JKMNyABCDEFHIJKMNyABCDEFHIJKNyABCDEFGHIJNyABCDEFGHIyABCDEFGHIyABCDEFGHIyzACDEGHyzADEGHzEGzEGEE
Poor execution
Day 3AyAByAByAByzAByzAByzABBBBBBBCDBCDECDECDEFCDEFCDEFGCDEFGHCDEFGHCDEFGHCDEFHCEFHCEFHEHHMHMHMHMHMHMHMHIMNHIMNHIKMNHIJKMNIJKLMNIJKLMNIJKLMNIJKLMNIJKLMNIJKLMNIJKLNIJKLNIKLNKLNKLLLLL
Day 4FFEFEFEFGEFGEFGEFGEGHEGHILEHILMEHIJLMEHIJKLMEIJKLMNEIJKLMNEIJKLMNEIJKMNDEIJKMNDEJKMNDEJKMNCDKMNACDNACDNACDNABCDNzABCDzABCzABCzABCyzABCyzABCyBCyBCyByByByyyy
Market auctions aboveprevious day's high toexplore. Auctionuncovers responsivesellers.Rectanglerepresents good daytimeframe execution.
Rectanglerepresentsgood execution.OpeningMarket openslower but fails totake out prior low,leaving single printbuying tail.
FIGURE 7.1 Analyzing the previous day’s activity: Multiple daily proﬁles.Source: Copyright ľ 2006 CQG, Inc. All rights reserved worldwide. www.cqg.com.
direction and conviction of the trend. All of this information should beknown but kept in the background; too much attention to specific details can blur your short-term analysis. After the market opens, you shouldbe looking for a place to sell above value relative to the previous dayif you’re looking to short, or buy at or below value if you’re lookingto buy.Markets are much more understandable if you think of price as simplyan advertising mechanism; you want to learn how to gauge the market’scollective response to each ad, as it were. Unfortunately, most traders focus solely on price, not its qualifications, and it’s no secret how “most”traders perform, in the long run.
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On Day 4 in Figure 7.1, the market opened by advertising price belowthe value area for the previous day. This price was quickly accepted byresponsive buyers, as evidenced by the single print buying tail in y period.Buyers would need to act quickly on this day, while sellers would probablyhave time on their side. Which brings up an important (and oft-mentioned)point: probability and intelligent risk/reward are not the same thing. It isnot unusual, for example, for me to correctly assess that a market has extremely high odds of auctioning upward, yet I’ll be in the process of shorting that same market. Why? Because the current, short-term auction, whilebullish, may ultimately be providing a greater, lower risk opportunity toplace a short. This is applicable to all timeframes. What we’re saying, inthis case, is that while the odds of the market continuing higher in the veryshort term are good, the amount of price appreciation remaining is relatively small in relation to the risk of price destruction, once the currentauction ends.For example, let’s estimate the odds of the market moving higherat 75 percent with the potential to earn an additional 3 percent. However, because the upward price movement is occurring very late in theoverall auction, a break from this level could easily produce a 20 percent loss. As this is being written, the New York Times is reporting thatsmall caps are down more than 10 percent and emerging markets morethan 20 percent since the beginning of May. There was clearly a point,while these markets were topping out, when late investors were buying and still seeing gains. However, the potential reward—relative to therisk—was not acceptable. In fact, an auction usually isn’t over until wesee one last upward spike that draws in the remaining buyers (Gladwell’slaggards).When we use the term odds, we’re not referring to odds calculatedvia prescribed rules of mathematics, but odds based upon logic. If higherprices are causing investors to become less aggressive in their buying, thenlogic says that the auction is likely to stall and eventually reverse. If higherprices are causing investors to become more aggressive, then logic saysthat the auction is likely to continue, perhaps even accelerate. What we’redescribing is a process based on how we observe investors’ actions as theyare manifest in a multidimensional graphic that combines price, time, andvolume—the market profile.As we move deeper into our discussion of short-term trading, wewill continually examine how trade location determines the risk ofchange inherent in each trade. We are always in search of asymmetricopportunities—which simply means that the odds of success are greaterthan 50 percent, and that the potential win would be greater than the potential loss. In fact, if we were to rank the importance of the information we have shared with you here in Markets in Profile, the concept of
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asymmetric opportunities would rank right at the top—it’s the theme ofsuccessful investing.
COMMON MIND TRAPSAn important element of successful short-term trading isunderstanding—and avoiding—some of the common traps your braincan set for you. The first is a natural tendency to believe that if something has been occurring for some time—a trend relevant to yourtimeframe—then it is likely to continue. You believe that repetition iseffectively predicting future events, and with this insight into the futureyou establish a trade in the direction of the trend. We have provided amplematerial to support a case for making better judgments, but memoriesare short, and the longer something has been reiterating, the less risk isinvolved (or so we imagine). We recently experienced this in the emergingmarkets, which rose by approximately 20 percent in the first four monthsof 2006; gold increased in value by approximately 40 percent and copperprices doubled. But of course investors didn’t concern themselves withrisk, choosing instead to focus solely on return. Was there a way forshort-term traders to participate in these advances, as well as the ensuingbreaks that carried these markets sharply lower? Yes, indeed—by applyingthe same auction logic we’ve discussed throughout the book, and notcaving in to the immediacy of emotional wish fulfillment. As long as higherprices continue to attract more volume and the consecutive balance areasare distinctly higher, then the odds of the auction continuing upward arehigh. Similarly, as long as lower prices continue to attract more volumeand the balance areas are distinctly lower, then the odds of the auctioncontinuing downward are high.The second trap investors fall prey to is over-simplifying the data,which can have the effect of providing a view directly opposite of whatis actually occurring, which can of course lead to the mismanagement ofopportunities and risks. For example, since Market Profile was first formally introduced by the Chicago Board of Trade in 1982, numerous services have sprung up that attempt to offer trading services based on thisinnovative tool. These services claim to provide you with hard and fastrules about what to do with each market profile pattern, such as buyingand selling tails, range extension, etc. They will also attempt to predictthe range of each time period, based on the “average” of these time periods in the past. There’s an old adage about the man with his head in thefreezer and his feet in the oven who says “Well, my average temperature isjust right.”
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But there is always the hope that this time it’s different.It is human to crave predictability. Unfortunately, predictability—likebeing average—can be the end of your trading life. Everything is alwaysdifferent, to some degree. Context is always changing. You can’t be successful over the long haul by applying formulated solutions to a market inconstant flux.We believe that success relies heavily on one of two things: being in theright market at the right time, and/or having the right skills for the currentmarket cycle. There are great bull-market traders and there are great bearmarket traders, but how often are they one and the same? There are phenomenal volatility traders and there are those traders who fold when themarket heats up. In short, we realize that different skills are better adaptedto certain types of markets, but the way to increase your odds of long-termsuccess is to become a whole-brained trader, with skills that apply to anytype of market. It all starts with looking at the right information in the rightcontext and developing an objective, probability-based approach to trading.
WHEN AND WHERE TO LOOK FORSHORT-TERM TRADESWe can teach and study endless details, but never make the markets cometo life. The market profile enables us to see these details in their propercontext by giving form to market activity. To make sense of this information, it’s important to be involved in the process that forms the profile.Those who stay with it will soon begin to visualize the completed profilebefore the day is over. When this first happens, you will experience thejoy of creativity, just as you’re making a nonlinear leap in your learningprocess.It should be clear by now that the one thing the market is not ispredictable. It would be comforting to describe specific patterns to lookfor, as well as hard rules on what to do when those patterns occur. Unfortunately, it’s not that simple—every day the market opens and is influenced by new circumstances, new participants, new contributing factors. In short: everything is always different. This is especially true inshort-term trading where every piece of new information is important,and may or may not influence market behavior. Thus, for much of thebalance of this chapter, we will take you through a series of short-termtrading opportunities—as they unfolded—providing you with access to thethinking, analytical framework, and play-by-play commentary of real-lifescenarios.
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OPPORTUNITIES AROUNDINTERMEDIATE-TERM BRACKETSGood short-term trades often occur within, or on the fringes of,intermediate-term brackets, and might include the following . . .Ĺ Breakouts from balance. Figure 7.2 shows a breakout from a balancearea following an inside day (an inside day occurs when the most recent day’s range is entirely contained within the previous day’s range).This scenario can be a high-probability trade. As Figure 7.2 shows, thekey is to monitor the auction closely for continuation once the breakout occurs.Ĺ Fading bracket extremes. Nonsymmetric trading opportunities—thosethat offer significantly higher potential return than risk—are oftenafforded by fading (going against) a recent auction in which price“hangs” at one of the extremes of a range defined by multiple daysof overlapping value. It is the opposite of a breakout trade, when priceauctions to one extreme of the balance on decreasing volume.Ĺ In Figure 7.3, the market rallied to new recent highs and then bids simply dried up. Because it often takes traders some time to get over theinfluence of price, the market will just hang around like this until therealization grows that the rally is over. And once this realization sinksin, you have limited time to act. Homework is a beautiful thing.Ĺ Bracket breakouts. Figure 7.4 shows a breakout from an intermediateterm bracket—an identical trade for intermediate and long-termtraders (versus breakouts from balance areas); at major breakouts,multiple timeframes converge and volatility increases.I don’t have hard and fast definitions for “intermediate term” or “longterm,” but I’m willing to go with nearly any breakout from balance. Likewise, I will fade a balance area extreme if volume doesn’t support theauction’s advertisement at that price level. And then there are those occasions where the market is in total balance and volume doesn’t discloseany meaningful information, in which case I simply wait for a new auctionto begin.
TECHNICAL INDICATORSWe observe the market’s behavior around key technical indicators (ratherthan rely on the technical indicators themselves) as yet another piece of
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Double exampleBBBBBBCBCBCDBCDGHIBCDFGHICDEFGHIDEFGHIEFGHIKLEFGIJKLNEFIJKLMNEJKLMNJKLMNLMNMNMN
GGGHMGHILMEFGHIJKLMCDEFGHIJKLMCDEFJKLMCDEFJKMCDEJKMNCDKMNBCNBCNBCNBCNBCBBB
Second day is aninside day, anotherform of balance.
Two days of overlappingvalue, short-term market isbalanced.BBBBBCBCBCBCMNBCMNCMNCDEMNCDEMNCDEMNDEMNDEMNDELMEGHLMEGHJKLMEGHIJKLEFGHIJKLFGHIJKFGIJKFGIJFIFFF
FIGURE 7.2 Breakout from balance following an inside day: Multiple daily proﬁles.Source: Copyright ľ 2006 CQG, Inc. All rights reserved worldwide. www.cqg.com.
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Just hanging out
LMN
LLKLNKLMNJKLMNIJKLMNHIJKHIJGHJGHFGFGFGEFGEFCEFCECDECDEBCDEBCDEBCDBBBBBB
BCDBCDBCDBDBDBDFGHIBDEFGHIBDEFHIJLMBDEFJKLMJKLMNMNNN
NLMNLMKLEKLEFHIKEFGHIJKEFGHJKDEGBCDBCDBCDBBB
BBCDEMBCDEFGHIJKMBCDEFGHIJKLMBCDFGJKLMBCKLMBKLMNKLMNKLNKLNKLLLL
Big rally and marketjust hangs around andexplores recent highswith no success.
BBBBBBBBBCBCCCCCCDCDCDEDEEEEEIEHIEFGHIEFGHIFGHIGHIGIJKGIJKJKMKLMLMLMLMNLMNNN
Once bidscease todominatemarket, marketwill auction(explore) inthe oppositedirection.
BCBCBCBCDBCDEBCDEGBCDEFGBDEFGHBDEFGHBDEFHBDFHKBDFHIKLBHIKLMIJKLMIJKLMIJKMNJKNN
FIGURE 7.3 Bracket extreme in the S&P 500: Multiple daily proﬁles.Source: Copyright ľ 2006 CQG, Inc. All rights reserved worldwide. www.cqg.com.
market-generated information. In many ways, technical analysis is the antithesis of how we approach markets and trading because it fails to include time and volume, which enable the visualization of market structure.A classic example would be a moving average, which is one of the most
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Upside breakout
Longer balance area, whichcould be intermediate-termdepending upon yourtimeframe.
FIGURE 7.4 Breakout from an intermediate-term bracket: Daily bar chart.Source: Copyright ľ 2006 CQG, Inc. All rights reserved worldwide. www.cqg.com.
popular technical tools. A simple moving average is constructed by usingthe average price of a tradable security over a defined period of time. Afive-day moving average, for example, would be calculated by adding theclosing prices for the past five days and dividing by five. Our aversion tomoving averages is based on the fact that they treat all prices as equal; theyfail to distinguish between prices made on low or high volume and whatdirection the market was attempting to auction that day, which can resultin very misleading information.Let’s expand on moving averages by examining Bollinger Bands, whichare based on the classic idea that price will revert to the mean. The bandsconsist of two channels and a center line, which represents an exponential moving average. The bands represent a standard deviation above andbelow the moving average, which is considered the true value, or mean.The upper and lower bands then become price targets. In an upward trend,for example, when price rotates to the lower band, the security is thought
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to be oversold, which indicates a buying opportunity. Our concern is thatthe moving average is based on price alone, which doesn’t give a true picture of how the mean migrates. The market profile is based on time, price,and volume, which provides a more comprehensive means of observing themean’s progression.We have similar concerns about mathematically derived technical indicators like Fibonacci numbers. This doesn’t mean such indicators areinvalid; in fact, we follow many of them closely because they can providesolid trading information. For example, recently the S&P 500 was tradingaround its 200 day moving average, and as a result there was increasedvolatility due to the fact that this moving average is widely followed byinvestors, traders, and hedge fund managers. For example, in May–June2006, many of the market experts thought that the 200-day moving averagewould support the May–June 2006 market break. What we saw via marketgenerated information and the market profile was that as the market auctioned lower, volume increased, while on rallies volume decreased—datathat suggested the 200-day moving average would be taken out, which isexactly what happened (and quickly). The fact that a large number of market participants are focusing on a certain level or indicator increases theodds that we will at least witness increased volatility when that indicatoris in play, and with volatility comes opportunity.There were certainly successful traders in the world long before Market Profile arrived. We maintain, however, that successful traders have always understood that higher prices on decreasing volume will eventuallyspell trouble. It doesn’t require studying a profile to realize that as you approach any market reference point—whether it be a long-standing high orlow or a standard technical indicator—it is more likely to be taken out ifvolume is increasing, and more likely to appear to be a meaningful supportor resistance level if volume is decreasing.
YOUR OWN WORST ENEMY: YOUR BRAINShortly after I began trading, I began to understand that I was often myown biggest adversary. I took the standard path and began to read a lotabout psychology, which eventually led me to neuroeconomics—whichcombines psychology, economics, and neuroscience—to discover how wemake choices. This study helped me better understand how humans learnand evaluate, and how the chemistry of the brain affects our decisionmaking process. It is well beyond the scope of this book to provide realdepth to these subjects. However, we will suggest that your success in themarkets can be highly dependent on your understanding of how your brainprocesses information; the more you comprehend the brain’s workings, the
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more you’ll be able to understand the true nature of your trading decisions.You might also come to learn when it might be necessary to rewire yourbrain to get past unproductive tendencies. We bring this up here becausewe suspect that distinguishing between price and value may be extremelydifficult for some, requiring not only learning something new, but also unlearning modes of thinking that have become second nature.In Mozart’s Brain and the Fighter Pilot: Unleashing Your Brain’s Potential (New York: Harmony Books, 2001), a book we highly recommend,Richard Restak, M.D. writes, “[C]ognition refers to the ability of the brain toattend, identify, and act.” He includes among the components of cognition:perceptual speed, learning, memory, problem solving, and creativity—allof which, in our opinion, are utterly necessary to successful investing/trading.We have discussed the importance of maintaining a balanced perspective, and how monitoring market profile structure helps maintain that perspective, especially when viewing both daily and multiday profiles. “Experts are not only better at putting things into perspective,” Dr. Restakpoints out, “but quicker at detecting when they are starting to lose thebig picture.” We have talked a lot about timeframes that coexist, occasionally merging together and causing large, nonlinear moves. I have been wellserved by continually making sure that I can mentally keep the timeframesseparate; significant losses are often a result of allowing the timeframes toblur together—losing the big picture.When I first heard the phrase cognitive dissonance, a condition of conflict or anxiety that results from inconsistency between one’s beliefs andone’s actions, I paid it little heed. I considered it nothing but a psychological term that clearly didn’t apply to me. However, following several periods of extremely shaky trading, I realized that several of the trades thathad caused me the most harm clearly went against my analysis. I had seenthe opportunity correctly and my timing had been good, but when the timecame to act, I couldn’t pull the trigger. On more than one occasion, I didpull the trigger, but in direct opposition to what my research was tellingme to do. Delving into behavioral science literature and neuroeconomicshelped me greatly reduce the negative effects of cognitive dissonance.For example, once I began to understand what neuronal networks areand how they’re formed, I made several trading breakthroughs. Neuronalnetworks begin to form as the brain encodes our repeated experiences.This occurs as the result of practice over time. As I correctly viewed andacted on market-generated information, it became better encoded in mybrain and assisted me in overcoming cognitive dissonance. “Over severalgames,” to quote Dr. Restak again, “but not necessarily in a single game,these networks will prove superior to the trial-and-error approach of thenovice.”
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Some may take issue with referring to investing and trading as a game.However, we agree with the idea of game as defined by Sid Meir, designerof the classic “Civilization” computer games, that is, “a series of meaningful choices.” Meir’s definition also helped me develop a better understanding of how stress impacts performance. Today, because I’ve learnedto handle stress (only occasionally do I now swear at the computer screen),it’s difficult for someone in the same room with me to know if I’m “doingwell” or not. The point I’m trying to make is that learning must begin withunderstanding—to play any game, you have to understand the game. To besuccessful, you have to become a lifelong student of the game, immersedin the markets with an open mind and an inquisitive spirit. Of course, youcan also choose to be a spectator, someone who knows a lot of interestingfacts, able to recite all kinds of impressive statistics. But the fact remains:spectators can’t play the game.
SEEKING THE “EXCEPTIONALLYTASTY PATTERNS”Many of the really good trades require that you place your trade responsively, fading the most recent move—which makes you a contrarian. As acontrarian, you are no longer part of the crowd. You may have to standalone, occasionally incurring the doubt or even rancor of your friendsand associates. By reading extensively about the brain and the way ourdecision-making process works, I have managed to increase my confidenceto a level that enables me to place trades with less stress and cognitivedissonance, particularly those trades that fade the most recent market direction. Self-control is mandatory when markets begin to run hard; in thepast, when I wasn’t operating from a place of calm self-control, I wouldhave trouble accepting the fact that I had missed a big move, sometimesgetting in late with poor trade location and excessive risk.Let’s look at some real examples of market structure that providedexcellent trading opportunities, as well as the emotional complexities eachengenders. First, we’ll examine the development of countertrend auctions.Prior to the start of the countertrend rally, just one full-size S&P 500futures contract had declined $21,000 (see boxed area in Figure 7.5). If youhave never traded, it will be difficult to relate to the emotions that thiskind of volatility inspires. Even experienced traders will suffer the pulsepounding effects of an adrenaline surge when the market travels that kindof distance in such a short period of time, making it increasingly difficultto maintain emotional control and objectivity. Understanding this naturalhuman reaction, I seldom trade the first countertrend auction following asignificant directional move. The emotional G-forces are just too intense.
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S&P 500 June 2006Futures contract
Boxed area showsnonlinear break.
After storing the imageof thenonlinear break in yourmind, go to Figure 7.2.
FIGURE 7.5 Countertrend rally occurring in the S&P 500 (after the nonlinearbreak): Daily bar chart, June 2006.
Figure 7.6 serves several purposes. First, it offers a review of the upside breakout that began in November of 2005 and ended in May 2006. (Thisis the same period shown in Chapter 6, which enables us to maintain thematic continuity.) Second, it allows us to more easily visualize market behavior during the upward auction from November 2005 through May 2006so that we can better understand how this behavior reverses once it becomes clear that the intermediate-term auction has changed course, turning down. Third, it reveals the first meaningful low that occurred after thenonlinear, downward auction.The low on May 24 marks the beginning of the first countertrend (upward) auction. After the excess low is established, it is difficult to knowhow long the countertrend auction will last. In this example, however, it issafe to assume that the first countertrend auction will not carry very far,as the market has just plummeted so sharply that it will most likely takesome time for it to come into balance, giving everyone time to catch theirbreath. I prefer to wait and study the first countertrend auction, extractingas much information from it as possible. If this turns out to be a longerterm low, there will be plenty of good trades down the road. Now let’s takea more detailed look at the countertrend auction via the market profile.
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May 2006 high
Mode has changedsell rallies.Buy breakBuy break
May 26
Buy breakBuy break
May 242006 firstmeaningfullow
Nov 2005 upsidebreakout
FIGURE 7.6 Longer-term upward auction and subsequent nonlinear break occurring in the S&P 500: Daily bar chart, November 2005 through May 2006.
From the November 2005 upside breakout until the May 2006 high,buying every break eventually rewarded traders with higher prices.Traders—like everyone—have a habit of doing something until it doesn’twork anymore. It would follow that once it became clear that theintermediate-term trend had turned down, the expected trader behaviorwould be to switch to the opposite strategy, selling rallies and repurchasing on breaks. Figure 7.6 shows the first meaningful low, following the May11 nonlinear break, occurring on May 24—the low that marks the beginningof the first countertrend auction. Let’s put the countertrend auction undera microscope by examining the auctions through the market profile.The low occurred in J period, and the market closed clear back up inthe top quarter of the profile. On the following day, the market establishedclearly higher price and value. (We are always more interested in valuethan price.) The solid line to the right of each profile marks the day’s valuearea. Notice that Day 2 is fairly elongated, which tells us that prices wereauctioning higher with ease. Volume was approximately 1.6 billion, which,from our earlier guidelines (1.6 through 2 billion being the normal range)is light. The light volume should alert you to the fact that the upward auction attempt is weak. However, individual indicators must always be considered within the larger context—the market closed on the high and theday’s profile was elongated, which means that the odds would suggest thatthe rally is not complete. As an investor or trader, you should continuallycollect and process information as each auction unfolds before you. It is
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quite common to observe that some of the information you collect contradicts other information, a phenomenon that is often caused by differenttimeframes responding to different criteria. Remember, it is common tohave an intermediate-term auction going one way, and either a shorter- orlonger-term auction going another direction. Notice in Figure 7.7, on Day3 of the rally, how the profile becomes squat (from high to low) and wide(from left to right), which suggests that the countertrend rally is ending, orhas ended. In addition, the day had light volume—another indication thatthe rally is coming to an end. This was a three-day, short-term trade thatshould have been exited on Day 3. Light volume provided an early warningon Day 2, and the shape of the profile and another light-volume report onDay 3 indicated that the odds of continuation were low. Counter-auctions,which by definition are against the trend, generally require quicker exits.Before and after you place a trade, the most important question to askis this: How much confidence is the market exhibiting to support yourtrading decision? Some of the factors to monitor in order to better understand the market’s confidence are:Ĺ Attempted direction—which way was the market attempting to go?Ĺ Volume associated with the directional move.Ĺ Value area placement—overlapping-to-higher, higher, unchanged,overlapping-to-lower, or lower.Ĺ Shape—was the profile elongated, symmetrical, or squat?As we have said, the market profile enables you to see the structureof unfolding market activity. And over time, your experience will enableyou to recognize partial patterns that enable you to visualize how the day’sauctions might unfold. We are always seeking to identify trades that enablean advantageous risk-reward relationship. It is impossible for the humanbrain to accurately digest, comprehend, and analyze the dense thicket ofinformation that influences the market from moment to moment. But thebrain has evolved to be remarkably adept at recognizing patterns, and themarket profile captures the complex and everchanging interconnectionspresent in the market in patterns that can be recognized and understood inan intuitive way.Ralph Koster, author of A Theory of Fun for Game Design (Scottsdale, AZ: Paraglyph, 2004