’ve been discussing, you’d have found evidence that just the opposite was true. During this frenzy of market volatility, if you were ableto acknowledge your emotions as a product of herd mentality and newshype, instead focusing your empirical mind on the patterns being revealedin market structure—revealed by organizing purely market-generated information via the market profile—you would have seen that the marketwas struggling mightily on the downside.
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NNBNBMNPBMNPBMNPBCMNPBCMNPBCMNPBCLMNBCLMBCELMBCELMBCDELMBCDEKLMCDEJKLMDEJKLMDEJKLDEJKLEJKEHJKEHJEGHJEGHIJEFGHIJEFGHIJEFGHIEFGHIEFGHIFGIFGFFFFF
BCDEFLBCDEFLBDEFLBDEFGHKLMNBFGHKLMNBFGHKMNBFGHJKMNFGHJKMNFHJKMNHIJKNHIJNIJNIJNPIJPIP
Day 13BBBCBCBCDEarly warningCDFGCDFGCDFGHICDEFGHICDEFGHIJCDEFGHIJKCEFHIJKCEFHJKEJKEKKLDay 14KLBKLMBLMBLMBMBFMBCFGMEarly warningBCFGMNBCFGMNBCFGNBCFGHNBCDFGHNPBCDEFGHNPBCDEFGHIJPBCDEFGHIJKPBCDEHIJKNDay 15BCDEIJKMNBCDEIJKMNCDEIJKMNCDEIJKLMNBCNPDEIJKLMNBCDNPEJKLMNBCDNPJKLMNBCDEFGNPKLMNBCDEFGKNLMNBCDEFGHIKNLMNBDEFGHIKNLMNBDEFGIKNLMNBDEFGIKLNLMNBEIKLMNMNBEIJKLMNMNPBIJKLMMNPIJKLMMPIJLMPIJLJLJLL
NNNNPNPNPNPNMNMNLMNLMLMLMLMLKLKLKLKKKKDEJKDEFHJDEFGHJDEFGHIJDFGIJCDIJCDJBCDJBCGapBCBCBBBB
Day 16
Balanced day
FIGURE 7.13 Further analysis of the nonlinear break and countertrend ralliesoccurring in the S&P 500: Multiple daily proﬁles.Source: Copyright ľ 2006 CQG, Inc. All rights reserved worldwide. www.cqg.com.
NEVER BE A LAGGARDWe have spent a good deal of time discussing the notion of timeframesand conflicting information. Trading is extremely difficult when you aren’t
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able to separate the actions of the various timeframes; oftentimes, whatappears to be “conflicting” information is simply information coming fromtimeframes with different motives conducting business on the same day.Days 14 and 15, for example, offer excellent day-timeframe opportunitiesand poor intermediate-term opportunities. For the five days prior, evidenceaccumulated that suggested intermediate-term shorts were late in the auction process, and any new shorts placed during these days had poor tradelocation. Auctions generally have to complete themselves, which leads tothe situation we discussed earlier when the odds are high that the marketmust continue in the direction of current auction, but that the risk/rewardrelationship inherent in trading with that direction is extremely poor.On Day 16, all the conflicting, compounding information finally overwhelmed the market, which gapped higher and nearly took back the previous five days in one elongated trend day. Returning to Kuhn’s description ofmajor transitions, such shifts occur when new circumstances violate whathas been considered “normal” by all those invested in what was previouslyconsidered status quo—in this case, the downward auction. On Day 16, thetransition was universally recognized as the market shot upward, leavingthe late majority and the laggards holding the bag.When I’m analyzing any auction for any timeframe, the key issue I focus on is this: What are my competitors doing? For example, as the kindof conflicting evidence discussed above begins to mount, I try to discernhow much money is getting short at disadvantageous levels, often referredto as “getting short in the hole.” Experience has taught me that that thosewho get in late are the first to exit—as in accounting, last in first out. This isweak money and unlikely to have staying power. The nonsymmetric shapesthat we have been labeling “early warnings” not only tell us that the market is struggling as it goes lower, but should also cause us to ask “Why isit struggling?” The answer is often because there are patient, longer-termbuyers who are gradually but steadily accumulating inventory—inventorythat they’re willing to hold for a long time. It’s not uncommon, particularlyin intermediate-term auctions, to see this process occurring over severaldays before it becomes unmistakably evident to a broader participant base(the late majority and laggards). These are the conditions that lead to reversals, or at least meaningful corrections.
A GOLDEN OPPORTUNITYWe’ve made a pretty strong case that a healthy trending market trends,then stops and balances, then trends again. But it doesn’t always happen this way, particularly when speculation takes over like it did in gold
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0=H=L=C=∆=
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Point 1
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Gold makes newcontract high
7000
Notice the lack ofbalancing areas asgold skyrocketed inprice.
6750
6500
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The intersection of the verticaland horizional lines representthe volume for gold on the lastupside breakout.
11 May 060=7190H=7360L=7160C=7286
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Total Vol
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988735996050000Vol =102290Dec17 24 0114 21 01 12 19
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AprMarFeb23 01 13 21 01 13 20 27 03
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14 21
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01 11 18 25 02 09 16 23 01
Dec
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P003
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FIGURE 7.14 Upward trend in Gold driven by speculation: Daily bar chart, December 2005 through June 2006.Source: Copyright ľ 2006 CQG, Inc. All rights reserved worldwide. www.cqg.com.
during the first half of 2006. Due to extreme speculation, the market neglected to stop and balance along the way; when such speculative tradesare unwound, a freefall can result. Let’s examine the relatively rare instances in which trades can start out as short-term positions and thenevolve into much bigger opportunities.At Point 1 in Figure 7.14, gold topped out in much the same way theS&Ps did back in May 2006—gold made a new life-of-contract high on substandard volume. The arrow at the bottom of Figure 7.14 points to volumeon the day that we’re discussing. As you can see, the volume was well below the range that high-volume days can generate in this precious metal.Notice that gold rose from about $580 an ounce to about $750 withouta prolonged balancing period. This is usually a sign of extreme speculation, which can end badly for those who arrive late, or those who get inearly but continue to build on their positions, and for momentum players.Balancing periods are healthy and important, in that they allow the marketparticipants to “catch their breath” and reevaluate value before proceedingonward. Balancing periods enable you to judge the structure of the market in order to determine how much more momentum is remaining in the
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dominant auction. Periods of balance create what are akin to “marketmemory.” Once a market begins to fall (or rise in the converse), previousbalance areas will often provide some level of support (or resistance), serving to slow price down as market participants assess whether this area ofpreviously accepted value is still relevant.Without this balancing process, there is no structure to support a market. Once a market begins to fall, for example, the balance areas act likeelevator stops—they may not completely stop the fall, but they will usuallyprovide a pause in the downward auction that offers enough time for youto exit a trade, or at least judge where you are in the larger decline.Returning to Figure 7.14, anyone who was monitoring the volume during the final run-up in gold at Point 1 and placed a short-term short, quicklydiscovered that all timeframes had joined in the selling. With no structureto provide support to a downside break, what might have begun as a shortterm trade can blossom into a meaningful, long-term trade. For those whoinsist on buying into markets with no underlying structural support, wesuggest you do it with options rather than outrights.
FADE THE EXTREMES, GO WITH BREAKOUTSGood short-term trades often present themselves when a market has comeinto balance. Such markets usually provide two opportunities: fading anauction that reaches one of its bracket extremes and fails to continue; andgoing with a breakout from the balance area. Figure 7.15 demonstratesboth of these possibilities.Day 1 of Figure 7.15 is a trend day that has moved sharply higher. Youcould reasonably expect that a move of this magnitude should show someadditional upward price appreciation. You can also assume that much ofthe buying that drove the stock higher during the initial trend day occurredlate in the day, as that is where the market profile begins to take shape (thecircled area); the lower portion of the profile is thin, which indicates pricewas moving rapidly without much time for volume to attach to it.Day 2 established a very narrow value area that was totally containedwithin the upper portion of the value area from Day 1. At this point, youshould be thinking about the mindset of the buyers from Days 1 and 2—arethey satisfied? Are they frustrated? Know your competitors, and stay onestep ahead of the game.Day 3 opened slightly above the close on Day 2, trending higher all dayand closing with a late upward spike. When the day was complete, valueonly managed to be overlapping-to-higher, and the shape, prior to the latespike, exhibited the familiar p shape of short covering; it’s clear that MER
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DAY 3DAY 1LLLLNKLNKLMNKLMNJKLMNIJKLMNHIJKNHIJHIJHJGHGHGFGFGFGFGFGEFEFCEFCECECDECDECDECDEBCDEBCDEBCDBBBBBBBBB
DAY 2DBCDBCDBCDBDBDBDBDHBDFGH IBDEFGH IBDEFH I JBDEF JLMBDEF JLMBJKLMKLMNMNNNN
NLMNLMLLKLEKLEFKEFGH I JKEFGH I JKEFGHJKDEGHDCDBCDBCDBCDBCBBBB
DAY 5
DAY 4BBBCDEMBCDEFGMBCDEFGH I JKMBCDEFGH I JKLMBCDFGHJKLMBCDJKLMBCKLMBKLMBKLMNKLMNKLNKLNKLNKLKLLLLLL
3-Day balance
Trend day uplarge advance
Trend day
Compare trendday, which ismore elongated
Trend day
BBBBBBBBBBBBCBCBCCCCCCCCDCDCDCDEDEDEEEEEEIEIEHIEHIEFGHIEFGHIFGHIFGHIGHIGIGIJKGIJKJKJKMKLMLMLMLMLMNLMNLMNMNNNN
High confidenceselling,single printsfrom opening bell
Downside breakoutfrom three daysof balance
FIGURE 7.15 Bracket extreme and subsequent breakout from balance occurringin the S&P 500: Multiple daily proﬁles.Source: Copyright ľ 2006 CQG, Inc. All rights reserved worldwide. www.cqg.com.
(Merrill Lynch) is having difficulty advancing. Price traders probably feltgood at this point, as everyone who bought within the past three days hasgone home with a profit.Day 4 opens on the high and establishes inside value, with price closinglower at about the same closing level as the original, upward trend day.
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Days 1-4combined intosingle profileNLMNLMBLBDLBCDEMLBCDKLBCDEFGMLBCDEKLBCDEFGHIJKMLBCDEFKBCDEFGHIJKLMLNBDEFGHIJKBCDFGHJKLMKLNBDEFGHIJKBCDJKLMKLMNBDEFGHJKBCKLMKLMNBDHDEGHBKLMJKLMNBDFGHIDBKLMNIJKLMNBDEFGHICDKLMNHIJKNBDEFHIJBCDKLNHIJBDEFJLMBCDKLNHIJBDEFJLMBCDKLNHJBJKLMBCKLGHKLMNBKLGHMNBLGNBLFGNBLFGNLFGLFGFGEFEFCEFCECECDECDECDECDEBCDEBCDEBCDBBBBBBBBB
Could you visualizethe combinedprofilefrom looking atindividual days?
BBBBBBBBBBBBCBCBCCCCCCCCDCDCDCDEDEDEEEEEEIEIEHIEHIEFGHIEFGHIFGHIFGHIGHIGIGIJKGIJKJKJKMKLMLMLMLMLMNLMNLMNMNNNN
BCBCBCBCBCBCDBCDEBCDEBCDEG
FIGURE 7.16 Multiple-day proﬁle for the Days 1–4 shown in Figure 7.15, followed by the activity on Day 5: S&P 500 proﬁles.Source: Copyright ľ 2006 CQG, Inc. All rights reserved worldwide. www.cqg.com.
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Day 3Day 1LLLLNKLNKLMNKLMNJKLMNIJKLMNHIJKNHIJHIJHJGHGHGFGFGFGFGFGEFEFCEFCECECDECDECDECDEBCDEBCDEBCDBBBBBBBBB
Day 2DBCDBCDBCDBDBDBDBDHBDFGHIBDEFGHIBDEFHIJBDEFJLMBDEFJLMBJKLMKLMNMNNNN
NLMNLMLLKLEKLEFKEFGH I JKEFGH I JKEFGHJKDEGHDCDBCDBCDBCDBCBBBB
Day 5
Day 4BBBCDEMBCDEFGMBCDEFGHIJKMBCDEFGHIJKLMBCDEGHJKLMBCDJKLMBCKLMBKLMBKLMNKLMNKLNKLNKLNKLKLLLLLL
3 Day balance
Trend day uplarge advance
Trend day
Compare trendday, which ismore elongated
Trend day
BBBBBBBBBBBBCBCBCCCCCCCCDCDCDCDEDEDEEEEEEIEIEHIEHIEFGHIEFGHIFGHIFGHIGHIGIGIJKGIJKJKJKMKLMLMLMLMLMNLMNLMNMNNNN
High-confidenceselling,single printsfrom opening bell
Downside breakoutfrom three daysof balance
FIGURE 7.17 Bracket extreme and subsequent breakout from balance occurringin the S&P 500: Multiple daily proﬁles.Source: Copyright ľ 2006 CQG, Inc. All rights reserved worldwide. www.cqg.com.
How do you think all the price traders who bought during the previous fourdays are feeling at this point? Before we continue, take a look at Figure7.16, which combines the four days we have just discussed.
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EHIEHIEFGHIEFGHIFGHIFGHIGHIGIGIJKGIJKJKJKMKLMLMLMLMLMNLMNLMNMNNNN
Day 5 from Figure7.15
BCBCBCBCBCBCDBCDEBCDEBCDEGBCDEGBDEFGBDEFGHBDEFGHBDEFHBDEFHBDFHKBDFHIKBDHIKLBHIKLMIKLMIJKLMIJKLMIJKLMIJKLMJKNJNNNN
Downside continuationfollowing elongatedtrend day
BCDBCDEBCDEFBCDEFBCDEFBCDEFGBCDEFGMNBCDFGHIMNBCGHIMNBGHIMNHIMNIMNIJMNIJMJLMJKLMJKLMJKLMJKLLL
BBBIBIBCIBCIBCHIBCHILMNCHILMNCDEGHIJKLMNCDEGHIJKLMCDEGIJLCDEFGJDFGJFGFFFFF
BBBDBCDBCDBCDEBCDECDECDE
FIGURE 7.18 Subsequent downside continuation in the S&P 500 following Day5 shown in Figures 7.15 and 7.17: Multiple daily proﬁles.Source: Copyright ľ 2006 CQG, Inc. All rights reserved worldwide. www.cqg.com.
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The combined profile shows the cumulative p pattern that we have constantly discussed when viewing individual profiles—short covering met bynew sellers who are selling for a longer timeframe. As you gain experience,you will begin to visualize different patterns long before they’re complete,which will make you feel more comfortable leaning into the wind, placingshort-term trades before they are actually under way, which will help yousecure advantageous trade location.In Figure 7.17 (see page 135) (a repeat of Figure 7.15), we see that afterfour days, more and more market participants have begun to recognizethat the upward auction is over; nearly all long positions placed duringthe previous four days are now under water. Put yourself in their shoes,imagine the stress level climbing. Short-term trading is a game, and theyare your opposition.Notice the notation in Figure 7.17 that suggests you compare the trendday up that started the last rally with the trend day down that reversed thatrally. The trend day that started the rally lost its elongation near the upperend of the range, and during the following three days there was very littlefollow through. The trend day down stayed elongated through the closingbell, which suggests downside continuation. This trade should have beentaken home short, and any long positions established during the previousseveral days should have been exited. While it can be psychologically difficult to take this loss if you’re still long, the exit may be one of the besttrades you make. Figure 7.18 (see page 136) shows the resulting downsidecontinuation—Day 5 exhibits an elongated profile that tells us that pricedid not go low enough to cut off the selling.This type of analysis is what trading is all about, and unless you arefully immersed in the markets, you will simply never learn to assess andamalgamate the many elements—both tangible and intangible—that enableyou to place a trade that ameliorates risk without compromising potentialreward.
“THE EXPERT REASONS CONTEXTUALLY”In his book Enhancing Trader Performance: Proven Strategies Fromthe Cutting Edge of Trading Psychology (Hoboken, NJ: John Wiley &Sons, 2006)—which should be read and reread by all serious marketparticipants—Brett Steenbarger states:Where the novice thinks concretely, the expert reasons contextually. Instead of thinking A alwaysleads to B, the expert creates a web of possibilitiesin which A leads to B under conditions X and Y,but leads to C under other conditions.
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In other words, the expert is able to stay flexible, avoiding the natural human tendency to make choices based on available surface information, then to defend that choice come hell or high water—regardlessof whether “other conditions” have arisen that invalidate all previousbeliefs.We all face a continuous flow of conflicting information, and it’s easyto overweight the latest piece of information, or to choose just one of thosepieces of information as the basis of a trade decision. History reveals thatpeople aren’t very good at reaching accurate conclusions when enormouslycomplex information must be analyzed and weighted correctly. We may begood at looking at each piece of information separately, but when it comesto relating each piece to the larger, cohesive whole—well, let’s just saycontext is an elusive thing. Consider just a few of the myriad divergent information sources that can influence the performance of a market, sector,or single security at any given moment:Ĺ Corporate governance—both good and illĹ Shifting government regulationsĹ A company’s ability (or inability) to innovateĹ Earnings—rising, falling, or remaining staticĹ PE multiples—expanding or contractingĹ Sales—expanding or contractingĹ Competitors—entering or exitingĹ Profit margins—expanding or contractingĹ Overall sector growth and acceptanceĹ Global eventsĹ Analyst upgrades or downgradesĹ Money managers long or short on cashĹ Redemptions vs. new cash enteringĹ Commodity prices—rising or fallingĹ Interest rates—rising or fallingĹ Trending vs. tradingĹ Tax sellingĹ Forced liquidation due to an external eventĹ Foreign market crisesAnd of course every element on this list can exist anywhere on thescale of “relevant” to “immaterial,” depending on whether the market hascorrectly anticipated the future implications of that element. The bottomline: We are constantly bombarded with a mind-boggling amount of information, and the brain has a habit of filtering out everything except what ismost self-serving. This process may make us temporarily comfortable, butwhen has comfort ever been associated with profitability?
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That’s where the market profile proves to be an invaluable tool, keeping us psychologically and intellectually honest. We may not be good atcrunching enormously complex data, but we humans are exceptionallyadept at spotting patterns and integrating them into workable solutions.Economists claim that you can’t understand what markets do without taking into account how people perceive what they do, and that it’s virtuallyimpossible to accurately measure the complex patterns of human behavior.We disagree—Market Profile does exactly that by arranging the aggregateresult of all these complex actions in a single, simple distribution curve.
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Day Trading Isfor Everyone
The man who insists upon seeing with perfectclearness before he decides, never decides.—Henri-Frederic Amiel
M
uch of the world seems to hold day traders in ill regard. As wehave pointed out on multiple occasions, however, everyone is aday trader on the day they enter or exit a trade. Every tick, everybasis point of performance matters.Consider this: Everyone who participates in a hedge fund, separatelymanaged account, pension fund, endowment, foundation, or mutual fundis affected by day trading.Here is a case in point. Over the years I’ve handled numerous calls fromtraders with the same question about large institutional orders: “ShouldI fill it now, or do I have time to work the order over the remainder ofthe day?” When you’re working large orders, the quality of the fill affectsboth the filling broker and the performance of the institution providing theorder flow.Recently, I read The Mighty and the Almighty: Reflections on America, God, and World Affairs (New York: HarperCollins, 2006) by MadeleineAlbright, a book that delivered one of the messages that we’ve been reiterating throughout Markets in Profile. In reflecting on her daily routine at theState Department, Albright recounted how every morning she would readthe President’s Daily Brief, after which she would wade through the National Intelligence Daily, which was the longer version of the Daily Brief.This reading was followed by a briefing on terrorist threats. After downloading all this intelligence, she reported one thing missing: “certainty.”141
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What also caught my attention was the following, “[U]nless you were verycareful, what you would see often depended more on what you expectedor hoped to see than on what was really there.”It is often said that there is “too much noise” to successfully trade inthe day timeframe. During the early years of the Chicago Board OptionsExchange, I’d occasionally have lunch with Fischer Black, who, along withMyron Scholes, provided us with the Black-Scholes Option Pricing Model.One of our most frequent topics of discussion was “noise.” My position,which differed quite a bit from Fischer’s at the time, was that there wasno such thing. I felt that what people called noise was simply somethingthey didn’t yet understand. Peter Steidlmayer best dismissed the conceptof noise when he said that every trade occurs to satisfy some condition ofthe market. This remains my belief today. For example, if a market ralliesquickly, and just as quickly retreats, it may well have done so because themarket got “too short” or, said another way, the market got out of whackin the short-term and inventory had to be rebalanced. The mirror image occurs when the market gets too long and we experience short-term liquidation breaks that serve to correct long inventory imbalances. These rallies orbreaks occur for a reason. They satisfy the need to bring inventories backinto equilibrium. In this chapter, we demonstrate several techniques for assessing such short-term inventory conditions. Armed with this understanding, you are better equipped to effectively execute your day-timeframe orders.In Advances in Behavioral Finance (New York: Russell Sage Foundation, 1993), edited by Richard Thaler, there is an article reprinted from theJournal of Finance in which Fischer wrote:Noise makes financial markets possible, but alsomakes them imperfect. If there is no noise trading,there will be very little trading in individual assets. People will hold individual assets, directly orindirectly, but they will rarely trade them.Imperfection creates opportunity as well as its converse: risk. We bringup noise here because we believe it is vital for traders to accept responsibility for the outcome of every trade and every action, avoiding the tendencyto externally assign credit or blame. Let’s take the next step and discussthe tactics of day trading.
WHAT’S A DAY TRADER TO DO?Successful day trading hinges on understanding what your opponents aredoing; sometimes you’ll want to join them, and other times—especiallywhen either long- or short-term inventories are out of balance—you will
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want to step aside or even fade (go against) the imbalance. There will alsobe times when the short-term inventory conditions aren’t corrected by themarket’s close and can be expected to effect the after-hours markets, possibly even carrying over into the following morning’s activity.We begin by discussing the more accepted definition of day trading:trades that begin and end on the same day—a buy and a sell, which canoccur in any order. Some complete only a limited number of trades in asingle day; others are far more prolific. For a quick recap, let’s review thedefinition of day traders from Chapter 3.The day trader enters the market with no position and goes home thesame way. Day traders process news announcements, reflect on technicalanalysis, and read order flow in order to make trading decisions. They alsohave to deal with long- and short-term program buying and selling, brokerage firm margin calls, mortgage banker’s duration adjustments, speechesby Federal Reserve governors, and “important pronouncements” by political leaders and influential portfolio managers. Anyone who believes markets are rational should spend a day trying to digest and react to the landslide of conflicting data day traders must wade through to make a decision.This group focuses on large quantities of technical information. Theylove numbers and levels and hype. Like scalpers, day traders also provideliquidity for markets, although very often at great personal expense.The second, nonstandard definition of day trader is one that we havereferred to throughout the book: the one-sided buy or sell order placed byother-timeframe participants, including individuals, hedge funds, mutualfunds, endowments, foundations, institutionally managed accounts, and soon. In Chapter 7, for example, we discussed short-term trading and statedthat the beginning or end of all short-term trades are day trades. However,not all day trades are the beginning or end of short-term trades.There is endless philosophy surrounding the definition of day trading. Some tell you to study what has happened during previous days andovernight markets; others advise you to do no homework, beginning eachday “fresh” with absolutely no opinions. Some suggest that you trade early,as most activity occurs during the first half of the day, and still others advise you not to trade until the market has been open for a couple hours,and you have a better sense of the day’s developing structure