Market Profile – Basic Concept N Terminology

Market Profile – Basic Concept N Terminology

Market Profile – Basic Concept N Terminology,  is a part of the section I had started for posting few descriptions and uses of various Technical Analysis Tools and Indicators and off late have been busy with work so must not have posted in recent times and finally making an attempt to write down this piece as I was trying to accumulate as much information I can and then present this article and hope it will be of use for newbies as well as few other conventional traders and analysts as well. Market Profile is an important tool under the Auction Market Theory. No. This is not the so called Holy Grail indicator that the snake oil vendors sell for various trading software and in fact this is not an indicator at all… Its a graphic presentation of the developing market price which was devised and developed by  J. Peter Steidlmayer who was an active trader at the Chicago Board of Trade (CBOT), He was interested in seeking the information to evaluate the Market Value as it develops during the day. In this pursuit he developed this charting technique which was later introduced to the public in 1985 as a part of the CBOT product (Market Profile is the registered trademark of CBOT ). Before we get into a detailed illustration of Market Profile, let me tell you again that this is not a Holy Grail and as a trader it needs a lot of patience, perseverance, determination and  understanding to use any of the available charting techniques. There are many people who want to learn trading and keep searching the Internet for what they have to do or what they should do to make profits from the market. They come across various studies and start following a particular indicator or an average.  Lets say, they start following a  ‘X’ period Simple Moving Average or ‘X’ period Exponential Moving Average. My friends, there is also a way to trade that Simple Moving Average as well but patience is the key. Now after few days they trade and trade and trade until they can bear the losses and then again their search for the new indicator starts. Now they come across Stochastic Oscillator and they merge the Stochastic Oscillator with the Simple Moving Average and then make profits for the 1st, 2nd and 3rd day and on the 4th or 5th day give away all the gains as those averages or oscillators will take time to react to what is happening in the market and by the time they can get a sell signal from their already long position, the price will be below their buying price or vice versa for a sell trade. I am not at all an critic of SMA or EMA or any indicators and to be frank ; Until I could come across Market Profile, I had started using those Averages and Indicators and had been able to devise a strategy on how to trade using them. But the mind was always questioning that will I get to chase the complete up move/down move or will I have to be satisfied with few points of profits before they run into losses. It is not that those averages, average crossover of the shorter and longer average, indicator divergence related to price, price making higher high and and lower high and lower low, candlestick patterns, gaps etc. are not good trading tools, but they do not give a clear picture of the Market Structure. Basically, the fact is that, all traders are trying to device some trading method or trying to learn some technique that can make them successful and fetch good returns. What these traders are looking at is a mathematical formula which moves/oscillates with the price and is not constant. As the markets are ever changing, we either need something constant or solid/concrete technique,  in other terms we require a technique to determine the fair value. Markets do not produce a sine wave that can be read on an oscillator (few of my friends who are really seasoned traders always argue that they trade with indicators and they have made decent profits and I am not at all denying that fact). There are many who trade with Averages crossover combined with indicators and then the last pane on the chart is Volume. They say that if the breakout or breakdown is with Volume then its considered that the trend will stay there for sometime. When it comes to Volume, then on a simple Candlestick/Bar/Line chart we can have volume as an overlay or in the other pane; but how do we know what that volume is all about ?? whether the big boys are buying or selling or adding or liquidating and what not. Few say that high volume created before any important event day with a rise in price is buying.  They start making assumptions based on this volume bars and also have mathematical targets fixed in their minds and few of them say that if Inflation comes lower,  then next day markets will rise and if comes higher it will fall and if Industrial Production Index Data comes better then expected then it will rise and if comes poor then expected, then it will fall. All these assumptions and predictions don’t work in the markets as the term Future Contracts itself is an evidence that the Markets always discount the Future. Coming back to the Volume chart, the volume bars in the next pane of the bar chart are not a representation of anything else, but the overall volume traded in the particular Stock, Index or Commodity during that particular time frame. This is exactly where we need to look into the Market Profile.  J. Peter Steidlmayer developed this method to determine the Volume distribution during a trading day and for that reason he created a graphic representation of the Volume distribution in terms of Price over Time. Price and time are very important to determine the volume distribution and as the price and volume develop during the day, a bell curve develops. This curve shows the acceptance and rejection of price on that day. We are now able to make out when the market is in balance and when its imbalanced.  Have a look at this chart below.

Havells MP Chart with a Bell Shaped Curve

Value Area

In the above chart of Havells, each letter represents 30 minutes of trading time. So “A” represents the first 30 minute of the trading and “B” represents the second 30 minutes of trading and so on.  Its not necessary though to have different letters for every 30 mins but the objective is that we have 30 minute interval each to calculate the volume generated for every 30  mins during the day. On a line chart it would look like the red and green line in this chart where we do no have any idea where exactly the buying and selling took place. But on the Letter graphic we can see that the middle area had more concentrated lettering than the upper and lower end. In Market Profile terminology we call it the Value Area – Approximately, the 70% area of the price move wherein the price trades over time in the entire time frame. Value Area – Volume is the 70% are where the 70% of the volume is traded. The yellow line in the middle is the Volume Point of Control (POC- Where the most of the volume activity of the day took place) and the lower line is the Value Area Low (VAL) and the upper line is the Value Area High (VAH). The opening half hour is letter A and closing is letter M here. Lets think of this graphic in terms of an auction. Why did it form a bell curve ? The reason is simple that when the market opened, there were few traders who kept asking for higher price till no one was interested to bid for such higher price and in few hours the bidders started bidding  at much lower price where there were no  traders interested to sell so finally both came to a consensus at the middle price where the buyers were happy to buy and the sellers were comfortable to sell. Hence, after stretching towards both the ends the prices settled in the middle which both the Buyers and Sellers considered to be a fair price. So we have a clear picture in the mind now that the market auctions higher and lower till the buyers and sellers agree to a fair price and thus the value is established. Different software have different density for the letters to be plotted for the price but normally I use density as 1 for most of the scrips above 500 as there will be too much concentration of letters if we follow the tick increment price of each scrip. Though there will be a difference in Value area depending upon the density but will be very much negligible.

Value Area High (VAH)

The highest price of a Value area of the TPOs or the highest point of the 70% area where the volume was concentrated in any time frame is known as the Value Area High (VAH). It can be a daily, weekly, monthly or a composite profile for any defined period.

Value Area Low (VAL)

The lowest price of a Value area of the TPOs or the lowest point of the 70% area where the volume was concentrated in any time frame is known as the Value Area Low (VAL). It can be a daily, weekly, monthly or a composite profile for any defined period.

Point Of Control (POC)

The price of a Value area at which the highest number of the TPOs are placed in the 70% area in any time frame is known as the Point Of Control (POC). It can be a daily, weekly, monthly or a composite profile for any defined period.

Volume Point Of Control (VPOC)

The price of a Value area at which the highest volume is concentrated in the 70% area in any time frame is known as the Volume Point Of Control (VPOC). It can be a daily, weekly, monthly or a composite profile for any defined period.

Initial Balance

Initial Balance or the IB in Market Profile means the first  two brackets A and B of the opening hours or in simple terms, two initial 30 mins brackets after the opening where the price traded.  Many traders like to use two initial 30 mins brackets and few also use one or four 30 mins brackets depending upon the trading hours of the markets, personal observation and trading style.

Few popular concepts of trading with Market Profile

The most popular of the Market Profile Trading strategy is the 80% rule. Please have a look the chart below :

LT- 80 Percent Rule and Minus Development

In the above chart we can see the LT established a value area of 1664 VAL, 1681 POC and 1695 VAH on 18-07-14 and opened at 1655.55 on 21-07-14. As we waited till the initial balance to form it just went above the VAH in the 2nd 30 mins and was back into the previous day’s value area. As J. Peter Steidlmayer has discovered, if price trades for 2 consecutive brackets inside the value area then there are 80% chances that it pushes through the entire value area from VAL to VAH or VAH to VAL. Here the we can open a Low risk High reward short trade nearest to the VAH and book out near the POC and VAH. Though LT just fell shy of the VAL target and closed at 1670 near the VAL. Other way of trading on the basis of Market Profile is if after a balanced distribution day if the market opens below the value area and trades there to form initial balance then initiate a short trade nearest to the previous days Value Area Low (YVAL) with a Stop loss of YPOC and the opposite for a long trade if the market opens above previous days value area and trades there to form initial balance then initiate a long trade nearest to the previous days Value Are High (YVAH) with Stoploss of YPOC. Few traders combine this technique with Key Retracement Levels or Weekly highs and lows as a guidance for their trades. Remember that Market Profile is a technique to determine the structure of the market and not an indicator on its own.

Unfinished Auction and Minus Development

According to Steidlmayer, the auction normally distributes volume in the entire price range of the day with concentration in the middle as we discussed before. Contrary to this we can see an unusual profile in the LT chart on 18-07-14. The market auctioned higher from 17th July’s value area leaving behind single or double prints. Such single or double prints develop when there is unopposed buying or selling (In this case buying) and the market becomes imbalanced ( A trending market on either side is known as an Imbalanced Market in Market Profile Terminology). An imbalanced market has a tendency to revisit such areas where there is minus development and fill that area. The same happened in LT on 21-07-2014.

LVN and HVN

Low Volume Node (LVN) and High Volume Node (HVN) are other important reference points in Market Profile.

SBIN- Low Volume Node and High Volume Node

In the above chart we can see that the volume distributed separately in two stages in the lower and upper area leaving behind the highest concentration near the green lines and the lowest concentration near the red line. The price with the highest concentration is the High Volume Node (HVN) and the lowest concentration is the Low Volume Node (LVN). Though its better to see HVN and LVN on a tick chart rather than a 30 minute chart as it gives the precise price value of the HVN and LVN.  These are important reference points for future reference as these prices show the intention of the buyers and sellers at those prices. Though there is high concentration of volume at the HVNs they do not become the POCs. But they do state the intention of the traders at that particular price and hence there is bulge in the profile. The above chart also represents a Double Distribution day which we will discuss later in the day types.

TPO (Time Price Opportunity)

Indusindbank – TPO chart

Auction is a process where prices travel from one point to another in a particular time. This activity related to time is known as TPO which represents the time spent at a particular price. In the above chart of Indusind Bank we can see there are 30 TPOs below the POC and 139 TPOs above the POC so the price traded for a longer time above the developing POC and for a very little time below the developing POC.

Auction Point

Auction Point is the first price outside the Initial Balance once the Initial Balance is formed.

Responsive Buying

A trader may think that the market is undervalued even though its trading below the value area. The buying that takes place below the value area is known as Responsive Buying.

Responsive Selling

A trader may think that the market is overvalued even though its trading above the value area. The selling that takes place above the value area is known as Responsive Selling.

Initiative Buying

A trader may think that though the market is trading above the value area but still the fair price should be higher. Such buying that takes place above the value area is known as Initiative Buying.

Initiative Selling

A  trader may think that though the market is trading below the value area but still the fair price should be lower. Such selling that takes place below the value area is known as Initiative Selling.

Range Extension

Prices trending upwards or downwards above or below the Initial Balance is known as Range Extension.

Buying Tail

Long term buyers or OTF (Other Time Frame) buyers tend to auction prices higher and leave behind two consecutive single prints at the bottom of the Profile. Such an action is called a Buying tail in Market Profile Terminology.

Selling Tail

Long term sellers or OTF (Other Time Frame) sellers tend to auction prices lower and leave behind two consecutive single prints at the top of the Profile. Such an action is called a Selling tail in Market Profile Terminology.

Poor  or Unfair High

A price where the Buyers do not have buying interest anymore and think that they cant find a fair value any higher is known as a poor or unfair high in Market Profile Terminology.

Poor  or Unfair Low

A price where the Sellers do not have selling interest anymore and think that they cant find a fair value any lower is known as a poor or unfair low in Market Profile Terminology.

J. Peter Steidlmayer had stated various types of trading day types and opening types as the Opening price has a lot to say about a traders intention.

Normal Day

There is minimal or negligible range extension above or below the Initial Balance and the market stays in balance forming a Gussain Profile (A bell shaped curved profile). This day is known as a Normal Day.

Normal Variation Day

The range extends twice above or below the Initial Balance. This day is known as a Normal Variation Day.

Neutral Day

The range extends considerably above and below the Initial Balance but the OTF buyers and OTF sellers get involved in the auction and indicate uncertainity of driving the price away from the previous days Value Area and the day ends with a very little change. This day is known as a Neutral Day.

Trend Day

The OTF buyer or OTF seller take control of the prices since the opening of the market and drive prices in up or down from open until close. This day is known as a Trend Day.

Open Auction

A type of open where the price rotates around the opening price without any directional conviction is known as an Open Auction.

Open Auction In Range (OAIR)

An opening type that opens within the previous days range and auctions back and forth around that opening values. Such open generally closes into a Neutral or a Normal Trend Day.

Open Auction Out Of Range (OAOR)

An opening type that opens above or below the previous days range and auctions back and forth around that opening values. Such open lead to a conviction that the OTF buyers or sellers have stepped in and will manage to drive prices in their direction.

Open Drive (OD)

An opening type that opens and auctions aggressively in any direction away from the opening values. Such open has a  better conviction due to the aggressive price movement.

Open Test Drive (OTD)

An opening type that opens and auctions with lack of conviction initially and visits a reference area to check if there is no unfinished business left in that area and swiftly auctions back through the open. Such open has a  lesser conviction but still a preferred open type for a swift directional move.

Open Rejection Reverse (ORR)

An opening type that opens and auctions in a single direction but finds strong OTF participants and auctions back through the Opening price. Such open is understood to be rejected by the OTF participants and hence leaves behind a buying or selling tail.

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So these are the basics of Market Profile/Volume Profile trading and its a wonderful study to be used as a guidance along with anyone’s existing trading strategy to understand the Structure of the markets. There is not a defined rule that all the above observations described above will always stand true but we can refine the usage by constantly studying and applying it with bit of twists and tweaks in our everyday trades.

I have tried to present the above to the best of my knowledge and from the little understanding that i have and will try to keep posting various other charts to get a better visual understanding of whatever is written here.

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Happy Trading,

Rishi.

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Disclaimer :

Market Profile and any other words or software used herein are the registered trademarks of their respective owners and hereby duly acknowledged. The charts and other writings are for illustration and educational purpose only and not a recommendation to trade. Trading is a risky affair and personal discretion is advised. Usage of this post is in accordance with the Disclaimer and Terms of use of justfintech.com.