturalorganization of the market and how it works and considered the implications of the fact that market activity consists simply of human beings using the markets. We havegiven some insight into the kinds of human behavior exhibited in markets, and we have seen how market developed can be captured, defined and monitored.In the remainder of this book, we will apply this information to practical use by you, the reader, in your owntrading practice.Most trading books cover only mechanical methods orSystems, leaving the reader with a very limited and nonflexible base from which to develop. Instead, I'd like totake all the ideas we've discussed and use them to helpyou start on what I call the natural way to trade. It relieson the natural flow of information (understanding distributions) from the market, which, äs I think you'll find, isfar superior to any mechanical method, both because itallows for changing markets over time and because it provides a path for greater personal development by the individual trader.
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Trading is being young, imperfect and human; not old,exacting and scientific. It is not a set of techniques, but acommitment. You are to be an information processor.Your trading skills can be developed only by participating in the markets. You need to become a part of themarkets, to know the state of the markets at any giventime and, most importantly to know yourself. You need tobe/patient, confident and mentally tough.
fhe good trader offers no excuses, makes no complaints.(e lives willingly with the vagaries of life and the markets.
Start by becoming capital safe so that you can participatein the markets on an ongoing basis. Position yourself sothat you can't be knocked out of a market by a few setbacks.Continuous involvement prepares you to take advantageof any good opportunity that arises. It also contributes toyour self-confidence. It creates a safe environment in whichyou can experiment and learn, knowing that no experiencewill be a career-ending one.
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As your trading experience grows, you will begin to gaina feel for the market that enables you to sense changes ästhey occur, not after. You will develop the ability to recognize opportunities rather than going after dreamt-uptrades. You will learn to recognize when you are wrongeven before your dollar position teils you so. And you willbegin to see, time after time, that when you have exiteda trade it was usually the right move to make.In other words, you will begin to experience trading.
Now it is time to further sharpen and refine your skills —to work to learn. Try to develop a sense of the price/valuerelationship underlying the trades you make. You'll findthat there are only three possible price/value relationships:price may be at value, above value or below value. If yourtrades are not buying a price above value or selling a pricebelow value, your trading circumstances will be favorable;the effects of your mistakes will be muted, and it will berelatively easy to recover from them. Mistakes outside theseParameters can be disastrous and career ending.
Profile of the Successful Trader
Remember that you can learn a lot about trading from yourmistakes. When you make a mistake —and you will —don'tdwell on the negative. Take your lesson and keep going.
Never forget that markets are made up of people. Thinkconstantly about what others are doing, what they mightdo in the current circumstances, or what they might dowhen those circumstances change. Remember that whenever you buy and hope to seil higher, the person you seilto will have to see some opportunity at that higher pricein order to be induced to buy.
bu will need a sound approach —one that allows you towin at trading. It's best to try to win on the grind: Plan ontaking a small profit from a large number of trades, äs welläs a large profit from a small number of trades. Don't thinkf yourself äs a take-off artist; rather, think of yourself äsarketing an idea whenever you enter a trade.
Never assume that the unreasonable or the unexpectedcannot happen. It can and it will.
Traders who lose follow one of several typical patterns.Some repeatedly suffer individual large losses that wipeout earlier gains or greatly increase a small loss. Othersexperience brief periods during which their trading wheelsfall off; they lose discipline and control and make a seriesof bad trades äs a result.The wise trader makes many small trades, remains involved and constantly maintains and sharpens his feel forthe market. For all of this work, he hopes to receive some
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In the early stages of your trading career, don't worry toomuch about whether you should buy or seil, but ratherabout how you've executed whatever trade you've made.You'll learn more from your trades this way.
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profit, even if it is small in dollar terms. In addition, continual participation allows him to sense and recognize thefew real opportunities when they arise. These generate thelarge rewards that make the effort of trading truly worthwhile.
The program you follow must allow you to have reasonablepositive expectations; it must make trading fun and excitingfor you. If it does, you will find that the common complaints you hear about the anxiety of trading and the fearof pulling the trigger will not affect you. As your experience grows, your patience and confidence will also grow.You will learn to stand alone and to make the tough trades —but not the tough stupid ones.Discover what you do well consistently äs well äs whatyou do poorly. Find a base and build on it. This is howthe successful trader is made.
Although this chapter may appear complex, it is really verysimple. All I have to say here can be reduced to two basicprinciples. The first requirement for a successful trade isa good idea. The second is to effectively place that idea inthe/market under advantageous circumstances. This is alltl>ere is to successful trading. We could stop the chapterrjght here, but instead, we will develop these two ideasin detail. As we do, however, you should always remember this simple beginning because everything eise growsfrom it.
FROM AN IDEA TO AN OPPORTUNITY
Every good trade Starts with an idea. The idea will existin a sort of floating time frame in your mind, awaiting thecircumstances that will transform the idea into an opportunity. In a moment, we will get into some definitions andrequirements that will help you get started in developingideas, but your ultimate goal should be to make the processnearly instinctive. Realize that it takes time to be able toconsistently come up with good ideas; this is one reason164«
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we've emphasized making trades and participating in themarkets äs a necessary part of your training to become agood trader.An opportunity can be defmed in two ways. It can bedefined äs a price away from value or äs an identifiableSituation that is going to change or continue. As we'vealready noted, there are three possible price/value relationships in the marketplace: price may be at, above orbelow value. You must learn to track how the current priceis related to value at all times.A related concept—which at first may appear to be thesame idea —is the price/value conditions under which themarket is currently operating. In a fundamental sense, valueis equal to conditions. For instance, suppose a certain stockis priced at $10 and is earning $2 per share. Further suppose that the average multiple for the industry is five timesearnings. Under these conditions, we can say that the stockis priced at value. Any change in these conditions wouldobviously afFect the price/value relationship and could betaken advantage of by those who perceive it.In order to under stand the conditions under which themarket is currently operating, we need to use our knowledge of all the relevant economic and other factors. Anynumber of facts, trends, conditions, changes or elementscould be involved: a current increase in the demand forsoybeans; a declining Standard of living, causing diminishing consumption of red meat; expanding global supplies ofoil; political unrest threatening the continuing flow of goldand silver from South African mines —any of these, andmany more, could change the conditions of the market.Tracking such changes is tedious, time-consuming work,but it pays big dividends in terms of sound ideas for trading.
An easier method of determining the condition of themarket is to stucly a bar chart covering price data for oneor several past years. Compare the present price locationto the total, long-term ränge. Look at the price areas themarket moved away from quickly in the past, and comparethem to those areas in which the market historically spentthe most time. This process will allow you to ballpark thecurrent Situation; over time, with practice, you can acquirereasonable proficiency at it.To get closer to the market, work on understanding theprice/value relationship that the market is using or theconditions under which current opportunities are beingdisplayed. There are situations in which price moves sharplyaway from value because of some surprising event; in suchcases, the market usually falls back to value quickly.More common is the Situation in which price and valuemove generally together, although not in perfect unison;one will move ahead of the other or fall behind for a shortmme. This can occur during the growing season of a crop.For example, during 1988, the summer-long drought affected the quantity and quality of the growing crops, causing a price increase. While the price was rising, the cropwas deteriorating, so the value of the crop was increasingalso. Thus, both price and value were increasing, althoughnot always at the same speed. The difference between thetwo represents opportunity in the short term.The third and last kind of price/value conditions is theone most favorable to the trader. This is the one in whichvalue moves far away from price, either on the high sideor the low side. Here is where you should try to makeyour few large trades with the greatest profits. Such circumstances arise rarely. When they do, it is due to thebasic human tendency to avoid change. Because of this
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Whatever the reasons for them, we'll use these phenomena äs trading guides until the markets teil us otherwise.They serve äs useful reference points for implementing ouropportunities. Whenever possible, we'd like to have threeof these low-volume reference points above the market'semerging activity, and three below. This will allow us totake advantage of price äs it reaches any of these areas.Three areas are usually enough to contain the current ränge;it may expand to more in the future.The goal of the active trader is to take advantage of pricewithout paying a premium to implement the opportunity.Because of the opportunity time frame, these are goodreference points to use in dealing with opportunities thatyou may have missed. You may also find that, in an active,trending market, the market holds the first resistance areabelow; then, äs it tires, moves to the third resistance point.You'll develop a sense of this äs your experience grows.Suppose you think there's an opportunity to buy soybeans. Your first opportunity is to buy them at 7.75. However, you pass up that opportunity, for whatever reason,and the market subsequently moves up to 7.80. At thispoint, you commit to the market. Having had the opportunity to buy at 7.75, you are now paying a 5 cent premiumfor the right to go long, which really wasn't necessary. Sonow you need the market to develop further, which it mayor may not do.If the market Stalls, your trade will not be in äs favorablea circumstance at 7.80 äs it would have been at 7.75. Ifyou consistently pay this kind of premium over a largenumber of trades, your desired small profit will turn intoa small loss. Furthermore, you're missing the real goal ofthe trader: to take advantage of price opportunity. So learnfrom experiences like this, and develop the needed skills.
The next step in trade preparation is determining theactivity of the long-term buyers and sellers. This is coveredmore fully in the Market Profile section of this book, butwe'll touch on it briefly here.There are three forms of activity by long-term tradersthroughout the ränge for any day: activity at the tops andbottoms of the ränge (extremes); activity that causes themarket to move away from its first balance (ränge extension); and activity in the fair traded area (the TPO or time/price opportunity count). Take the last five days activity,and simply count the buying and selling activity in eachprofile. Suppose, over five days, you find ten forms ofbuying and three forms of selling, äs opposed to ten formsof selling and three forms of buying. This would establishdistinct set of conditions in which to market your trade,and it may influence you to act immediately or to wait forbetter conditions (see Figure 13-2).One point that many traders fail to grasp is the fact thatmajor market moves occur rarely. Thus, the opportunities — and the dangers — that large price changes representonly appear a small percentage of the time.Figure 13-3 offers a good example. This chart tracks aboutsix months of price activity in the Japanese yen market. (Asimilar chart could be created for almost any commodity.)Note that significant market moves only appear twice onthis chart: during a period of about five days in the latterhalf of June and during a period of about five days in midOctober. Thus, the market was moving significantly ononly about 10 of the 180 days shown in the chart. The restof the time, the market was trading within a narrow priceränge.To be successful, a trader needs to find these majormoves and take advantage of them — or at least, not be onthe opposite side when they occur.
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RESPONSIVE TRADES VS. INITIATING TRADES
loss or profit. Formulate your plan before entering thetrade, and stick to it.Your orientation to the market should include all possibilities. If you feel that there's no way Event X can occur,that's exactly when it is likely to happen. And it's likelythat everyone eise feit the same äs you; so when the unexpected takes place, everyone must react to it. The moral:be very cautious when you feel that you're 100 percentright about anything; what you've found is probably obvious not only to you, but to everyone eise äs well. Youalways trade best when you respect the market.Putting the trade on means getting your idea to themarket. The best kind of trade to make is the tough trade,which, paradoxically, can be both the hardest and the easiest trade to make. It is hard because you don't have a lotof Company when you make a tough trade, which makes itlonely. But when you are right, others will follow you,giving you a market to exit on. Thus, the tough trade makesyour trading easier in the long run.The area in which to make the tough trade is the firstor third Standard deviation of the