TRADING TECHNIQUES

Market ProfileBasics

Every off-floor trader would like to get a feel for how thingsreally are on the exchange floor. Mastering Market Profilemay help you get it.

by Jayanthi Gopalakrishnan

orried that you’ll never beable to compete with thefloor traders? After all,they’re right there in themiddle of the action.They’re privy to inform-ation that off-floor traderssee late or maybe never.Once you start usingMarket Profile, however,you may find yourself with

information than thefloor trader. No longer willfloor traders, decked outin their colored jackets, frantically gesturing and scramblingto make themselves heard and seen by other traders, seemchaotic, intimidating, or bizarre. Instead, with the use of Market Profile, you will see the order in the markets.J. Peter Steidlmayer developed Market Profile in the 1980sin conjunction with the Chicago Board of Trade. Traders whouse it say that they get an in-depth understanding of themarket, contributing to improved trading. Many factors canbe monitored from Market Profile.Market Profile is not an indicator in the typical sense. Itdoes not provide buy/sell recommendations but acts morelike a decision-support tool. It organizes the data so thatyou can understand who is in control of the market, whatis perceived as fair value, and the direction of the pricemove. It is possible to extract enough information fromMarket Profile for you to position your trades moreadvantageously.Market Profile is useful for the pit trader as well as the off-floor trader. The indicator can help the off-floor trader get abetter sense of the market; prior to the introduction of MarketProfile, only floor traders had access to this information.Although all references here refer to using futures contracts,Market Profile can be used just as effectively for othertradables. Software vendors such as Cqg and WindoTraderprovide Market Profile displays for equities.

THEORY

The concept of Market Profile stems from the idea thatmarkets have a form of organization determined by time,price, and volume. Each day, the market will develop a rangefor the day and a

value area

, which represents an equilibriumpoint where there are an equal number of buyers and sellers.In this area, prices never stay stagnant. They are constantlydiverging, and Market Profile records this activity for tradersto interpret.Market Profile is based on the normal distribution curve,wherein approximately 70% of the values fall within one

P R I C E

TIMEPricesabovevalue

VALUE AREAWhere 70%of tradestake place.

VolumePricesbelowvalue

DISTRIBUTION CURVE

standard deviation of the average. If you rotate the normaldistribution curve so that price is along the vertical axis andtime on the horizontal axis (as shown in Figure 1), you havethe structure of Market Profile.A normal distribution curve assumes that the number of occurrences follow a bell-shaped curve. Anyone who hastraded in the markets, however, knows that prices neverfollow a definite pattern; in fact, you rarely see a normaldistribution. What you

see are skewed distribution of prices, which makes it possible to see the price at which mostof the trades actually took place. This provides significantclues about the direction of prices and is the groundwork forunderstanding Market Profile. In theory, this helps the traderidentify where prices are in relation to values.Monitoring price distribution over time gives insight intowhat levels are considered fair and unfair. You may takeadvantage of this information and identify good tradingopportunities.Volume is the key to understanding Market Profile. If prices move away from the value area but volume starts to dry

FIGURE 1: MARKET PROFILE STRUCTURE.

Thestructure of Market Profile follows that of a normaldistribution curve of price occurrences.

Reprinted from

Technical Analysis of

& C

KERRY TALBOT

up, it is likely that prices willmove back to the value area.Such a movement indicatesthat sellers are not happy thatprices are below value andbuyers are not happy thatprices are above value.Trading activity may increaseonly when prices return to thevalue area.If, on the other hand, pricesdiverge from the value areawith increasing trading act-ivity, that indicates marketparticipants are reevaluatingtheir idea of value. By observ-ing market activity throughMarket Profile, you can get agrasp of who is in control of the market and determinewhich way the market is likelyto move.

ATCHING

DEVELOP

The development of MarketProfile can be seen during thecourse of the trading day inFigure 2. Market Profile ismade up of

time priceopportunities

(Tpos), whichare represented by letters.Each letter represents onehalf-hour of the trading day(but beware that the letters usedto represent time periods arenot consistent across vendors).In the example in Figure 2, theperiods are represented withletters

, with A being thefirst half-hour.The first hour of tradingsets the general pattern forthe day and is your firstopportunity to view marketactivity. This period is import-ant for determining what thefloor traders are doing; thosetraders are trying to find aprice at which both the buyerand seller agree to make atrade. There are two broadcategories of market particip-ants: the

day-timeframe trader

and the

other-timeframetrader

. The floor trader isreferred to as the day-

P R I C E R A N G E

DOUBLE-DISTRIBUTION DAYOct. ‘99 crude oil (CEC-NYM), 8/31/99

2230 G2225 G2224 GKL2223 GKL2222 GKL2221 GKL2220 GKL2219 GKL2218 GJKL2217 GJKL2216 GJKL2215 FGJKL2214 FGHJKL2213 FGHJKL2212 FGHIJL2211 FGHIJL2210 FGHIJL

2209 FGHIJL2208 FGHIJL2207 FGHIJL

2206 FGH2205 F2204 F2203 F2202 F2201 F2200 BF2199 BF2198 BDEF2197 BCDEF2196 BCDEF2195 BCDEF2194 BCDEF2193 BCDEF2192 BCDEF2191 BCDEF2190 BCDEF2189 BCDEF2188 BCDEF2187 BCDE2186 BCDE2185

BCE2184 BCE2183 BCE2182 BE2180 B2179 B2178 B2154 B

4590 F4586 F4584 DF4582 DF4580 DE4576 DE4574 YDE4572 YDE4570 YDE4566 YDE4564 YDE4562 YDE4560 YDE4554 YDE4552

YD4550 YD4544 D4540 D

Reprinted from

Technical Analysis of

& C

timeframe trader and all others as other-timeframe. The lattertrader type provides market direction by moving prices to newlevels, whereas the former is interested in trading large volumeson few ticks. They provide liquidity to the markets.The

initial balance

is the price range of market activityduring the first hour (the first two time periods). In Figure 2,this is represented by A and B. On September 7, 1999, theinitial balance for the December 1999 coffee contracts wasestablished in the first two half-hour periods between $91.00and $91.90. A wide initial balance suggests that prices willstay within the range, whereas a narrow one suggests thatprices may extend beyond it. The ability to differentiatebetween the two will only be possible after some experience.If the price range falls outside the the range set by the initialbalance, there is the suspicion that the other-timeframe traderhas entered the market and tried to move prices away from thearea of balance.During D period, the other-timeframe seller entered themarket and drove prices lower. However, during the subsequentperiods, buyers entered the market and drove prices higher. InH, the seller entered again and held control till the close, as canbe seen by the activity during I and J periods.

9190 B B9185 B B9180 B B9175 A B AB9170 A B C ABC9165 A B C ABC9160 A B C ABC9155 A B C ABC9150 A B C D G ABCDG9145 A B C D G ABCDG9140 A B C D G ABCDG9135 A B C D G ABCDG9130 A B C D F G ABCDFG9125

A B C D E F G H

ABCDEFGH

9120 A B D E F G H ABDEFGH9115 A B D E F G H ABDEFGH9110 A B D E F H ABDEFH9105 A D E F H ADEFH9100 A D E F H ADEFH9095 D E H DEH9090 D E H I DEHI9085 D E H I DEHI9080 D E H I DEHI9075 D E H I DEHI9070 D I DI9065 D I DI9060 D I DI9055 D I DI9050 D DI9045 I9040 I J IJ*9035 I J IJ9030 I I9025 I I9020 I I

P R I C E R A N G E

InitialbalanceSellingtailPointofcontrolValueareaClosingrangeBuyingtail

MARKET PROFILE BREAKDOWN

Dec. ‘99 coffee “C,” 9/7/99

P R I C E R A N G E

Point ofcontrol

NORMAL DAY

Sept. ‘99 soybeans (CBOT), 8/30/99

4700

YD4696 YD4694 YDH4692 YDH4690 YDHI4686 YDHI4684 YDHI4682 YDHI4680 YDHI4676 YDHIK4674 YDGHIJK4672 YDGHIJK4670 YDGHIJK

4666 DGHIJK

4664 DGHIJK4662 DGIJK4660 DFGIJK4656 DFIJ4654 DFI4652 DFI4650 DF4644 DEF4642 DEF4640 DEF4636 DEF4634 DEF4630 DEF

OpenValueareaClose

The height of the entireprofile — that is, the high tothe low — is known as the

range

. In this example, therange is $90.20 to $91.90,which is wider than theinitial balance.On occasion, prices goabove or below the initialbalance. This is known as a

range extension

. In thisexample, the range extendsbelow the initial balance,indicating a seller rangeextension.The price range where 70%of the trading activity takesplace, one standard deviationfrom the mean, is the valuearea. In this example, it is thearea between $90.80 and$91.55. Calculation of this areais covered in more detail in thesidebar, “Value area calcula-tion.” This is where the bellcurve comes in. The value areareflects the acceptance levelof a certain price range orbalance area. Any attempt to move prices away could provideimportant clues to direction.The

point of control

is the longest line of Tpos closest to thecenter of the range. In Figure 2, $91.25 represents the pointof control. This is where most of the trading activity took place and is considered to be a fair value for the trading day.J period is the

closing range

and designates the day’sclose. Here, it is $90.40. The closing price is importantbecause you need it as a reference point for the followingday’s opening activity.When you have a series of single letters on either extreme,it is known as a

single-print buying/selling tail

. The presenceof such a tail indicates a strong reaction by the other-timeframetraders. In this case, both single-print buying and selling tailsare present. Since both are very short — only three letters —the response from the other-timeframe traders was verystrong. The buying tail represented by the three I periodsshows that the other-timeframe buyer responded quickly tolower prices. Conversely, the three Bs at the top of the profileindicates that the other-timeframe sellers responded quicklywhen the prices were above value.

ECOGNIZINGDIFFERENT

DAYS

Now that you know how a profile develops, it’s time toexamine the different types of days you might encounter.There are several types of profiles, and you should be able torecognize the shapes associated with the different types of

FIGURE 2: MARKET PROFILE BREAKDOWN.

Market Profile is made up of timeprice opportunities (TPOs), which are represented by letters. Each letter repre-sents one half-hour of the trading day and is placed at each price level occurringduring that time.

FIGURE 3: PROFILE OF A NORMAL DAY.

Awide initial balance and a relatively balancedmarket characterize a normal day. The TPOsare represented by DEFGHIJK. The Y periodrepresents trading prior to the open.