As a continuation of our Learning TA series, we bring you a different way to look at stock charts: the Market Profile.
Market Profile is a way to visualize how prices have changed and how much been traded at different price points. It began in CBOT (The Chicago Board of Trade) and was originally created by Peter Steidlmayer. It is for the most part, an intraday data based visualization framework. Let’s take a deeper look.
If you divide a trading day into half-hour trading time-frames, for each half-hour, you get the range in which the stock traded (High minus low for that half hour). Now, divide the price chart into increments of, say, 10. If in the first half-hour you trade between 7850 to 7890, you mark that range with “A” vertically.
in the next half hour, the market trades between 7870 and 7910
In the third half hour, the market goes from 7860 to 7940 (volatile!)
In the fourth half hour, the market is 7910 to 7920, and in the fifth, 7880 to 7900:
You can see how this builds up. Already we are seeing that 7890 and 7880 is where most of the prices have been in (it has the longest horizontal “length”) if you may.
We could use half hour sessions for a day, or use 1 minute resolution (where A stands for the first minute, B for the second and so on).
The range where 70% of prices lie is the Value Area. The calculation starts from the longest bars (the most volume) and expands on both sides until you get to 70% of total. A time profile would map 70% of all the price coverage in terms of time of the day.
Instead of pure price/time coverage we could use Price/Volume, so for the 1st minute what we mark with A on a time profile, we will mark with the quantity traded. This gives us a Volume Profile which can be different (and more valuable since a high can occur on a miniscule number of shares). Again, a Value Area for a Volume Profile would be where 70% of the volume occurred.
The Value Area High (VAH) and Value Area Low (VAL) are important levels to work with.
Cut through the BS: What Can I Do With This?
Well, too much theory without a tradeable answer is useless. So let’s cut to the chase – the Value Area of the previous day has this:
If the price opens outside the previous day’s Value Area, and then trades inside it, for more than 30 minutes, there is an 80% chance of it hitting the other side.
Why Previous Day? Because today’s price action hasn’t yet finished to discover today’s Value Area.
So if the price opens BELOW yesterday’s Value Area lower bound and then goes up to trade above that lower bound, it has an 8/10th of a chance of hitting the Upper Bound of the previous day’s Value area.
Here’s recent Nifty (Futures) data:
The above chart was generated in AmiBroker and we use a library that plots Market Profile. Let me know if you want the AFL (if you use Amibroker).
The Blue lines indicate the value area, and the bars inside are candlesticks on 30 minute intervals.
(You need intraday data for this to work, honestly, because in my experience longer timeframes like days or weeks don’t help)
There are two cases above:
• on the 22nd, the market opened way below the Value area of the Previous Day. Then it moved in, and stuck there for at least 30 minutes. And then it moved all the way up to the other side and beyond.
• On the 23rd, the Nifty opened above the value area and went in – and then, it slid all the way down to the other side.
Instead of the open, you can wait for about half an hour so that you don’t get affected by just the open price. In fact to set up the trade, the Market Profile defines an “Initial Balance” (IB) as the first hour or so of the day – you don’t use the open, you consider the first hour as where the price tells you if there is a trade or not – if the price is outside the VAH/VAL even after one hour and then comes back in, you might have a trade.
Of course, this still means that 20% of the time – or one in five times – you will get faked out. The stop loss for such a trade would be the entry level – the upper or lower bound that was broken.
The first hour of a trading day sets up a range. This, on a normal day, is about 70% to 80% of the range of the day.
The part of the market that trades beyond that first hours range, is the Range Extension. When the extension is just 20% to 30% of the initial range, we are in normal territory – if the range extension is higher it means there is a strong intraday move. Sometimes the range extension is more than 2x the initial range! (This happens on strong trend days)
if there is more range extension then the market is likely to be less “balanced” and thus, the longer term traders determine the market more than the short term traders. The opposite is implied when range extensions are small.
Where the market is more balanced, you would fade extreme moves. There are complex ways to figure out if the market is balanced or not, but the quick way is to say that if every time (within the day) the market moves away from the high volume area it returns back, it’s more likely a balanced day. The trade then, in such a day, would be to just wait for prices to go to either extreme and trade it like it will fade back in.
Today (10/10/2014) we saw the market break down, and in the middle of the day there was an opportunity of sorts.
But because we weren’t able to stick inside the value area for too long (it needs to be there for a half-hour) the trade couldn’t be taken.
Interestingly the Point of Control (POC) which is the price at which there was the highest traded volume, of two days ago acted as support. Given the concepts it makes sense – it is where the max trading happens that forms areas of support or resistance.
The basic premise of Market Profile is that in the short term, the market looks to get back to a semblance of normalcy before proceeding in whatever direction it is moving. Even a chart that looks like it’s going up has small periods in which it reverses downwards, and those moves can also provide opportunities.
Market profile works in the very short term – intraday for the most part, according to me – it would basically handle situations like a sudden bout of selling from a large participant. Once the selling is done, the market will go back to a higher price, and that small period provides a trading entry (and exit).
Apart from that, the structure of the distributions (time or volume) gives you a visual idea of where the market “likes” to trade. This part is very subjective and has no easy “formula” to make it work – but there are a number of traders who are able to define a trading move by just looking at the pattern on Market Profile. We’ll leave you the heavier reading for now.
• Read CBOT’s 6 part guide to the Market Profile.
• An excellent seven part introduction to Market Profile and various opportunities it provides.
We don’t really do much Market Profile work at Capital Mind, because the intraday trading time frame is really too difficult to manage. (Too much work with way too much data, means tracking a minute by minute price is too difficult) However looking at Value Ranges has been helpful in both entering and exiting trades, especially for stop losses (where there may be a support or resistance at a Value Area level).
Please do let us know your thoughts or get in touch through the Google group.
Nothing in this newsletter is financial advice and should not be construed as such. Please do not take trading decisions based solely on the matter above; if you do, it is entirely at your own risk without any liability to Capital Mind. This is educational or informational matter only, and is provided as an opinion.
Disclosure: The authors at Capital Mind have positions in the market and some of them may support or contradict the material given above, or may involve a direction derived from independent analysis.