Stock Trading with Market Profile

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The concept of Market Profile has been promoted most effectively by J. Peter Steidlmayer. In his excellent work ‘Mind Over Markets’, Steidlmayer explains why he thinks Market Profiling is so unique. I have found it useful myself, of course, and offer here a quick overview in case you find the topic stimulating.

Central to Market Profile theory is the concept of the ‘Value Area’. This is a continuous slice of the days’s action that holds a standard deviation of the market activity (i.e. roughly two thirds of the day’s action is confined to within this area). The Value Area is determined in advance based on yesterday’s action, and can be large or small, depending on (upon other things) volatility. Markets have 2 kinds of stock trader – the short term (locals or ‘day frame’ participants) and long term (other frame) participants. To consistently make money, it is usually wisest to prepare to align with the other-frame buyers/sellers, no matter which side is actually winning the battle on a particular day. On a day when there is no strong other-frame conviction present, price is likely to rotate up and down in an essentially random support/resistance mode. The trick is to be able to determine who (if anyone) is in control, and when that control is faltering or even reversing.

There are 6 ‘types’ of day identified by using the Market Profiling technique.
* Normal Day – Not as common as the name might suggest. Typified by early entry of other-frame buyers or sellers creating a large initial price range. The action then wanders back and forward during the day in standard auction fashion as buyers and sellers struggle to get the upper hand.

* Normal Variation on Normal Day – Less extreme initial price action, as if the other-frame buyers/sellers are waiting and watching in order to build their conviction. Then the market mnakes a more dramatic move followed by standard 2 way auctioning to the close.

* Trend Day – One side of the other-frame is in control right from the open, and for the whole day. A succession of higher highs/lower lows forms. Experts at have determined that this day type shows a high level of directional confidence throughout the day. The initial range is often narrow.

* Double Distribution Trend Day – This is a variation on a trend day. Looks similar to a normal variation on a normal day, except more time is spend wandering in the first range while the other-frame buyers/sellers build up conviction to make the market move. Something ‘changes’ mid session to cause a change in conviction – perhaps insider news or a report.

* Non Trend Day – Often looks like a Trend day at start (narrow range). Then meanders with no conviction in a range bound area. Often seen before a big news announcement as the market waits to see whether it should jump up or down.

* Neutral Day – Like a non-trend day, except other-frame buyers and sellers are active, they just happen to agree on value (broadly speaking). Traders at say this day type is characterized by range extension beyond the initial balance during the session as the two sides test the edges of each other’s tolerances. Has 2 variations – “Neutral Center” in which price closes near the open (no resolution between buyers/sellers), and “Neutral Extreme”, one side wins, closing either up at the top of the range, or down at the bottom.

The Open often tips the Market’s hand as to what sort of day this is going to be (other things remaining equal). Four types of Open can usually be detected in any Market:-
* Drive – This is the strongest and most definite type of Open. Usually caused by other-frame buyers/sellers reaching strong conviction before the market opens. From the very start the market will auction aggressively in one direction and is unlikely to come back and test the opening range at any point. The initial large move happens in the first time period, i.e. the first half hour, but other large moves may happen later. Generally indicates a Type 3 Trend Day or a Type 2 Normal Variation Day. This Open type is uncommon.

* Test Drive – This Open starts in a similar way to the Drive Open, but stops and reverses. The market is taken lower to go higher or vice versa. The initial large move and reverse back past the Open happens in the first time period, i.e. the first half hour. This is caused by other-frame buyers/sellers wanting to test a previous support/resistance to ensure there is no remaining business there – when this has been confirmed by price rejection, it will roar off the other way. The extreme that has been tested has slightly less chance of holding than the extreme set at the start of a Drive Open, but is still strong. Generally indicates a Type 3 Trend Day or a Type 2 Normal Variation Day, obviously trending in the OPPOSITE direction to the Drive Day type. This Open type is uncommon.

* Rejection / Reverse – Like a test drive, but the initial large move and subsequent reversal take longer to develop (i.e. more than the first half hour). The initial extreme is only likely to hold during the day about half the time. The participants are less convinced than in Drive or Test Drive Opens, and the counter buyers/sellers effectively enter ‘late’ to force price to reverse. Indicates a two-sided trading day, i.e. low probability of a trend day, and that the initial extreme may be re-tested. Generally indicates a Type 1 Normal Day or a Type 2 Normal Variation Day.

* Auction – This Open falls into 2 subtypes, although both look like a market with no firm conviction in either direction. In the first subtype, if the market opens within the Value Area of the previous day, a non-convictional day is likely to develop, as market sentiment remains unchanged from the last session and other-frame buyers/sellers are not strongly present. Any extremes established early have a LOW probability of holding. Usually a Type 1 Normal Day, Type 4 Non Trend Day or Type 5 Neutral Day will develop. If on the other hand the Open is “out of balance” (i.e. outside the previous day’s Value Area) then a “big Day” is likely. Although it may appear to be wandering randomly, the mere fact that the Open was OUTSIDE yesterday’s Value Are suggests the activity of strongly convictional other-frame buyers/sellers. Usually a Type 4 Double Distribution Day will develop.

Relationship of Open to Yesterday’s Range
The Open in relation to yesterday’s range can give valuable clues as to today’s expected range. A Market that opens within the Value Range is generally in balance, and awaiting new information.

The Market can open in one of 3 ways, each of which can be accepted or rejected by the Market.
* Within yesterday’s Value Area – If the price auction spends more than 1 time period within this area, it tends to indicate an acceptance of price, i.e. balance. Range will most likely be similar to yesterdays, with one extreme forming the end to measure from. As long as the extreme holds, the range to the other end will probably be similar in size to yesterday. If the Open is rejected, i.e. it moves in the first time period beyond yesterday’s entire range, there is no way of telling how far it may go in the initiative direction.

* Outside the Value Area, but within Yesterday’s Range – Not quite as balanced as #1, but still relatively balanced. Likely to produce a range similar to a #1, but offset either to the long or short side. As in the first case, if the Open is rejected, i.e. it moves in the first time period beyond yesterday’s entire range, there is no way of telling how far it may go in the initiative direction.

* Open Outside of Range – Conditions have changed and the Market is out of balance. Other-frame buyers/sellers can often make the Market move substantial distances in short times in the direction of the initial break out WITHIN 1 TIME PERIOD. Alternatively, price may auction around the new level (typically for more than 1 time period), and has unlimited potential in EITHER direction. A trend day (3) is likely to develop from this. If this Open is rejected, and price moves back into yesterday’s range within the first time period, there is unlimited potential in the OPPOSITE direction to the initial breakout.

My own feeling on this is that any interest in ‘Market Direction’ is wasted effort – watch for strong penetration or confirmation of major support/resistance – if you see it, go with it. Expect trouble at the NEXT level of support/resistance, and be prepared to jump off if it turns against you. Major support/resistance = pivot/sr123, or anything that develops during the day (e.g. the close, the high low, the fibs, whole numbers, last week’s high low – LET THE MARKET TELL YOU WHERE the levels are!).

It is probably wise to stay out of: –

* Non-trend days – The day’s range is small. Activity is scarce. Go home.
* Just before a News Day – Big News can screw up a market – witness the 150-point jump either way in the Dow in 3 minutes on news of a large interest rate cut in November 2002. Keep an eye on the calendar and go flat a safe distance before a news announcement.

General Rule – Have Patience! If the market is meandering, WAIT for real activity. Never trade because you get bored.

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