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first, let’s explore the two predominant types of information that affect thebehavior of all investors: fundamental and market-generated information.
FUNDAMENTAL INFORMATIONFundamental information includes a broad array of different types, fromthe esoteric, like Kondratieff waves and S-curves, to basic demographicdata and big picture business cycle research. Fundamental information canalso provide insight into the expansion of price earnings multiples during secular bull market cycles, as well as the compression of price earnings during secular bear markets. This kind of information reveals thatgood earnings don’t necessarily lead to higher stock prices—some of thestrongest market advances have occurred during periods of relatively poorearnings growth. Then of course there is fundamental information on sectors, industries, and individual companies that shows earnings, sales, margins, growth rates, and the list goes on.To make matters more complex, there have been numerous studiesthat reveal that fundamental information must be viewed in the right context to have any relevance. For example, a 5 percent yield on the benchmark 10-year Treasury note is viewed from one perspective if the yield hasfallen from 7 percent, but viewed from a totally different perspective if therate has just climbed to 5 percent after having been as low as 3.5 percent.It’s all about context.Let’s take a real-world example that illuminates the importance of context in interpreting information. A few years after the markets peaked inearly 2000, the economy showed signs of reduced inflation and slowergrowth for several months running, which caused the experts to begin talking about recession or perhaps “worse” (there were constant referencesto Japan, which had recently suffered just such a depression). When themarket began to shows signs of inflation in late 2004 and early 2005, itwas generally considered to be good news, as the moderate inflation indicated that we were not, after all, likely to slip into a recession. Thenin late 2005, bonds again rallied on economic news that suggested inflation was well contained and that real returns were in focus. It’s allabout context. A fish looks pretty silly flopping around on the dock, butthat same motion—in the context of water—results in graceful, powerfulmovement.In addition to the larger economic environment at any given moment, which dictates whether inflation is considered good or bad news,there is also personal context to be considered—that is, information may
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be viewed differently depending upon an investor’s “timeframe” (suchas scalper, day trader, short-term trader, intermediate-term trader, andlong-term investor). A company’s reported earnings may be positive whenviewed from a long-run perspective, but short-term traders might takethe same news to be negative due to dashed hopes for even highernumbers.Countless articles have been written that support the value of fundamental research. But articles have also been published that suggest thesame research is so flawed and biased that it actually has a negative effecton performance. Because of this common bifurcation, it is important to distinguish between the accuracy of thoughtful research and the ability of thatresearch to predict future securities prices. A piece of fundamental analysis may be absolutely correct—an analyst may have accurately analyzed acompany’s earnings—but the market may respond to that information ina completely unexpected way. Of course, that doesn’t mean the analysisis bad. Firms that produce fundamental research often produce that research for noninvestment purposes, or from the perspective of a differenttimeframe, or for institutional clients who use the information to generatenew business. They’re not soothsayers, however, despite what many mightwish to believe.Nobel Prize–laureate Daniel Kahneman sums up context this way:“People don’t assign the correct weights to information, and they assigntoo much weight to information, especially if they have collected it themselves.” Due to the information glut available to everyone who trades, it isnearly impossible to view all incoming information in the “correct context,”especially considering the short-term focus that seems to be pervasive today. As a result, information can be used to make just about any point, orjustify any position one wishes to make.A much publicized example of the inherent challenges of understanding fundamental information is commonly known as the Greenspan conundrum. In 2005, the former chairman of the Federal Reserve, AlanGreenspan, failed to comprehend why fixed income securities didn’t react as expected to the multiple rate hikes he initiated during the previous year. Of course, there was no shortage of experts deriding him forthis oversight—after the fact. During this same period, the fixed incometrading results of many of the largest and most respected financial service firms were negatively affected by the same conundrum. The expertsexpected the fixed income market to behave a certain predictable wayand positioned their books accordingly, but it didn’t. One of the primarygoals of this book is to explain how market-generated information canhelp you navigate through “conundrums” like the one that flummoxed Mr.Greenspan and many of his contemporaries.
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RATIONAL OR IRRATIONAL?Kahneman and Tversky demonstrated that investors are not only irrational,but that they’re predictably irrational. But is “irrational” really the rightterm for this behavior? Imagine you’re at the track. You’ve gone over allthe odds, read the expert’s opinions, and completed your own analysis,which is of course influenced by myriad factors, like the fact that one ofthe horses shares a name with your alma mater, and another happens tohave placed in his last three races. You make your wager before the racestarts and settle in to watch the horses run.What if we changed the rules and let you place your bet after the raceis already under way? A totally different side of human psychology wouldbe revealed. Once again, all information must be placed within its propercontext—how will your decision be affected if the horse you had plannedto bet on is currently in the lead? What if the horse is losing momentumaround the second turn? How will your betting habits be affected by thisreal-time information?We should expect, considering a general understanding of human nature, that the larger the horse’s lead, the more individuals will place betson that horse to win, and that bets on the horse in the back of the pack willevaporate. When you extrapolate this behavior in the context of financialmarkets, is it really so “irrational”? When you think about it, betting on aclear winner is a pretty rational decision, in the immediacy of the moment.This phenomenon is commonly known as “momentum investing,” which isoften the primary force behind short-term market movement. And just asthe payoff odds decrease in a betting pool as more money is placed upon aparticular entry, the payoff odds decrease for late-momentum investors asthe market explores price extremes.The racetrack vignette was meant to illustrate the ways in which markets can change people’s actions. But there is one important differencebetween the track and financial markets: The horse race has a specifiedbeginning and end, whereas financial market movements are never ending. In such a continuously evolving environment, the human behavior described above can provide opportunities for both “momentum” and “value”investors. (Value investors, on the long side of the market, seek securities that are undervalued relative to certain criteria, which may mean lowprice-earning multiples, low price-to-book value, large amounts of cash,etc.). We’ll explore these opportunities at length later in the book.Irrational or not, market behavior is the sum total of the actions ofall of its individual participants and disciplines and timeframes. It is influenced by the confluence of innumerable information sources and the
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whims of human nature. There are very few individual or institutionalinvestors that aren’t affected by this fantastically complex convergence,and it is extremely difficult to gain an advantage in today’s markets, dominated as they are by a short-term orientation.
MARKET-GENERATED INFORMATIONThe premise of this book is that market-generated information, whencombined with fundamental information, can provide that elusive advantage. Market-generated information is information gained from observingthe actual flow of orders within the market’s present-tense context. Making sense of this source of information begins by recognizing that marketsare constantly moving from low to high and high to low. This two-way auction process enables all market participants to express their opinions—nomatter how those opinions were obtained—with real money; the auctionseffectively establish a fair price where business can be conducted at anygiven time. This expression of the market’s collective will results in a constant flow of objective market-generated information.In order to manage this information, as we mentioned in the prefaceto this book, we employ the Chicago Board of Exchange’s trader supporttool called Market Profile. Market Profile is not a trading system, nor isit predictive. Market Profile simply allows you to observe the structure ofthe market as it unfolds, enabling a more accurate interpretation of whichtimeframe is in control of market movement. This concept of timeframecontrol will be a recurring theme throughout Markets in Profile.The market, as we have said, is the manifestation of all possible influences, all news sources, all global and political events, and all marketparticipants. As the market’s continuous auctions unfold, a market profile enables us to experience a composite of all available information (andopinions), because it is solely based on real order flow. Market-generatedinformation, when properly organized and understood, can greatly demystify the endless complexity of the market. Such data can uncover vital information about what is driving change by providing clues that help unravelthe strength or weakness of market momentum.To establish the significance of an objective means of interpreting market activity, let’s revisit the potential pitfalls inherent in relying solely onfundamental information. Suppose that an analyst performs methodical,well-informed research on a company and comes to the conclusion thatthe company is well positioned for strong growth in the next quarter. Butwhat this fundamental information may not reveal is whether the price ofthat company’s stock has already moved to reflect that fact. Or perhaps
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the industry within which the company operates is on the verge of collapse, and nobody is interested in the sector as a whole. The positive report may be meaningless unless viewed in the proper context. Think of thenumerous factors that must all line up to make fundamental informationrelevant. Even the slightest miscalculation can result over time in seriousinvestment consequences. Of course, investors and money managers mustbe aware of fundamental indicators, but wouldn’t it make sense to employan objective means of ensuring those indicators are actually resulting inthe expected market activity?Let’s say you bought shares of a good company that had an underpriced stock—you bought value—but the price has remained basically flatfor an extended period of time. This is not uncommon, and is why manyinvestors wait to invest until price momentum validates their buy decision. By using the Market Profile tool, one can often discover confirming information (positive or negative) in the market structure before it isreflected in significant price movement. Securing good trade location—orbeing able to exit a bad trade earlier—is the advantage we were discussingearlier.Before we provide a mechanical description of market profile construction, let’s first define “trading,” which in the context of this discussion is no different than “investing.” Trading is the anticipation, timing, andplacement of orders to capitalize on change—no matter how short- or longterm the underlying investments.
THE AUCTIONSAuctions are made up of three fundamental elements: price, time, and volume. Price is simply the auction’s means of advertising opportunity. Timeregulates each opportunity, and volume measures the degree of successof each auction. As with any auction, there are goods for sale, bidders attempting to buy, and sellers trying to sell. While price is the mechanismused to fairly distribute goods among participants, the skew of volume andprices enables us to see how willing or unwilling the participants were toeither acquire or give up their holdings; some will be willing to relinquishtheir goods at fair value, while others will only enter the auction process ifthey perceive price to be away from fair value. As in all successful financialendeavors, it quickly becomes clear that not all prices are equal, and thatidentifying the “fair value” consensus is pivotal in understanding the underlying forces at work in any given market (Warren Buffett has been sayingthis for years). A market profile, by its very nature, helps identify price inrelationship to value.
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FAIR VALUEFair value is defined as the price levels that are attracting the greatestvolume of trade. As you will see as we progress, fair value has differentrelevance for different timeframes. Markets are generally “fair” only in theday timeframe, and what is considered fair in the day timeframe is often unfair from a longer point of view. As the market’s two-way auction processunfolds, there is an ongoing search for information between buyers andsellers (much the same way that manufacturers and distributors continually seek information about each other to maximize profits). Once eitherparty perceives an advantage, they will attempt to move price away fromfair value in order to increase profit. This attempted divergence is constant,and the market profile records the resulting auctions via a histogram, ordistribution curve.Historically, scientists have employed the histogram to organize dataso that it can be observed and better understood. As Peter Bernstein establishes in his book Against the Gods: The Remarkable Story of Risk (NewYork: John Wiley & Sons, 1998), “The normal curve, or bell curve, enabledthe evolution of human civilization” by providing a means of determining,statistically, the potential risk and reward intrinsic in any venture (such asopening a trade route to the West Indies).A market profile histogram is created through the ongoing development of the market’s information-discovery system—its continuous twoway auction process that advertises price in order to distribute volume ina fair and competitive manner. The volume, or bidding activity, determineswhether or not divergences from value can be sustained. On one day, sellers are discouraged by prices below value, and buyers are discouraged byprices above value. When both sides have essentially established a “valuearea,” any movement away from value will serve to shut off the flow of auction activity until price returns to equilibrium. This is commonly known asreversion to the mean. On another day, the same market may find that divergences from value—higher or lower prices—actually attract more volume rather than shutting it off, which forces participants to reassess theiridea of value (investors who trade via reversion to the mean will be unable to sustain profitability when divergences from value are successful).We demonstrate how knowledgeable, Profile-experienced traders can perceive both situations while markets are unfolding by observing the Profile’sgraphic depiction of the relationship between time, price, and volume—thetrue fundamentals of market behavior.In the discussion above, we referred to the day timeframe; however,the same theory applies to all timeframes. While we have not yet describedthese timeframes, we have referred to them as scalpers, day timeframes,
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short-term timeframes, intermediate-term timeframes, and the long-termtimeframe.
MARKET PROFILE FUNDAMENTALSAuthors’ NoteThe following section contains a very brief discussion of market profileconstruction. For a detailed discussion on market profile constructionand mechanics, please refer to Mind over Markets and other texts mentioned throughout this book and in the References.The construction of a histogram requires a constant and a variable.Market Profile treats time as a constant, placing it on the horizontal axis,with price, the variable, arranged on the vertical axis. You can constructa market profile graphic using any time interval, and any liquid financialmarket. For demonstration purposes, we’ve chosen to represent the daytimeframe auction, which we’ve broken down into 30-minute intervals,each of which is assigned a letter. As the market passes through variousprice points, the letter designating the current time period appears besidethose prices. Over time, the letters (known as time-price opportunitiesor TPOs) accumulate, creating a graphic view of the day’s distributioncurve. Once again, this concept is the same for any of the timeframes mentioned above.Figure 2.1 shows a relatively balanced market forming a fairly typical bell curve. There is an accumulation of prices (greater volume) at thecenter of the distribution, and diminishing accumulation (less volume) atthe extremes. As you become familiar with the way market profile evolvesover time, you can begin to visualize the completion of the histogram—andhow best to trade it—prior to the day’s completion. To effectively trade themarket represented in Figure 2.1, a reversion-to-the-mean strategy wouldbe most appropriate, as it’s clear that there is consensus in the market regarding value (highlighted below by the bracket).Figure 2.2 shows the same profile, only we have kept each time intervaldistinct, so you can see where the market moved during each period.In addition to day-timeframe distributions, experienced investors alsoview profiles that cover longer timeframes in order to maintain a clearlong-term perspective of market activity. A longer-term histogram revealswhether the intermediate auction is occurring within the context of abracketing or trending market. A bracketing market—also referred to asa balancing, range-bound, trading, or sideways market—consists of several days with overlapping ranges. Trending markets show much less tendency to overlap, as price and value areas consistently trend up or down.
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Information
yyAyABLyzABKLyzABDKyzABCDEFKBCDEFGHJKBCDEFGHJKBDEFGHIJBDGHIJHIJHIHFIGURE 2.1 Balanced market proﬁle showing symmetrical distribution of TPOs.Source: Copyright ľ 2006 CQG, Inc. All rights reserved worldwide. www.cqg.com.
Price
11418114171141611415114141141311412114111141011409114081140711406114051140411403
yyyyyy
zzz
AAAAA
BBBBBBBB
CCC
DDDDDD
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GGGG
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Ti m eFIGURE 2.2 Market proﬁle from Figure 2.1 separated out according to 30-minutetime intervals.Source: Copyright ľ 2006 CQG, Inc. All rights reserved worldwide. www.cqg.com.
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We will expand on the relationship between price and value as we moveforward.One of the most important, yet challenging market assessments thatinvestors wrestle with is determining whether a market is bracketing ortrending. To make this determination even more of a challenge, it is alsotrue that brackets and trends are largely timeframe dependent. A trend toa scalper is of no consequence to the long-term investor. An upward trendto a day-timeframe trader may simply be a series of thirty minute time periods with higher highs and higher lows; however, for the intermediate-termtrader this activity is considered non-trending, as the activity remains wellcontained within the middle quadrants of the intermediate-term bracket ortrading range. A trend for the intermediate-term trader may be a move between the extremes of a larger trading rang, with no longer-term trend, asthe market remains balanced from a long-term perspective. Context, context, context.The value area mentioned previously, a fundamental element of themarket profile, is defined as the range of prices that includes 70 percent ofall TPOs in a profile—the prices that saw the most activity, as witnessedby the greatest accumulation of individual time-period letters. The valuearea is determined by starting with the price that resulted in the greatestvolume—the longest horizontal line—then summing the volume occurringat the two prices directly above the high-volume price and comparing itto the sum of the two prices below. The dual-price total with the highestvolume becomes part of the value area. This process then continues until70 percent of the volume is accounted for. Figure 2.3 illustratesthis process.Notice that the value area represents approximately one standard deviation. This distinction enables you to distinguish price from value, the mostfundamental principle of investing. When price occurs within the valuearea, price and value are considered to be the same. When price occursoutside the value area, price is considered to be away from value. Regardless of your timeframe, as price moves away from the value area, therewill either be acceptance of the move—witnessed by TPOs accumulatingat the new level, which effectively changes the shape of Profile and shiftsthe value area—or rejection, in which case price will return to the valuearea with little change in the volume distribution. Trends occur when pricemovements result in value-area migration. Bracketing markets are revealedwhen price movements continually revert to a consistent value area, containing price within well-defined parameters that can last for months.Figure 2.4 (see page 26) shows the S&P 500 futures contract profile from November 21, 2005, through December 29, 2005—a 27-day,intermediate-term trading bracket that ranged from 1257.50 to 1284.70.During this period, the market completed five legs that traversed from low
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Price
Volume
100-04100-03100-02100-01100-0099-3199-3099-2999-2899-2799-2699-2599-24a99-2399-2299-2199-2099-1999-1899-17
AAALALALALALALACGKLABCGKABCGHKABCDEFGHIKABCDEFGHIJKBCDEFHIJKBCDEHIJBCDJBCDBCBB
TPOs
Selection Order
1016
42
1116
13
4
5b
a
High TPO priceOnly the closest price is used since it fulfilled the 70% or bettervolume requirement.
b
Notes:Total TPOs = 78.70% = 54.6 or 55.Value area is 99-21 to 99-28 (73%).For comparison, the volume value area was 99-20 to 99-30.
FIGURE 2.3 Calculation of the Value Area.Source: Copyright ľ 2006 CQG, Inc. All rights reserved worldwide. www.cqg.com.
to high; high to low; low to high; high to low; low to high; which was followed by a partial break and rally, and finally a high-to-low break that ledto a downward spike on the final trading day of 2005.Inspection of the profile in Figure 2.4 reveals that the longest horizontalline—which represents the highest volume—occurred in the lower portionof the profile. Recalling how we calculated the value area, by summingthe volume both above and below the high volume area (referred to asthe point of control, or POC), you will see that the POC was moving lowerover the course of the 27 days, which signifies that the value area was beingforced lower. Without the multidimensional view (time, price, and volume),what was really occurring in this market might have been masked by hype;the experts, especially the CNN analysts, were all reporting high odds fora Santa Claus rally—defined as the trading period between Christmas andNew Year’s. You couldn’t turn on the television without seeing some pundit
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128440128400128360128320128280128240128200128160128120128080128040128000127960127920127880127840127800127760127720127680127640127600127560127520127480127440127400127360127320127280127240127200127160127120127080127040127000126960126920126880126840126800126760126720126680126640126600126560126520126480126440126400126360126320126280126240126200126160126120126080126040126000125960125920125880125840125800
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Timea
High TPO price.
FIGURE 2.4 Intermediate-term market proﬁle: March 2006 S&P 500 futures contract, November 21, 2005–December 29, 2005.Source: Copyright ľ2006 CQG, Inc. All rights reserved worldwide. www.cqg.com.
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