Trading with Market Profile

03/03/2010 12:01 am EST

Focus: STRATEGIES

Graham Neary

Technical Analyst, FuturesTechs

Market profile is a distinct way of charting and analyzing price action. It has a very different feel to normal methods of charting, so be prepared to look at markets in a very different way after reading this tutorial! Hopefully, you’ll see why there are so many traders who swear by it.

Let’s jump straight in and have a look at one of these creatures:

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The above represents a single day’s trading in FTSE futures. It could equally be represented by 30-minute candlesticks like this:

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So what’s going on here?

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Each letter corresponds to a 30-minute period. The letter “m” is 8:00-8:30; “n” is 8:30-9:00; etc. The m’s are drawn in each price interval where this contract traded during the first half hour of trading; the n’s for the second half hour; etc.
Each letter is called a Time Price Opportunity (TPO). These form the building blocks of market profile.

Looking at the FTSE profile above, we can see that the letters are sat next to each other from left to right, forming a “heap.” Where the price bulges out the most tells us where the price traded in the most time intervals, giving a sense of “value” for the day.

With that said, let’s introduce some more terminology.

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Initial Balance Period (IBP): This is the range of the first hour’s trading. In the FTSE, then, it is represented by the price range covered by the m’s and n’s. CQG draws a blue line to the left of the profile to highlight this, and we’ll put it in bold below:

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The IBP is often important, depending on which market you’re trading, since volatility on the open can sometimes bring about a “comfort zone” within which people will trade with a sense of safety for the rest of the day. Breaking out of the IBP then is something that profile watchers will keep an eye on.

Point of Control (POC): This is the price region with the most TPO’s, i.e. which has been traded during the most time periods. If there is a tie for which price has the most TPO’s, then we choose the one closest to the middle of the day’s range.

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In the above profile, we see that 5220 and 5190 both have eight TPO’s, but 5190 is closest to the centre of the range, so it is the point of control.

This is a useful price because it tells us quite precisely where the market traded most frequently. Above there could be considered poor value for the day, while below there could be considered good value for the day.

This notion of “value” is expanded with the concept of the value area. This is the price range containing 70% of the TPO’s, split evenly around the point of control. (The reasoning behind this is that in the “normal” distribution, around 70% of observations are contained within one standard deviation of the mean.)

This gives us a wider range of value for the day. This range can then be overlaid onto a candle or bar chart, and we can use it to provide suggestions for support and resistance levels, or just to see how the market’s perception of value is evolving. Here’s an example:

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In the above chart, we have the following key:

Green: High of value area
Blue: Point of control
Brown: Low of value area

That completes our discussion of profile construction. Now let’s consider some of the ways to interpret what’s happening, which will involve some extra terminology!

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Initiative and Responsive Price Action: We can classifying buying and selling as “initiative” or “responsive” depending on whether it takes place above or below the previous day’s value area.

So if the price is expanding above the previous day’s value area, then we can call that “initiative” buying. And if those gains are being sold back down, that selling can be described as “responsive.”

Similarly, selling down below the previous day’s value area is called “initiative” selling. As you might guess, gains back through those levels would be called “responsive” buying.

Much of the philosophy behind market profile is to do with the fact that different types of market participants move the market in different ways. On the one hand, there are “liquidity providers,” the local or proprietary traders, who profit by making small gains on lots of trades every day. Their purpose is to facilitate the actions of the institutional traders.

The institutions are the ones who, thanks to their size, are truly capable of moving markets. In the context of commodity futures, these would be the commercial hedgers.

For example, the below chart shows a market which was fairly stable on the first day, and then made a big shift on the second:

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Without looking at the volume figures, we could surmise that much of the action in the first day took place with traders and a relatively small number of evenly matched institutions. The second day, though, took us out of that day’s range, with the gains being accepted by the market. That makes it initiative buying, and we can surmise that it was institutional demand that created it.

Single Print Tails: Time periods with just a single TPO, mostly at the extremes of the profile.

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In the above profile, we can see that this market had two such tails: For period “D” at 5300, and period “E” at 5440. The price moved into those regions, but the move was rejected. The move back from 5300 is probably “responsive buying,” while the move back from 5440 is probably “responsive selling.”

By Graham Neary, MSTA of FuturesTechs.co.uk

E-mail Graham at graham@futurestechs.co.uk

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