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The Logic
Behind the Tool
When
compared to other technical charting tools, Market Profile™
best depicts visually and rationally the dynamics of both
long and short-term supply and demand, the effects that
these forces have on market prices and finally how traders
react to these prices moves.
Determining Fair Value
This visualization is best and
most fundamentally illustrated by the determination of the High
Volume Price and Fair
Value . The high
volume price is very simply
what the market has determine at any given time as the
fairest price for a particular commodity or security given
all available information available to traders. In essence,
supply and demand are at equilibrium at this high volume
price. Absent any additional or new information the market
will tend to remain close to this “fairest level” as
scalpers (short-term traders) sell when prices rise
significantly above this price and buy if prices drift much
below this equilibrium as they seek short-term gains.
Fair
value simply takes the basic
statistical concept of standard deviation to expand and
define market equilibrium from a single price to a range of
prices that will capture the majority of trading volume. For
our purposes we use one standard deviation, which captures
approximately 70% of the volume around the high volume
price. The same concepts of equilibrium and how market
forces behave relative to the high volume price discussed
above also apply to the fair value area.
Short-term vs Long-term Traders
It is when prices begin to move
away, either above or below this fair value area that we
begin to get a read on market direction and momentum. Unlike
the short-term traders who will tend to keep price near
their current fair value price, it is the long-term players
that will emerge as buyers above fair value and sellers
below fair value. This is usually in reaction to the release
of new information regarding a particular commodity or
security and will cause the market to seek a new fair value
to reflect this new information. These long-term traders
have a much longer view than scalpers and as such are not as
concerned or sensitive to the cost of getting into a trade
and as a result will typically cause larger moves when they
enter the market.
This initiating
activity by long-term traders
is represented on the graphs by single
prints or a consecutive series
of prices with minimum volume. These single prints are
reflective of these long-term traders pushing the market to
either new highs (lows) looking for responsive
selling (buying) by scalpers.
These single prints which are visually very apparent on the
graphs will then serve as key support / resistance levels as
they represent where long-term traders previously entered
the market and where short-term traders finally responded to
halt the move away form the previous fair value area.
Searching for a New Fair Value
As this dynamic between short-term
and long-term traders continues to unfold, it also becomes
very significant for purposes of support / resistance as to
where the market closes relative to the previous top
(bottom) of the fair value area .
This again makes sense intuitively based on our discussion
above as a close outside of the fair value area would be a
clear indication that the market has left its old
equilibrium level and will begin to seek and define a new
high volume area, whether it be for a day, week, month or
longer.
While this brief discussion touches on the logic behind
Market Profile™ graphs and their representation of market
dynamics, the following section will go into much more
detail on how to use MacroGraph to recognize market
direction and momentum, determine profit potential and
define risk.
How
to Use the Graphs
Determine Momentum (Direction)
There are three primary signals
within the profiles that allow us to get a read on any
directional momentum that may exist for a particular
commodity or security.
Extremes
– The first signal that gives us a
clue as to momentum is defined as single
prints at the very top or
bottom of a range. In other words, extremes are the tails
(top or bottom) of a profile. Extremes are significant as
they represent the entrance of long-term players moving
the market away from a previous fair
value area , and will
continue until their buying (selling) is met by short-term
traders selling (buying). As such, buying extremes at the
top or above of a fair value area will signal positive
momentum and conversely, selling extremes at the below
value will signal a market that is developing a negative
bias.
Range
Extensions –
The second signal we get that gives us a read on momentum
is an extension of the initial balance referred to as a
range extension. In that initial
balance is the range of
equilibrium defined early in any trading session based on
the opening orders or trades, a move away from this
initial balance or a range extension is a significant cue
as to growing momentum in a given direction. Again, a
range extension reflects traders willing to push the
market out of a range of prices that had previously been
determined as equilibrium.
Close
Relative to High Volume Price or Top/Bottom of Value
- The third and final signal that is an
indication of market direction, is where the market closes
relative to a previous high
volume price or the top or bottom of the previous high
volume area. The close relative to one of these key levels
is often the determining factor that confirms or rejects
previous momentum indicators mentioned above such as extremes
or ranges
extensions. For example, if
early in the day we saw an extreme
to the upside, but subsequently saw the market sell off
hard and display a range extension below the initial
balance and then close just below the previous high volume
price, we would consider this a confirmation of downward
momentum and stay short.
Even without a previous momentum
signal, high volume prices provide good entry/exit
(support/resistance) points points.
Even more significant than a close relative to the high
volume price is a close either above the top or below the
bottom of a fair value area. This holds greater meaning in
that it increases the probability that the market has left
an old equilibrium area and is moving to establish a new
one. This type of close should be given due notice.
Entry Points – Where to Get In
(support/resistance)
Once we have determined a
specific read on momentum and direction, the obvious
question then is where to enter the market in order to
take maximum advantage of the indicated move without
giving away too much of an edge to get into the trade.
Entry
points (support
and resistance levels) –
Often old high volume prices provide support in a falling
market and resistance in a rising market. Very low volume
prices or single prints within two distributions act as
support/resistance when revisited.
Single
Prints – As
we mentioned in our previous discussion, single
prints represent the entry
of long-term players into the market and as such provide
excellent support or resistance due to the fact that they
act as a landmark of a previous, significant event. For
example, during any given session if we were to get a
negative signal on momentum due to say a range
extension below the initial
balance , we are then
looking for a prudent location to place a short. In this
case we would look for any single prints above the current
market level and set a short as close as possible to the
highest price in this single print range. The inverse
strategy would be appropriate after detecting a positive
momentum read. It is important to remember that selling or
buying against single prints is only effective when they
have not been previously traded through (the single print
prices have not traded since printing).
High
Volume Price
– While a close relative to a high
volume price can serve as a
key signal of momentum, the high volume price can also
provide an excellent spot to set a new position once
getting a clear indication on market direction. While this
is true any time during the session, is can be even more
significant toward the end of the day. For example, take
the case where a positive signal on momentum is apparent,
but the market has pulled well back off its highs and is
trading well within the old fair
value area but still above
the high volume price.
With the close approaching, the high volume price provides
an attractive support level and entry point as proof that
while the market may not have gathered the strength yet
for a new run at the highs, traders are not willing to
push it through is old fairest price and so the upside
momentum is intact.
Defining and Minimizing Risk
Now that we know which way the
market is going and where to get in, like any solid
trading strategy, we need to define where our risk is and
when its time to get out.
Top
and Bottom of Fair Value Area
– As defined, a fair
value area represents where
the majority of trading (70%) has taken place over a
previous trading session or period. It would then seem
logical, as we have previously discussed that any price
move outside of this well-defined area would reflect a
changing view in the marketplace. For this reason, the top
and bottom of fair value
areas serve as our best location for determining upside or
downside risk when it is time to exit a trade. More
specifically, long positions should be liquidated (set
stop) when the market trades through the bottom of the
previous high volume area and conversely, a short position
should be closed out with a trade through the top of the
previous fair value area. These fair value areas are
clearly defined by a thin vertical bracket to the right of
a profile and the bottom and top clearing designated by a
small horizon line.
The use of tops and bottoms of
value areas to determine risk and set stops may be one of
the most valuable aspects of MacroGraph. If stops are
continually rolled (trailing stop) to the next higher
bottom of value (rising market) or the next lower top of
value (falling) market, you can continue to hold a
position indefinitely taking advantage of momentum,
locking in profits but knowing you are continually
defining and minimizing your risk and consequently your
loses.
Single
prints – For
the same reasons that single
prints
provided excellent locations to originate a new position,
so also do they indicate significant levels of support and
resistance and consequently risk. Against a long position
liquidating stops should be set just below the lowest
price in a series of single prints and conversely, against
a short position stops should be set just above the
highest price in a series of single prints. Again, only
single prints that have not been traded through since last
printing should be used for this purpose.
Project Profit
Potential
Having initiated a new position and defined our risk with
a high level of confidence, last but not least we want to
know how much we can expect out of this trade. In other
words, what is the potential profit and when has it run
its course?
Average Range
– Unique to the MacroGraph is the measurement of average
width
(horizontal) and average
range (vertical) of each
profile that can be found in the lower left hand corner of
each chart. For purposes of projecting future price moves
we have found these average to be quite consistent over
time and therefore useful in projecting the magnitude of
potential price moves. For example, if on a monthly
profile we are confident that the momentum is to the
downside and on average the monthly range for this
particular commodity is 4 points then we would measure
starting from the high of this month to a price 4 points
lower to project price objective.
Finding Trade Opportunities
Using the measurements of
average width and average range supplied on each
MacroGraph chart provides traders with the ability to scan
any number of commodities or stocks looking for potential
trade opportunities.
Markets
that are Ripe for a Breakout – Most
markets follow a pattern of coiling, moving, coiling and
moving. In other words, after a vertical price move
(range) of some magnitude, markets will consolidate moving
mostly sideways (width), before a new set of factors
creates the next vertical move. By scanning various
markets looking for profiles that exhibit an above average
width or graphs that show consecutive profiles with below
average ranges you are able to quickly decipher those
markets that are overdue for a significant move or as we
would say are “ripe”.
Once you have identified a market that has experienced an
inordinate amount of sideways movement or is “coiled”
you have found a trade opportunity and can then focus on
detecting the first sign of momentum so as to determine
which direction the ensuing move will take.
Markets
that are Overextended
- Conversely, using the average measure of range, we can
look for markets that are overbought or oversold simply by
the magnitude of their recent vertical move. If for
example, a stock that has an average monthly range (low to
high) of $2.00 has, after only the first week of the month
already seen a rally of $1.85, chances are this stock has
run its course in the short run and could present a great
short opportunity once the appropriate momentum signals
are observed.
Using Multiple Time Frames to Confirm Reads
MacroGraph provides users with
the unique ability to apply the sound analytical concepts
of Market Profile™ to multiple time frames from week to
years. The question is then when to use which time frame
and how to relate one to the other.
Quite often when looking at a series of short-term
profiles, whether daily or weekly, there is no real
discernable pattern, and to the contrary it is very
difficult to even determine what value the market has
deemed as fairest. However, when this same series of
short-term profiles are consolidated into a single
longer-term profile - for example a month or a quarter, a
high volume price and fair value area quickly become
evident. In other words, the longer-term charts will more
often tell you that in fact the market is trading very
close to its equilibrium level even though short-term
charts look somewhat chaotic.
Experience has shown us that
using the shorter-term profiles to improve timing in
longer-term patterns is the most effective use of this
tool. In other words use the longer-term profiles to
analyze patterns or trends and use shorter time frames to
confirm or negate your suspicions. There is a brief moment
in time that a trend begins. If you understand the
potential and probability of a breakout you will be able
to react when the time presents itself with little risk.
GLOSSARY
High
Volume Price (Fair Value)
For any given time period that single price which reflects
the largest corresponding volume as represented by the width
of the chart at that price. This price reflects
equilibrium over this time period as that price at which
the most buyers and sellers are willing to transact given
all available information. Absent any new information or
evidence to the contrary and as long as the current price
is within the fair
market area the market will
tend to gravity to this price.
Fair
Value Area That range
of prices defined for any given time period as containing
67% of the prices above and below the high volume price.
In statistical jargon this presents one standard deviation
or would capture 67% of the price fluctuation over a given
time period. The top of value and bottom of value are used
as key support and resistance levels.
Top of
Value That price which
is the highest price in the fair
value area . Movement above
this price represents new momentum away from the current
fair value area and a buy signal. Once above this price,
it will then act as support.
Bottom
of Value That
price which is the lowest price in the fair
value area . Movement below
this price represents new momentum away from the current
fair value and is sell signal. Once below this price, it
will then act as resistance.
Initial Balance
The price range for any given trading session as defined
by the low price and the high price of the opening period
of that trading session. In most cases this would reflect
the first half hour. This range determines the initial
equilibrium of the market or fair value and is used as a
base to decipher the initiation and extent of any range
extensions or shifts in
momentum.
Range
Extensions Any movement
in prices either higher or lower away from the high volume
area that is usually or initial balance that is usually
characterized by single
prints. Range extensions
usually reflect new players in the market or a shift in
sentiment regarding the markets fair
value and are a strong
indication of a new trend.
Single
Prints Those prices
that reflect the minimum increment of volume as reflected
by the width
of the chart at that price. Single prints representing low
volume at those prices are reflective of initiating or
responsive activity and can be used as support and
resistance levels.
Extremes
Single prints immediately above or below the fair value
area. This can be reflective of a range
extension that is losing
momentum and should be faded.
Width
(volume) The distance designated
horizontally on the chart by a solid color or colors
associated with a specific price. This distance or width
represents or is a proxy for volume at that price.
Length
(range) The distance defined by a specific
price range (low to high). A relatively short length over
a given period may reflect a market that is “ripe” for
a breakout, while a large length (range) in early in a
specific time frame may reflect a market that is ready to
consolidate.
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