KLMNBIJKLMNBCIJKMNBCDIJKMNBCDIKMNBCDIMNBCDHIMNBCDGHINBCDGHIBCDGHIBCDGHBCDGHBCDFGHBCDEFGHBCDEFGHBCDEFGHCDEFHCDEFHCDEFCDEFCEFCEFCEFEFEFEF
Day 1
Collaspedday forreference
FIGURE 8.25 Example 2: Completed proﬁle for Day 1.Source: Copyright ľ 2006 CQG, Inc. All rights reserved worldwide. www.cqg.com.
Confidence was low surrounding the opening, and the constant reentryinto the previous day’s range—when the market was attempting to auction lower—reveals more proof of low confidence on the downside. Youmust continually ask yourself: What is the inventory position of my competitors, and can I anticipate their actions as the day goes on?
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Open
EFGIJLEFGHIJLEFGHILEGHILMHILMHLMLMNMNMNMNMNMNNNNNN
BBBBBBBBBBBBBBBBBBBB
Sellers
CCCCCCCCCCCC
DDDDDDDDDDDDDDDDDD ED EEEEEEEE
GGGGGGGGGGGGGGGGGF GFFFFFFFFFFFFF
HHHH
IIIII
MMML ML MLLLLLJLJLJ K LJ K LJ KKKKK
NNNNNNNN
Lower value
Down auction
Down auction
FIGURE 8.26 Example 3: Day with a low conﬁdence opening: Assessing what themarket is attempting to do.Source: Copyright ľ 2006 CQG, Inc. All rights reserved worldwide. www.cqg.com.
All of the examples just discussed are applicable for round-turn daytraders as well as institutional clients who are executing one side of a trade.Remember the question often posed by institutional traders: I have a largeorder, should I fill it now or will I have the whole day to work on it?
PRACTICE, PRACTICE, PRACTICEWe generally think of the type of analysis we’ve conducted in this chapter as something purely objective and logical. But we are all human and
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subject to our uniquely shifting emotional currents. Without factoring inemotion, you can’t even begin to understand risk—of any kind. As objective as your analysis might be, if you are too emotionally involved, yourdecision-making abilities will suffer and you may find yourself focusingonly on worst-case scenarios. Successful analysis must therefore take intoaccount the way you process information, which is part of the larger context in which you trade and invest. The whole-brained trader does not getlost in unrelated particulars or subjective desire, instead continually seeking to understand a sense of the larger whole.It is important to note here that this holistic insight ultimately has nobearing on how well you implement your understanding. You can intuitively grasp the fundamental concepts we’re discussing, but you must alsospend a substantial amount of time engaged in real work—researching onyour own, studying patterns until they come second nature, mastering youremotional involvement in the financial implications of trading—before youcan ascend to the ranks of the top performing money traders.I once read that the best way to learn is to practice something overand over, subtly altering circumstances on each iteration. This is how wegain experience and the flexibility required to make rapid adjustments. Theanalogy I have used before is that of an experienced surgeon: while thesurgeon does considerable prep work—looking at X-rays, reviewing the patient’s medical history, etc.—once the incision is made there will always beminute differences to which he or she must adjust on the fly. But becausethe doctor has experienced untold numbers of similar situations, the slightvariations are taken in stride, are accommodated with calm efficiency, andthe operation proceeds without mishap.Top professionals in any field are mentally prepared, they are engaged,and they have the right mental state with which to perform their duties witha clear, open mind—without being overwhelmed by conflicting stimulus oremotion.
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Profiting fromMarketGeneratedInformationA common fallacy is the idea that the majority setsthe pattern and the trends of social, economic, andreligious life. History reveals quite the opposite: themajority copies or imitates the minority and thisestablishes the long-run developments and socioeconomic evolutions.—Humphrey Neill
L
ife is endlessly complex and mysterious. It’s no wonder people tendto favor clean lines and clear objectives. And as much as we liketo think of ourselves as individuals and freethinkers, we all long foreasy, straightforward answers. When you consider the demands of modernliving—cell phones ringing, bills to pay, relationships to nurture, endlesse-mail cascading through the ether—it’s no wonder everyone’s looking forthat magical black box. But, of course, there’s no such thing.One of the core directives of this book is that learning isn’t linear, andthat to successfully trade, you must train your mind to be agile, able tofluidly shift between timeframes and mindsets to accommodate the everchanging auction. You have to accept the fact that you will never be certain, but if you improve your market understanding in conjunction with abetter understanding of how you process information and make decisions,you can develop a more intuitive ability to identify those situations whenthe odds are in your favor (over time, you’ll recognize that they occur moreoften than you might think).Nietzsche said, “Belief in truth begins with doubting all that has hitherto been believed to be true.” This mirrors the Humphrey Neill quote at the193
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beginning of this chapter. If you sense the power and potential in this book,then welcome to the minority. It is only the minority—the “innovators” and“early adopters”—that first respond to a change in the dominant paradigm.All this talk of “asymmetric trade location” challenges, by its very nature,the status quo. But think on this: In trading, as in all things, it is thewell-positioned minority that benefits from the actions of the majority.
TIMEFRAME DIVERSIFICATIONWe’ve come at last to the simple question that lies at the heart of thisbook: Why not have a portfolio that is both long and short? Most wouldagree that such an approach makes perfect sense. Yet few actually do it. Ifyou’ve already done your homework on individual securities—and you’reany good at it—then you should have come across both long and short opportunities. When you consider the risks inherent in being “all one way”in markets that have repeatedly proved that they can reverse on a dime,timeframe diversification is a far more efficient use of your resourcesbecause it enables you to employ all of your research to develop marketideas—not just the results that indicate possible long positions. The Maynonlinear break in stocks that we used for so many of our illustrations wasalso a marvelous example of the benefits of timeframe diversification. Casein point: On July 14, I received the following e-mail from a friend at StateStreet Global Advisors in Boston:From: Brian ShannahanDate: July 14, 2006To: Jim DaltonSubject: since the peak in early MayA thing of beauty. . .<.79> vs <6.22> net 5.44.State Street Global Advisors is one of the top five institutional moneymanagers in the world. They are number one in institutional assets with approximately $1.5 trillion under management. Prior tomy retirement from UBS Financial Services, I had asked StateStreet to develop a long-short portfolio for our clients based uponour specifications—basically 70 percent long and 30 percent shortsecurities—with directions to rebalance to the 70/30 mix any timethe shorts reached either 25 percent or 35 percent.Brian’s e-mail was informing me that, since the May nonlinear break,this portfolio had a return advantage of positive 5.44 percent over its
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benchmark. This is just one illustration of the power of the concepts thatwe’ve discussed in this book.Timeframe diversification evolves from the recognition that neither individual securities nor individual markets—such as the S&P 500 or 100,Dow, Russell 1000, 2000, or 3000—always move in a single direction. Evenif a market is in a long-term trend, there will be meaningful countertrends,which we refer to as intermediate-term auctions. These countertrend auctions can easily retrace 5 percent to 10 percent of the trend, and can actually be healthy developments in that they enable markets to come intobalance in order to prepare for the next significant leg of the trend. Thereis also general agreement that not all sectors, industries, or individual securities advance or decline together. In fact, it is more common to seecontrary movement or rotations. Because diversification among industries,sectors, and individual securities is widely accepted and encouraged, isit such a reach to accept that portfolios should also be diversified by being short securities or markets that are likely to diverge? The State Streetexample provided a real-life illustration of this concept: 5.44 percent positive difference for a portfolio of approximately half a billion dollars isreal money.While we believe that investors who rely on fundamental informationas the basis for their investment decisions can and do make money overthe long run, we don’t believe that fundamental information alone can everguarantee an absolute profit or even a relative advantage over competitors.At the time fundamental investors place their trades, they have no way ofknowing how much, if any, of that fundamental information has alreadybeen incorporated into the price they paid or received. That is the Achilles’heel that is exposed when one relies solely on fundamental information.Consider that the forces that push a security away from fundamentalvalue tend to be behavioral in nature, particularly at the end of extrememoves when the risk of price movement is greatest. The further behavioralforces drive the price of a security, the more interested the fundamentalists get, as they base their decisions (at least in the abstract) on perceivedvalue. When prices have been driven too low, for example, aggressive valuebuyers appear. Extreme examples would include buyouts, mergers, andspin-offs. In these types of occurrences, timeframe diversification wouldinclude lightening up on hedges placed when the security was too high.These hedges might include raising cash, moving into defensive securities,selling options on either indexes or individual portfolio securities, buyingindex puts on the overall market, industries or sectors, and so on.The point here is that just as there is fundamental information, thereis also behavioral information. Fundamentalists forecast, but there is little evidence that suggests there’s any merit to their augury. So why notcombine the analytical power of fundamental information with a real-time
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understanding of market activity, employing intermediate timeframe diversification in order to secure a competitive edge?Fundamental information reflects (or is an estimate of, based onall known contributing factors) the core long-term value of a security. Shorter-term behavioral forces can drive price away from this fundamental value—often times far away. The challenge for fundamentalinvestors—and most professional asset managers fall into this camp—isdetermining whether behavioral or fundamental forces are driving theprice of a security, to what extent, and what (if anything) can be doneto protect or improve their portfolio profitability. That is precisely wheremarket-generated information and the concepts presented in this book become invaluable.
THE NEW PARADIGMThis new paradigm claims that the prices of securities are not always the best estimate of the trueunderlying value of the firm. It argues that pricescan be influenced by speculators and momentumtraders, as well as by insiders and institutions thatoften buy and sell stocks for reasons unrelated tofundamental value, such as for diversification, liquidity and taxes. In other words, prices of securities are subject to temporary shocks that I call“noise” that obscures their true value. These temporary shocks may last for days or for years, andtheir unpredictability makes it difficult to designa trading strategy that consistently produces superior returns.—Jeremy SiegelWhen a professor of Wharton Business School is trumpeting the “newparadigm,” the world stands waiting for a new theory. Siegel states that itis difficult to build a “strategy” because of the unpredictability inherent inmarket activity. Markets in Profile puts forth just such a strategy, basedon a continual reevaluation of the risk of being long or short in any givenmarket.We have explored two themes: market understanding and selfunderstanding. We have campaigned for what we believe to be a moreconsistently reliable, objective source of information—the market itself.Using the market profile conforms to the way our brains receive and
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process information. We have offered suggestions and sources to help youhone your own process of self-understanding, emphasizing the importanceof unlearning old habits in order to clear your mind, so you can assimilatemarket-generated information in the present tense.It’s a simple thing to say, “Clear your mind.” It’s quite another toput into practice. Giving up an idea that you have clung to for a longtime can be extremely painful, and it is labor intensive to replace it withanother—especially one that lacks clear, easily parsed directives. You haveto be secure in yourself to let go of the status quo; secure people have confidence that they will assimilate new information and processes and getback on an even keel.The key to unraveling the flux of market-generated information, as understood from the context of your own evolving emotional and cognitivemakeup, is to accept the fact that all decisions are made under some degree of uncertainty. That is the fundamental nature of humanity.Nothing is certain. The agile mind, however, when properly trained andprepared, can discern in the elegant array of evolving market-generatedinformation occasional patterns—like oases of opportunity—that enablethe execution of trades that offer greater reward with diminished risk. Thatbeats average any day.
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APPENDIX A
Market Update
I
n Chapter 6, we discussed how markets rarely go from bull to bearor from bear to bull, but rather transition from bull or bear to bracketing. Once the bracketing process is complete, markets either returnto the previously established trend or begin a new auction in the oppositedirection.In latter chapters, we showed you a market that began to break hardin May 2006 (which was occurring as we were writing that portion of thebook). Our explication was bold, as the low hadn’t been established andwe had only the theories expounded in this book to guide us. Because wewere writing about real-time market activity, we promised that we wouldprovide an update on how the market played out when we completed thebook. Today is October 23, 2006—two days before we submit the final edits to our publisher. So far, using the December 2006 S&P 500 futures chart(shown in Figure A.1), the market’s high in May 2006 was 1353 with a lowof 1239 on June 14, and a recovery high of 1380 on October 18. The processmay not be complete; however, from the market low the recovery has retraced 100 percent of the break that began in May and has begun to auctionhigher.As you may recall, we also stated that the initial break was not unexpected, because the rally to the new highs in May 2006 were made on extremely light volume. Toward the end of the summer once “proof” that themarket was weak had arrived, numerous portfolio managers on the talkshow circuit began to turn bearish—well after the lows were establishedand far too late to provide a competitive advantage.
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O= 137160H= 138420L= 137010L= 138080∆= +590
1353.805/5/2006
1353.80
1239.906/14/2006
23 Oct 06O= 137160H= 138420L= 137010C= 138080 Sep
Oct
Nov
Dec
2006
Feb
Mar
Apr
May
Jun
Jul
Aug
Sep
Oct
FIGURE A.1 Continuation of a bracketing market. December 2006 S&P 500 futures.
There is a better way to understand and read markets. Long-term investors and traders armed with market-generated information and the insight provided by the concepts, techniques, and high-probability indicatorsdiscussed in this book will be better prepared to act before the herd hasturned, positioning themselves favorably in the ever-changing market.
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About the Authors
JIM DALTONAfter spending several years trading and mentoring traders, Jim was askedto return to UBS Financial Services in 2001 to direct and reorganize its nonproprietary hedge fund research. This opportunity greatly expanded his exposure to many of the world’s most successful traders and their strategies.Jim then retired in August 2005 after having held the titles of manager,Hedge Fund Research, and director of research for managed accounts. Hecurrently trades for his own account and is the lead author of Markets inProfile. His earlier book, Mind Over Markets (by the same authors), wasoriginally published in 1990 and continues to be popular among professional traders, providing a wealth of tactical trading strategies based onthe Market Profile. The book was recently translated into Chinese.Jim has been a member of both the CBOT and CBOE, and he servedas executive vice president of the CBOE during its early formative years.Additional experience includes four years active duty in the Marine Corp.and several years with IBM and Merrill Lynch. From his experience, hehas learned that “expert opinion” rarely pans out in the active market.He has also observed that superior trading results over the longer term arealways the result of a more flexible, adaptive approach to markets. Theseobservations set the stage for Jim’s introduction to the Market Profile, amethod of arranging data that enables the visualization of evolving marketstructure.
ROBERT BEVAN DALTONAfter a brief stint as assistant editor of a small-town Midwestern newspaper, Rob pursued a hodgepodge of endeavors, from wandering the Middle East to crafting hardwood floors in Tucson and playing at rock star201
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in Greenwich Village. He returned to the written word in the guise of aPR hack for various fashion agencies in Manhattan before fleeing the EastCoast for sunny Seattle, where he founded Jie23, a new media design firm.He is now a freelance writer living in the woods on Bainbridge Island withhis wife and two young boys. When he’s not servicing clients like Microsoft,Vail, Holland America, and British Airways, he crafts the occasional poemand writes for a strange m«elange of start-ups, creative collaboratives, andarts and environmental nonprofits. Not to mention the occasional book onneuroeconomics.
ERIC JONESEric Jones began his career around markets, investing and trading whileworking as a foreign exchange analyst at a small commodity research andinvestment management firm founded by his father. It was there that hedeveloped an appreciation for the power of quantitative trading systems.Also while there he met Jim Dalton, who introduced him to the MarketProfile, the concept of market-generated information and the tremendouslyexpanded potential of organizing data according to price, time, and volume,instead of just price alone, as was traditionally done.On and off over the years, Jim and Eric have worked together in various capacities: as partners in a futures market research and trading firm, asinvestment advisors to clients, as developers of new investment productsand platforms, and as leaders of investment research teams. Most recently,Eric was senior vice president, director of product development and investment manager research for UBS Financial Services’ Advisory and Consulting Solutions, a unit comprised of managed account, alternative investmentand fee-based brokerage products. In this role, Eric was responsible for thestrategic development, integration, and market positioning of managed account and alternative investment products and platforms.In addition to Mind Over Markets and Markets in Profile, Eric is alsocoauthor of Hedging Foreign Exchange, Converting Risk to Profit (Wiley,1986).
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Index
Absolute return, 7Absolute performance, 5, 7, 8Albright, Madeleine, 141Auctions, 20, 41–48, 60compound, 61long-term, 59Asymmetric opportunities, 12, 72–74,104, 124, 130Attempted direction, 42, 52–56, 115,162, 183Balance, 23, 62–66, 92–93, 120, 148Balance areas, 62–66, 120–122,131–132, 148, 160Behavioral information, 193Bernstein, Peter, 21Black, Fischer, 142Brackets, bracketing market, 8, 22,63–66, 77–80, 158–162, 199extremes, 65, 106–108, 161intermediate term, 79, 147Breakout, 63, 71–72, 80–81, 92–93,106–110, 132–137, 168Buying exhaustion, 82–83Center for Research in Security Prices,42Change, xii, xiv, 66, 68, 85–87Cohen, Gene, 53, 145Cognitive dissonance, 111Compound auctions, 61Confidence, 115–118, 171–190Consolidating market, 8, 78Context (importance of), 16, 22, 63, 75,101, 114, 137
Convergence, 77, 79Conviction, 116–117, 120, 152–153Correction, 155Counter auctions, 94, 112–130Day timeframe, 21Day trader, 32, 38, 141–45Day trading, 141–191Diffusion model, 15, 128Distribution curve, 24, 70–71Diversification, xiiiEfficient market theory, xi, 55, 72Efficient vs. effective markets, 71, 73ERISA, 3, 4Excess, xii, 82–85, 155, 160–161Exhaustion,buying, 83selling, 88–89Extremes, 65, 132–137, 160–161Fair value, 21Flight to safety, 153–154Fundamental information, 16–17, 193Gap, 84–85, 125, 147–148, 169Gladwell, Malcolm, xii, 2, 15, 96, 128Grudin, Robert, 158Imbalances, 31Ineichen, Alexander, 7Initial balance, 48Inside day, 120, 122, 148Intermediate-term auctions, 77–98brackets, 106, 147
203
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204Intermediate trader, 24, 32, 38Inventory, 30–31, 142imbalances, 31, 142–143, 145,155–157Irrational behavior, 18Kahneman, Daniel, xii, 2, 17–18Koster, Ralph, 115Kuhn, Thomas, 1, 96, 158Liquidity, 68Long liquidation, 118–119, 164–166,183–185Long-term investors, 32, 38, 35–37Long-term auctions, 59–76Long term profile, 26, 68–70, 134, 159Market condition, 158Market-generated information, xiv, 10,16, 19, 41, 48, 61Market-generated indicators, 48–57Market Profile, xvii, 10–12, 19–27, 41,45, 51, 57, 68, 100, 104, 139Mauldin, John, 8, 90Mean (distribution), 70, 101, 109Meir, Sid, 112Modern Portfolio Theory (MPT), xiii,6, 7Momentum investing, 18Multiple timeframes, 38, 51–52, 56Neuroeconomics, 13, 110–111Neutral day, 120, 122Noise, 142, 196Non-symmetrical markets, 55–56One-timeframing, 178Openings (types), 171–181Opportunity, 73–74Patterns, 112–116Point of control (POC), 25, 144Price, 20, 24, 27, 42, 50, 70, 101–103,116, 128Prospect Theory, xivRange extension, 48, 49–50Reference points, 124–129, 145, 171
INDEX
Rejection, 24Relative performance, 5, 8Relative return, 8, 97Responsive activity, 65Restak, Dr. Richard, 111Reversion to the mean, 21, 71Santa Claus rally, 25Scalper, 32, 38, 143–144Scholes, Myron, 142Short-term markets (analyzing),99–139Short-term traders, 32, 38, 142–145Short covering, 55–56, 61, 119, 122,134, 137, 149–150, 155–159Spike, 118–119, 121, 123, 126–128Standard deviation, 24Steenbarger, Brett, 137Steidlmayer, Peter, xviii, xix, 71, 142,171Style, xiii, 4, 6, 7Swing traders, 33Symmetry, 53–55Tail (selling), 116–117Technical indicators, 106–110Thaler, Richard, 142Time, 20, 42, 50Timeframes, 3, 17, 19, 21, 22, 29–39, 41Timeframe diversification, 194–197Time-price opportunities (TPOs), 22,24, 186Top down, 151–152, 170Trader development spectrum, 99Trading bracket (example), 21, 24–27Trading range market, 8Trend, trending markets, 22, 64–72,127, 144, 158Trend day, 120, 122–123, 127–130Tversky, Amos, xii, 18Value, 20, 21, 24, 42, 71, 101, 154Value area, 21, 24, 25, 43, 44, 48, 51, 71,162–163calculation of, 25Value investors, 18Volume, 20–22, 29–30, 42, 44, 50, 70,101, 110, 186
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