) wrote: “Based on my reading, the human brainis mostly a voracious consumer of patterns, a soft pudgy gray Pac-Manof concepts. Games are just exceptionally tasty patterns to eat up.” Wealso believe that one of the problems with patterns is that our minds arealso inclined to find patterns that don’t exist. We seek patterns that support our beliefs—it’s just human nature. From an investing standpoint, this
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tendency becomes nearly inescapable if you also listen to the hype on television and in “expert” newsletters; before too long, the brain begins to actively hide the truth from you.Koster’s enlightening book is about games and game design. The factis, trading is a game in which there are winners and losers, and score is keptin dollars and cents and those all-important track records that can make orbreak a money manager (not to mention a personal fortune). That’s whywe keep reiterating the salient factors—like profile shape, value area, andvolume distribution—that enable us to objectively see what the market isreally telling us.
ALL PRICES AND OPPORTUNITIES ARENOT EQUALThe shorter the timeframe you’re trading, the more important the timelyplacement of your trade; every time you enter or exit a trade, you are, infact, a day trader. By necessity, day timeframe information will be includedin the analysis of Figure 7.8, but note that the day timeframe will be morefully explicated in Chapter 8.In Figure 7.8, the first three days, reading from left to right, are thesame three days that made up the short-term, countertrend auction discussed previously in Figure 7.7. Having seen the initial countertrend rallyweaken substantially, we would look to trade from the short side as wecome into Day 4. The selling tail—the single set of downward prints in theopening B period—demonstrates a high-confidence opening; longer-termsellers are aggressively selling from the opening bell. Not only are they selling early, but notice that the selling started well below the previous day’sclose, a clear indication that the prevailing market sentiment is that pricesare too high.With this clear indication of directional conviction, we ask that youconsider the profile indicators that provide clues about the collective willof the market. The previous day’s close was near the high for the day, whichprobably gave traders comfort in taking home long positions, thinking thatthey could get out in the morning if necessary. When the market openedquite a bit lower, however, consider how badly they must have wanted tosell, if they were willing to sell well below the previous day’s close, continuing to sell at even lower prices all through the opening B period. Likeany game, it is important to continually attempt to figure out what youropponents are thinking and doing, and if they are right—with the largermarket movement—or are getting themselves into trouble, which meansthey’ll have to reverse their positions in the near future.
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Day 3
DDCDCDNCDNCDNCDNCDENBCDEGNBCEFGLNPBCEFGLNPBCEFGLMNPBEFGLMNPBEFGLMNPBEFGLMNBEFGLMNBFGHKLMNBFGHJKLMNBFGHJKLMBFHJKLMBFHJKLMBHIJKLMBHIJKLHIJKLHIJKLHIJKLIJKLIJKLIJIJIJJJJ
PNPNPNPNKLMNKLMNFGKLMNFGKLMFGKLMFGJKMFGHIJKBCFHIJKBCFHIJBCFHBCEFBCDECDECDECDECDCC
KNPKNPKLMNPFKLMEFHJKLMEFGHIJKLMBCEGHIJBCEGHIBCDEGBCDEBCDEDEDDD
End of firstcountertrendauction.
Day 2
Day 1Excess low, May 24,starting point for firstcountertrend auction.
FIGURE 7.7 Countertrend rally following a nonlinear break occurring in the S&P500 viewed through the lens of the proﬁle: Multiple daily proﬁles.
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Final day offirst countertrendrallyDay 3Squat
Day 2
DDCDCDNCDNCDNCDNCDENBCDEGNBCEFGLNPBCEFGLNPBCEFGLMNPBCFGLMNPBEFGLMNPBEFGLMNBEFGLMNBFGHKLMNBFGHJKLMNBFGHJKLMBFHJKLMBFHJKLMBHIJKLMBHIJKLHIJKLHIJKLHIJKLIJKLIJKLIJIJIJJJJ
PNPNPNPNKLMNKLMNFGKLMNFGKLMFGKLMFGJKMFGHIJKBCFHIJKBCFHIJBCFHBCEFBCDECDECDECDECDCC
Close
KNPKNPKLMNPFKLMEFHJKLMEFGHIJKLMBCEGHIJBCEGHIBCDEGBCDEBCDEDEStemDDD
Loop
Expected traderbehavior, sell rallies
BBBBBDay 4BBBBCBCDBCDEBCDEFHCDEFGHCDEFGHCDEFGHEFGHKEFGHIJKLEFGHIJKLIJKLMIJKLMJMJMMMMNNNNNNPPPPP
May 24,first day ofcountertrendrally shown inFigure 7.7.
High-confidence sellingfrom opening bell
Value builds lowerPPFNPDEFNPDEFNDEFGHNDEFGHJKNDEGHIJKNDEHIJKLNBDIJKLMNBCDIJKLMNBCDJKLMNBCKLMNBCKLMNBCKLMNBKMBKKKKK
Day 5
Price spike
S&P 500 futurescontract
FIGURE 7.8 Fading a countertrend rally following the nonlinear break occurringin the S&P 500: Multiple daily proﬁles.Source: Copyright ľ 2006 CQG, Inc. All rights reserved worldwide. www.cqg.com.
On Day 4 in Figure 7.8, the aggressiveness exhibited in the opening Bperiod should—if the sellers are correct—lead to lower value, an elongatedprofile, and high volume. Having this as a foundation for your analysis, younow have some parameters with which to monitor the day; your goal is tofree yourself from relying solely on the advertising mechanism of price to
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monitor the market’s intentions. Notice that the day’s profile shape following the B period sell off starts to resemble the letter b prior to the market making a late-in-the-day sell-off, demonstrated by the M period sellingprice spike (in the rectangular box). The b-shaped pattern is one that youwill see often, and it represents two things: (1) Sellers are primarily liquidating long positions (the opposite of a short-covering rally), rather thana combination of long liquidation and new shorting; and (2) buyers are atleast slightly more patient than sellers. This is important to note becausethese patient buyers are not in it for a “day trade,” but rather some longertimeframe—at least overnight. Unlike the day-timeframe trader, these buyers are more patient and may, in fact, be scaling into large positions. Youmay not see the effects of this type of buying for a few days. Recall that wenoted earlier that successful trading requires that you piece together longstrings of data, and that you retain your ability to objectively recall thatdata within the context of constantly evolving market conditions. Not aneasy task.All rallies, at least initially, include a combination of short coveringand new buying. For the rally to be sustained, however, new buying mustovertake short covering. When this occurs, the profile becomes elongated.When it doesn’t, and short covering rules the day, a lack of continued newbuying often results in a profile shape that resembles the letter p. The mirror image occurs on market breaks, which start out with longs liquidatingexisting positions, accompanied by the formation of new shorts. When newshorting is consistent, the market profile becomes elongated, while lack ofnew shorting often results in a profile shape that resembles the letter b.Our position, over the years, has consistently been that markets arenot efficient. If that is correct, then what has occurred in the past does, infact, affect the odds of future activity. If the markets were efficient, andall prices and opportunities were equal, the past would have no bearingon later outcomes. Back to Day 4 in Figure 7.8. The b formation servesas an alert that the odds of the market going lower have decreased—buthave not gone away. Late in the day the market spikes lower, which shouldcause you to question the conclusions we’ve drawn up to this point. Recall,however, that the buying we saw in the center portion of the market profilemay have been for a longer timeframe. The price spike on Day 4 may alsohave been the “completion” of what started early in the morning—tradersselling what they perceive to be price above value. The question posed bya price spike is this: will value be pulled down to price, or will price revertback to volume? If the spike was on low volume, then the odds favor pricereverting back to the mean, which would be the value area from the day thespike occurred; if the spike was on heavy volume, then you would expectvalue to be lower on the following day as the mean (value) moves towardnew price levels.
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Day 7
Spike
Day 6
Poor low
BBBBBBBBBBBCDBCDBCDECDEFHCDEFGHCDEFGHCDEFGHEFGHEFGHIKLEFGHIJKLEFGHIJKLIJKLMIJKLMJMJMJMMMMNMNNNNNNPPPPPP
Day 2Stem
PPFNPDEFNPDEFNDEFNDEFGHKNDEGHJKNDEGHIJKNDEHIJKLNBDIJKLMNBCDIJKLMNBCDJKLMNBCKLMNBCKLMNBCKLMNBCKLMNBCKMBKKKKKK
NNPNPNPNPMNMNMNMNMLMKLMKLMFHJKLMKHIJKEFHIJKEFGHIJKEFGHIKDEFGHIKDEFGIDEFGBDEBEEBDBCDBCDBCDBCDBCBCBCBBBB
BBBDBDNBDNPBDELNPBCDELMNPBCDELMNPBCDEIJLMNPBCDEIJLMBCEIJKLMBCEFIJKLMBCEFHIJKLBCEFGHIJKBCEFGHIJKBCFGHIKBCFGHBFGBFGBFGFGFG
Last day shownin prior figure
Balanced symmetricalshape
BBEBCDEBCDEBCDEFBCDEFBCFGBCFGHIBCGHIJGHIJHIJJKJKJKKKKKKKKKLKLKLKLKLKLMKLMLMLMLMLMNMNMNMNPMNPNPNPNPNPNPNN
Early warningEarly forming p,visualize stem andloop
Day 8
Day 5
FIGURE 7.9 Further analysis of the countertrend rally following the nonlinearbreak occurring in the S&P 500: Multiple daily proﬁles.Source: Copyright ľ 2006 CQG, Inc. All rights reserved worldwide. www.cqg.com.
The spike on Day 4 occurred on low volume, as did the whole day.I would have entered this trade—which was with the longer-term trenddown—looking for conviction to the down side. Because of the b shape
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of the profile that day, indicating no real seller conviction, the evidencesupported closing out such a trade. It takes a great deal of mental disciplineto exit a profitable trade that you had been looking for, especially when itis with the trend on a day that closes near the low. But there is a hugedifference between closing out a trade and reversing your position. Again,it is important to get inside the head of your opponents. What would mostmarket participants feel about the same trade? Probably that is was a goodtrade and that the market was weak (because they were focusing on price),so it is unlikely that the market will turn quickly.Anyone can tell you what the market did. But consider looking atthings another way—what didn’t happen? In this last example, the market profile was not elongated; the shape didn’t indicate that trade was being facilitated on the down side, and volume didn’t validate lower priceand value. Because the market was struggling to go lower, the naturalreaction is to begin to think about the upside. Remember, the market isa series of two-way auctions, which are the market’s means of gaininginformation—whether we’re discussing the day timeframe or any of thelonger timeframes, the two-way auction process is ongoing.
ONGOING FORENSIC INVESTIGATIONTurning our attention to Figure 7.9, let’s first remember that we had concluded that it would be wise to close out any short positions—despite thefact that price closed near the low of the selling price spike (rectangularbox on Day 4), which would tend to make anyone who took home a shortfeel pretty good. But because of lower volume and the b formation (circledarea), the trade should have been exited.On Day 5, the market opened higher, closed higher, showedoverlapping-to-lower value, and never seriously challenged the excess lowcreated by the late spike on Day 4. When a spike occurs, you can’t determine if it was, in fact, an excess low until the following day when themarket opens; there’s simply not enough nighttime volume to enable thisdetermination to be reliably made. Earlier, we talked about the perils ofconflicting information, which was evident on this day. Experienced Market Profile users would question going home with a long position on Day5, as value was overlapping-to-lower. The more important piece of information, however, was that the excess created by the spike on Day 5 wasnot seriously challenged, as well as the fact that a late rebound closedthe market near the daily high. To remain with a long position, I wouldhave needed to see continuation very early on Day 6. The Day 5 range wascompletely contained within the range of Day 4, which is referred to as an
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inside day, or as a neutral or balancing day. For short timeframe traders,we recommend that you trade with any directional auction following aneutral/balancing day; when markets come out of balance, there is always at least a short-term opportunity to take advantage of the ensuingauction.The following day (Day 6) was a trend day, which is essentially a day inwhich the market moves almost continually in a single direction for mostof the day. The biggest mistake a short-term trader can make is to refuseto believe a trend day. If you don’t want to go with it—that is, trade in thesame direction as the trend—then at least don’t go against it. The trend dayprovided early confirmation of our analysis from Day 5. Despite the daytimeframe trend day up, the market profile on Day 6 developed a shapethat resembles the letter p (“early warning” arrow), which means buyingwas being met by longer-term sellers, or at least by those who were willing to hold a short position overnight or for a few days. On this day, therewas an upward price spike late in the day (the single letter M through theletter N on the high). The p formation—just like its mirror image, the bformation—provides an early warning that the market is struggling to auction higher. It will take some experience to recognize these formations, andthe last two examples we discussed were somewhat camouflaged by latespikes, which are often the completion of an auction when they follow theb and p patterns.On Day 7, value was, in fact, established higher. Notice on this day thatthe low was made in F period and then matched in G period; if there hadbeen aggressive responsive buyers—those looking for an opportunity asprices sold off—then price would have probably only traded at that levelduring a single time period. The fact that the market traded on the low during two different time periods suggests that that particular price was notconsidered to be such a scarce opportunity by longer timeframe buyers,meaning also that it was probably not a very good low (and would be revisited). Some might say that this is just nuance. It is. But details matter, andsuccessful short- and intermediate-term traders tuck away these details aspart of their ongoing forensic investigation of the developing shape of eachday’s market profile.Day 7 is another balancing day (observe how the day is almost completely symmetrical, a sign of balance), and the same rules discussed earlier apply here as well—trade with the initial auction away from balance.Remember also that everything must be viewed within its proper context,and in this case the long-term auction remains down, which means thata trade with a break-out to the downside coming out of this inside day ismore likely to be significant than one to the upside.On Day 8 the market broke from balance, auctioning briskly to thedownside and creating a trend day capped by a long selling price spike.Take a moment to compare Day 8 to Day 6—both were created by
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breakouts from balance, but Day 8 was with the longer-term down auction,while Day 7 was against it. The breakout with the longer-term auction wasclearly the more significant of the two.With this breakout from balance into a selling trend day, we can clearlystate that Day 7 marked the high for the market’s second countertrendauction following the nonlinear break. Next, we will examine the auctions that followed Day 8, a trend day in the same direction as the major auction that erupted out of a balancing day that had established thehigh of the second counter-auction. Before we do, however, let’s reviewFigure 7.10, which will help us better understand the two countertrendauctions.
End of firstauctionDay 7End of secondcountertrendauction
Day 8Downsidebreakoutfrom balancingdayDay 5Start of secondcountertrendauction
Start of firstcountertrendauction
FIGURE 7.10 Further analysis of the countertrend rallies following the nonlinearbreak occurring in the S&P 500: Daily bar chart.Source: Copyright ľ 2006 CQG, Inc. All rights reserved worldwide. www.cqg.com.
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In the course of examining each day of the two countertrend auctions discussed previously, we have attempted to identify viable short-termtrades. With each auction we have learned something new about the shifting responses of the market’s participants. For eight days we saw only limited continuation of short-term auctions in both directions, which is consistent with a market attempting to come into balance, to catch its breathafter a strong, nonlinear move. Before we push on, take a moment to reflectback on the significance of spikes and trend days, and in particular the significance of trend days that don’t result in uniformly elongated shape, suchas Day 4 in Figure 7.9—a trend day down that resulted in the b formation,which did not bode well for continuation. Similarly, Day 6 was a trend dayup that resulted in a p formation. When spikes occur, you should observewhether price reverts back to value, or value is pulled to price. Finally, Day8 was a trend day in the direction of the intermediate-term auction.Now let’s review the days that followed, first reviewing them via a dailybar, and then via daily market profiles.
LOOKING FOR THE ALL-IMPORTANTREFERENCE POINTSMarkets by their very nature often provide easily identifiable referencepoints that can assist in identifying advantageous trade location. InFigure 7.11, for example, you can see a gap that was left at 1,303.50 duringthe initial nonlinear break. The second countertrend rally (that we just discussed) failed to fill that gap by .50, or half of a point. These are the “tells”that become extremely important to successful short-term and day traders,and they can be best viewed when using futures pit session bar charts, asopposed to cash or electronic futures. While the volume in the futures pitsessions is low relative to daytime electronic trading, I have found that it ismore reliable in identifying subtle clues to market intention. The electronicmarket tends to trade a tic or two both higher and lower than the pit session, which is often on miniscule volume. For example, the gap at 1,303.50occurred during the pit sessions, and would not have been evident if youwere using the electronic contract.In fact, it’s often possible to find compound evidence to help identifyasymmetric trading opportunities. In addition to the gap that wasn’t filled,you can also observe a reference point in the solid line drawn just beneaththe gap that separates the multi-week, upper trading range. This is theline beneath which the market accelerated once price found acceptance,spurring the first nonlinear break. As we have said, the auction continuallysearches for new activity as part of the information-discovery process. This
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New expectedbehaviorsell rallies
Prior tradingrange low130350Day 81303002-daybalanceOriginallowEarly warninglate in downwardauction
Upwardgap
FIGURE 7.11 Key reference points generated by the nonlinear break and countertrend rallies occurring in the S&P 500: Daily bar chart.Source: Copyright ľ 2006 CQG, Inc. All rights reserved worldwide. www.cqg.com.
phenomenon is clearly manifest in the second countertrend auction, whichpeeked up above the solid line into the previous balancing range, where itquickly discovered that higher prices were cutting off activity and attracting sellers; because the intermediate-term auction is down, in this instance,this is the expected behavior. Of the three pieces of information that identified the ideal place for a short-term trade, two were tangible (gap andprior trading range low) and the third, the expected behavior, was morepsychological.Once the downward auction got underway, it continued for eight days.Referring to the arrow marked “early warning” and the arrow pointing tothe original low, you will notice how price traded below the original lowand then traded back above that reference point for the next two days.Earlier in in this book, we discussed the idea of “clean breaks,” which is
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applicable in this example. The point marked “original low” had managedto contain price on the downside for 15 days after the market broke belowthe upper trading range and upper gap. After this low was taken out, pricequickly returned to the 15-day range for a day and a half before resuming itsdownside exploration. The “early warning” noted in Figure 7.11 is there because the break was not “clean”—in other words, once price broke throughthe original low, it didn’t immediately continue downward. This providesan early warning that the downside auction is starting to exhaust itself. Asyou can observe, a few days later the market made a low and gapped higherthe following day, quickly returning to the previous 15-day trading range.Before we review these same days via the market profile, let’s consider the heightened emotional state that most traders and investors mustoften endure. (If you’ve never traded, hopefully this will provide a glimpseinto the mental complexities that must be managed in order to trade successfully; for those who have traded, this may simply add realism to thediscourse.) When you see a market analyzed after the fact, like we’ve justdone, it’s hard to understand just what it is that’s so difficult about trading. Performing this kind of analysis under stress is incredibly challenging,and not just because money is on the line. For several years prior to thenonlinear break we’ve been discussing, average volatility remained wellbelow its historic average, and individual trader and trading-system strategies operated within a relatively low-volatility environment. Then came thebreak and volatility rose rapidly. This kind of quick transition is hard to adjust to, both mentally and emotionally. During times of stress and suddentransition, the mind has a tendency to become disoriented, often choosing to focus on worst-case scenarios rather than the bigger picture. Afterthe break, of course the news shows rolled out the “bears,” continually focusing on the declining markets, how bad things were, and how bad theycould get.Almost all of the experienced traders I talked to during this periodwere similarly infected with the prevailing sentiment of doom and gloom.No matter how well trained you are, no matter how experienced and confident and calm, it’s truly difficult to be objective when everyone around youhas lost their grip on objectivity, and price volatility is exhibiting nothingbut wide, volatile swings. When the market starts to whipsaw, it’s almostimpossible to catch your breath. Now the profile in Figure 7.12.As shown in Figure 7.12, Day 8 was a trend day down, finishing witha late price spike. During the next two days the market balanced from thecenter of the Day 8 spike downward. This tells us that value was beingpulled lower to price, which is a good sign of downward auction continuation. Day 10 also saw a late spike with price probing lower, once againraising the question, will price be pulled back to value or will value migrate
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BBCDEBCDEFBCDFGBCFGHIJGHIJIJKJKKKKKLKLKLKLMKLMLMLMNMNMNPNPNPNPN
Day 8
Last day we discussedin Figure 7.9 and the firstday down after the endoff the second countertrend rallyDay 8 on bar chart
Price spike
BBBBCDBCDHBCDHIBCDHIJNPBCDHIJNPBCDHIJLNPBCDEGHIJKLNCDEGHIJKLNDEFGHJKLMNEFGHJKLMNEFGHKLMNEFGHLMNEFGMNEFGF
Day 9
GFGFGHFHICDFHIJCDEFHIJCDEFJKLCDEFJKLBCDEJKLMBCKLMBCKLMBCKLMBMBMBMNMNNNNNPNPP
Day 10
Value develops atbottom of price spike,value pulled down toprice
Value overlapping tohigher; however, stillin bottom of spikefrom trend day
Day 12Day 11NNNBMNBMNPBMNPBCMNPBCMNPBCLMNPBCLMMCELMMCELMBCDEKLMBCDEKLMDEJKLDEJKEJKEHJKEGHJKEGHIJEFGHIJEFGHIJEFGHIEFGHIFGIFGFFFF
BDBCDFBCDEFBCDEFLBCDEFLBDEFLBDFGKLMBFGHKMNBFGHKMNFGHJKMNHIJKNIJNIJNPIJPIP
Day 13BBBBCDFCDFGCDEFGHICDEFGHIJCEFGHIJKCEFJKEKEKKLKLMLMLMMMNMNMNNNPNPP
FIGURE 7.12 Further analysis of the nonlinear break and countertrend ralliesoccurring in the S&P 500: Multiple daily proﬁles.Note: The market profiles in this figure have been condensed to fit the page, which changesthe scale and can result in slightly misleading profile shapes.Source: Copyright ľ 2006 CQG, Inc. All rights reserved worldwide. www.cqg.com.
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to confirm the lower price probe. As always, we focus on value, not price.On Day 11, a value trader saw clearly lower value, while a price trader sawunchanged price. Day 12 exhibited overlapping-to-higher value and lowerprice. Day 12 was also a balancing day, which positions us for a new directional trade once the market leaves that balance range.However, there is clearly conflicting information due to the fact thatDay 12 resulted in overlapping-to-higher value, while both Days 11 and 12remained below the average balance of Days 9 and 10, which alerts us tothe fact that the intermediate-term auction down may be tiring—but isn’tnecessarily over. This lets us know that the risk of remaining short hasgrown substantially; successful trading/investing is based on identifyingadvantageous probability.Day 13 was another trend day down with a late downward spike. Following this activity, we again observed to see if value was pulled loweron Day 14, which is exactly what happened. In Figure 7.13, notice the arrow labeled “early warning” in the upper portion of the Day 13 profile. Thenonelongated profile shape provided another alert that the auction was tiring. During this day, the news reports were growing more pessimistic asprice continued lower, and those with short positions were probably feeling more and more comfortable.Day 14 provided clearly lower price and value; however, notice another“early warning” arrow—the fat shape of the profile suggests that lowerprices are not engendering continuation to the down side. Our evidenceshows that while prices are steadily migrating downward, the market isstruggling to move lower, laboring step by step without the freewheelingconviction that accompanies sustainable directional movement. But thinkabout how this feels in the moment. When you look only at price, the market is clearly moving lower. How in the world could you buy? This is anopportune place to reintroduce Gladwell’s diffusion model. At this stagein the auction, it is the late majority and the laggards who are draggingprice downward because they focus only on price and because they’rescared—what if I’m missing out on the next major trend?On this day, if you could have measured the collective emotions ofall market participants, you would have found a predominance of fear inthose who were long, and a great deal of confidence in those who wereshort. But if you considered the balance of market-generated informationthat we