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Market Profile®, developed by the Chicago Board of Trade and J. Peter
Steidlmayer in 1982, combines price, volume, and time data into a statistical histogram,
with distribution represented by a vertical bell curve.
Used in conjunction with other forms of technical analysis it can be a powerful tool creating a balance between trend, trend reversal, and stop placement.
Steidlmayer, while working the open outcry pits at the CBOT®, noticed that
when the pit was quiet prices ebbed and flowed as buy and sell orders were executed.
He deduced that prices were in balance when this occurred, and short-term players in those days locals - but today more likely the very short term orientated “flippers” in the trading arcades - dominated that volume.
It is evident that short-term players dominated volume most of the time by examining the daily volume of a market and the change in open interest.
For example, Daily volumes can be very large amounting to more than 1 million contracts of volume on a daily basis but with an insignificant change in open interest amounting to a few tens of thousands
The majority of short-term players are bound by time
- they must exit their position by the end of the day - IE: Margin time
Steidlmayer's established three elements:
Price + Time = Market Acceptance = Volume = Market Value
Steidlmayer also observed that there were times when volume was high
and the market moved directionally in a distribution and trended. As prices were
pushed in one direction, short-term players would often follow that direction,
or if caught on the other side, reverse their positions.
He concluded that it was long-term players who decided the current value was unfair and pushed the market up or down mainly through initiating activity.
Steidlmayer also concluded that the trend ended when long term players determined prices had trended too far and were under-valued or over-valued and entered the market through response activity.
MP breaks down this activity and enables one to identify the short term from the long term participants.
MP splits the trading day into 30-minute periods from the opening. Each period is called a
Time Price Opportunity. MP associates a letter to each time period as placeholders for TPOs.
Every time the market trades at a price that has not occurred in a previous 30-minute period,
a letter is placed at that price. As the day progresses, letters build on each other to
produce a view of prices traded in the most or least time frames.
In order to break down market activity further, Steidlmayer created other tools.
A line to the left of the profile represents Initial Balance.
Traditionally, this refers to the first hour of trading. Steidlmayer reckoned that when a market opens, prices move up and down and eventually find a balance where buyers and sellers are willing to trade. When the market opens within the range of the previous day, short-term players usually dominate activity. If the market gaps higher or lower away from the previous close, it is possible that longer-term players may enter and continue in the direction of the gap (initiative), or view prices as unfair and move against the gap (responsive). This tactic is crucial to understanding the relationship of the previous day's close to today's opening, for example, when economic reports occur within the initial balance period, long term players can be forced into becoming short term players, which causes increased volume and volatility.
The line to the right of the profile represents the Value Area. This is the range of 70 percent of the day's volume, either as tic or actual volume. Through observation I have found there is a 95% correlation. So, while actual volume is better, a tic histogram in place of a volume histogram can be used. The Value Area is deemed to be what was fair value for the majority of participants.
MP is an essential tool for trading all products. It has applications in trading the short end 3 month Euro$ where most intraday momentum analysis yield poor results right the way through the asset spectrum of Bonds, Commodities, Currencies, Stock Indices as well as individual stocks.
Various aspects of MP should be analyzed to determine which strategies to use. It is often possible to eliminate one side of the market, unless something very unusual occurs during the trading day, to make short term trading easier. Because MP is frequently used as a day trading tool, it is unusual to analyze further than five days back - many short term traders cannot remember price action beyond that point. An exception to this rule is when price has rejected value, typically in a single letter time frame, i.e. a spike lower or higher. Lastly, no matter what product you apply MP to or even what time horizon, MP is an invaluable tool for identifying areas for the placement of stops.
What Significance is there?
Q: If the opening is higher or lower than the previous close?
A:> If the opening price is higher or lower than the close it signals a change in sentiment overnight. The greater the difference in price the more significant the change.
Q: If the opening is higher or lower than the previous day's value area?
A:> This is more significant because what was considered fair value yesterday is no longer considered fair value today. It's important especially if the price has previously been balanced, E.G. price has been in a narrow range and moving sideways.
Q: If opening price match, exceeds, or fails to meet the opening call level?
(This still has a bearing although with the advent of 24 hour electronic markets less so where the overnight session highs and lows have taken on greater significance)
A:> It's important to get the opening call so you know exactly how bullish or bearish the opening was, i.e., price has opened 10 tics higher than yesterday's value area, but was due to open 20 tics higher. The opening can be regarded as a failure on the upside if price never reaches 20 tics higher in the first time period. (and so one needs to be aware of the O/N High and Low to consider the same question and deduce the answer)
Q: If yesterday's close was at one extreme of the day's range?
A:> The current day's opening determines if the previous extreme close was caused by short term traders forced to liquidate or by long-term traders entering the market. If the opening is higher, and the initial balance remains higher, this confirms the close and we can expect a trend-up day. If the price breaks above the initial balance, or support is found when the price returns to the previous day's high or value area high, this indicates an uptrend. If the open is lower than the previous close, this suggests a potential for price reversal.
Q: If yesterday's close was within its value area?
A:> This suggests the market ended with the day balanced. It's important to see if there were any spikes or rejections of value as these might point the way to the next trend.
Q: Re: the highest level of volume?
A:> This provides a reference area of support or resistance, an important consideration when placing stops.
Q: Re: the control point?
A:> The control point is the highest volume of trade at a price, or prices, in a close range. The control point indicates fair value and aids in placing stops.
Q: And are there any zones of support and resistance on the previous day's extremes of value areas?
A:> Value Area highs and lows prevent poor stop placements, but also provide low risk entry points against the short-term trend. These trades work especially well in broad sideways markets, but can also be used as profit taking points.
The following FAQs apply to the first hour after the market opens. What Significance is there?
Q: If the Initial Balance Range is much smaller than normal?
A:> If smaller, it is highly likely that price will break out in one direction or another, or possibly both directions. Typically, in the absence of any news event that may drive a price, a breakout is not regarded as a directional move.
Q: If the first series of letters or TPOs created an excess that has not been touched by the second letter?
A:> This suggests the opening was regarded as unfair value and often precedes a directional trend move. It's crucial to know the opening trading range.
Q: If yesterday was a trend day, a balanced day, or a neutral day?
A:> Balanced days, where the open is near the close, have similar properties to Japanese Candlestick Dojis, and indicate potential turning points. A neutral day occurs when price distributes in one direction outside the initial balance, then reverses and distributes in the other direction. This is often caused by news events. Generally, short-term traders are caught on the wrong side and the reverse can often be swift and violent. Neutral days indicate nervousness and a possible change in trend and can be compared to key, hook reversals, as well as Japanese Candlesticks engulfing patterns.
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