$ INTRODUCTION $ The purpose of this writing is to illustrate what Market Profile is and to define its underlying principles. Before the early 1980s, the only technical tools available were the bar chart and the point and figure chart. Since then Market Profile®1 was intro­duced to expand the arsenal of technical tools. Market Profile is essentially a statistical approach to the analysis of price data.2 For those without a statistics background, a familiar example may be helpful. Consider a group of students taking an exam. Typically, some score very high (say 90 or higher), some score very low 60 or lower), but most scores tend to be clustered around the average score (say 75). A histogram can be used to depict the fre­quency distribution of these test scores in a "statistical picture" (Figure B.1).As can be seen, the most frequent score, or modal score, is 75 (6 students) while the range of scores is defined by the low­est and highest scores (55 and 95). Note how the scores distrib­ute evenly around the modal score. For a perfectly symmetric distribution, the modal score will be equal to the mean, or aver­age score. Next observe that the distribution is "bell-shaped," the telltale sign of a normal distribution. For a perfect normal distribution, specific standard deviation intervals correlate to specific numbers of observations. For example, if the test scores are, in fact, perfectly normally distributed, then 68.3% of these scores will fall within one (1) standard deviation of the mean. While actual data is unlikely to form a perfect normal distri­bution, it is often close enough that these relationships can be employed.Prices, like other physical measurements (e.g., school test grades, population heights, etc.), distribute around a mean price level as well. What is the Market Profile graphic? Visualize it as simply, a frequency distribution of prices displayed as a price his­togram turned on its side
The centerpiece of the Market Profile graphic is the (bell‑shaped) normal curve used to display the evolving price distribu‑tion. Once the normal curve assumption is acknowledged, amodal or average price can be identified, a price dispersion (stan‑dard derivation) can be computed and probability statements canbe made regarding the price distribution. For example, virtuallyall values fall within three (3) standard deviations of the averagewhile about 70% (68.3% to be exact) fall within one (1) standarddeviation of the average (see Figure B.3).
Market Profile provides a picture of what's happening here and now in the marketplace. In its pursuit of promoting trade, the market is either in equilibrium or moving toward it. The profile's natur­al tendency toward symmetry defines, in a simple way, the degree of balance (equilibrium) or imbalance (disequilibri­um) that exists between buyers and sell­ers. As the market is dynamic, the profile graphic portrays equilibrium as periods of market balance—when price distribu­tions are symmetric, and represents dise­quilibrium as periods of market imbal­ance—when price distributions are not symmetric or are skewed.
Market Profile is not a trading system nor does it provide trade recommendations. The aim of the profile graphic is to allow the user to witness a market's developing value on price reoccur­rence over time. As such, Market Profile is a decision support tool requiring the user to exercise personal judgment in the trading process.
MARKET PROFILE GRAPHIC
The Market Profile format organizes price and time into a visual representation of what happens over the course of a single ses­sion. It provides a logical framework for observing market behav­ior in the present tense displaying price distributions over a period of time. The price range evolves both vertically and horizontally throughout the session. How is a profile graphic constructed?
Consider a 4 period bar chart (see Figure B.3a). This tradi­tional bar chart can be converted to a profile graphic as follows: (1) assign a letter for each price within each period's price range, letter A for the 1st period, B for the 2nd, and so on (see Figure B.3b) and then (2) collapse each price range to the leftmost or first col­umn (see Figure B.3c). The completed profile graphic reflects prices on the left and period frequency of price occurrence on the right, represented by the letters A through D.‑
sents a Time Price Opportu­nity or TPO to identify a specific price at which the market traded during a specific time period (e.g., in B period prices traded between 163 and 166). These TPOs are the basic units of analysis for the day's activity. In other words, each TPO is an opportunity created by the
market at a certain time Figure B.3c
and certain price. Market
Profile distributions are
constructed of TPOs. The Chicago Board of Trade (CBOT) assigns a letter to each half-hour trading period on a 24 hour basis; upper­case letters A through X represent the half-hour periods from midnight to noon while lowercase letters from a through x repre­sent the half-hour periods from noon to midnight.3
MARKET STRUCTURE
When you visit a commodities trading pit on a busy day, you observe what is best described as "controlled chaos." Beneath the screaming and gesturing locals and other traders, there is a describable process. Think of the market as a place where partici­pants with differing price needs and time constraints compete with each other to get business done. Emotions can run high as anxiety levels soar.
The Market Profile concept was introduced by Mr. Steidlmayer in an attempt to help describe this process. As a..
CBOT floor trader (local) and student of market behavior, he observed recurring patterns of market activity, which ultimately lay the foundation for his understanding of the market. Since the CBOT trading floor conducts trade in an auction-like man­ner, he defined Market Profile principles in auction terms. For example, an off-the-floor trader would describe an advancing market as one that is rallying or trading up, whereas Mr. Steidlmayer would instead say something like, "the market con­tinues to auction up, advertising for sellers to appear in order to shut off buying."
To explain why a trading pit auction process works the way it does, he invented some new terms unfamiliar to off-the­floor traders. He began with a definition of a market's purpose, which is to facilitate trade. Next, he defined some operational procedures, namely that the market operates in a dual auction mode as prices rotate around a fair or mean price area (i.e., sim­ilar to the way school grades were distributed). Lastly, he defined the behavior characteristics of market participants, namely that traders with a short term time frame seek a fair price, while traders with a longer term time frame seek an
advantageous price.
MARKET PROFILE ORGANIZING PRINCIPLES
Auction Setting: The purpose of the marketplace is to facilitate or promote trade. All market activity occurs within this auction setting. Initially, as price moves higher, more buying comes in, as price moves lower, more selling comes in. The market moves up to shut off buying (i.e., auctioning up until the last buyer buys) and moves down to shut off selling (i.e., auctioning down until the last seller sells). The market actually operates through a dual auction process. When price moves up and more buying comes in, the up-move advertises for an opposite response (i.e., selling) to stop the directional move. The opposite is true when price moves down.
Continuous Negotiation: When a mar­ket moves directionally it establishes price parameters, an unfair high and an unfair low, and then trades between them to establish a fair value area. All trade takes place through this negotiating process and remains within these parame­ters until one side or the other side is eventually taken out (i.e., a new high or new low is formed). (see Figure B.4.)
Market Balance and Imbalance: The market is either in equilibrium or working toward equilibrium between buyers and sellers. To facilitate trade, the market moves from a state of balance (equilibrium) to one of imbalance (dise­quilibrium ) and back to balance again. This pattern of market behavior occurs in all times frames, from intraday ses­sion activity to single session activity to aggregated or consolidated sessions Figure B.4 activity which form the longer term
auction.
Time Frames and Trader Behavior: The concept of differ­ent time frames was introduced to help explain the behavioral patterns of market participants. Market activity is divided into two timeframe categories, short term and longer term. The short term activity is defined as day time frame activity where traders are forced to trade today (e.g., locals, day traders and options traders on expiration day fall into this category). With limited time to act, the short term trader is seeking a fair price. Short term buyers and sellers do trade with each other at the same time and at the same price. Longer term activity is defined by all other timeframe activity (e.g., commercials, swing traders, and all other position traders fall into this category). Not forced to trade today and with time as an ally, these traders can seek a more advantageous price. In pursuit of their interests, longer term buyers seek lower prices
while longer term sellers seek higher prices. As their price objec­tives differ, longer term buyers and sellers generally do not trade with each other at the same price and at the same time. It is the behavioral interaction between these two distinct timeframe types of activity that causes the profile to develop as it does.
The Short Term Trader and Longer Term Trader Play Different Roles: Short term and longer term traders play key, but different, roles in facilitating trade. A market's initial balance (i.e., a place where two-sided trade can occur) is usually estab­lished in the first hour of trade by short term buyers and sellers (day timeframe activity) in their pursuit of a fair price. Most of the day's activity occurs in the fair price or value area. Prices above and below this developed fair value area offer opportuni­ty and are advantageous to longer term traders. With time on their side, longer term traders can either accept or reject prices away from fair value. By entering the market with large enough volume, longer term buyers and sellers can upset the initial bal­ance, thereby extending the price range higher or lower. The longer term trader is responsible for the way the day's range develops and for the duration of the longer term auction. In other words, the role of the longer term trader is to move the market directionally.
Price and Value: The distinction between price and value defines a market-generated opportunity. There are two kinds of prices: 1) those that are accepted—defined as a price area where the market trades over time and 2) those that are rejected—defined as a price area where the market spends very little time. A rejected price is considered excessive in the market—defined as an unfair high or unfair low. Price and value are all but synony­mous for short term traders as they ordinarily trade in the fair value area. For longer term traders, however, the concept that price equals value is often inaccurate. Price is observable and objective while value is perceived and subjective, depending upon the particular needs of longer term traders. For example, a price at the top of today's range, while excessive or unfair for today, is cheap to the longer term trader who believes that prices next week will be much higher (i.e., today's price is below next week's anticipated value).The longer term trader distinguishes between price and value by accepting or rejecting current prices away from his per­ception of fair value. Recall that rising prices advertise for sellers while falling prices advertise for buyers. When the longer term trad­er responds to an advertised price, this behavior is expected and is referred to as responsive. On the other hand, if the longer term trad­er did the opposite (i.e., buy after prices rose or sell after prices declined), then this unexpected activity is referred to as initiating. Classifying longer term activity as responsive or initiating relative to yesterday's or today's evolving value area provides anecdotal evi­dence of longer term trader confidence. The more confident the trader becomes, the more likely he is to take initiating action.RANGE DEVELOPMENT AND PROFILE PATTERNS
Since market activity is not arbitrary, it's not surprising that over time recognizable price patterns reveal themselves. A skillful trad­er able to anticipate such pattern development in its early stage may be able to capitalize. Mr. Steidlmayer loosely identifies the following daily range development patterns:
1. A normal day occurs when the longer term trader is rela­tively inactive. The day's range is established in the pioneer range (defined as the first column of prices) during the ses­sion's first half-hour period of trade. The short term trader establishes the initial balance, the unfair high and low, and then prices rotate between these parameters for balance of the day (see Figure B.6: Panel #1—Orange Juice).
2. A normal variation day occurs when the longer term trad­er is more active and extends the range beyond the initial balance. In this instance, the short term traders initial bal­ance parameters do not hold and there is some directional movement which extends the range and sets a new high or new low parameter. As a rule, the range extension beyond the initial balance can be anywhere from a couple of ticks to double the initial balance. This profile type is probably the most common (see Figure B.6: Panel #2—Dow Jones Industrial Average).
3. A trend day occurs when the longer term trader extends the range successively further. In this instance, the range is considerably more than double the initial balance with the longer term trader controlling direction as the market con­tinues its search for a fair price. Here the market moves in one direction and closes at or near the directional extreme (see Figure B.6: Panel #3—Japanese Yen).
4. A neutral day occurs when the longer term trader extends the range after the initial balance in one direction, then reverses and extends the range in the opposite direction. Neutral days indicate trader uncertainty and occur when the market probes or tests for price trend continuation or change TRACKING LONGER TERM MARKET ACTIVITY
With the exception of option sellers who profit when prices remain static, the profit strategy of most traders requires direc­tional price movement. The trader wins when he gets the direc­tion right and loses when he is incorrect. Because the longer term trader is responsible for determining the market's directional movement, we monitor this activity to help detect evidence of a price trend. After identifying and evaluating longer term trader activity, an educated conclusion regarding price direction can be reached. We begin the process by identifying the longer term trad­er's influence in today's session and then considering how that influence extends into the future.
• Influence in day's range development: The profile graph­ic helps identify longer term trader behavior during daily range development. By monitoring longer term activity throughout the range, particularly at the extremes, at range extension, and after value area completion, we can deter­mine whether longer term buyers or sellers are more active and hence control market direction. Activity at the extremes provides the clearest indication of longer term trader influence, followed by range extension and then value area buying and selling.1. Extremes are formed when the longer term trader com­petes with the short term trader for opportunities at a par­ticular price level (which later becomes either the session high or low). A minimum of two single prints is required to establish an extreme. The more eager the longer term trader is in this price competition, the more the single prints and the longer the single print extreme. Anything less than two prints suggests that the longer term trader is not very interested in competing at that price. A local top or bottom is formed when only one single print defines the top or bottom of the range. This condition implies that the market offered a price opportunity which no one really wanted (i.e., no evidence of competition.
2. Range Extension occurs when the longer term trader enters the market with enough volume to tip the initial balance and extend the range up or down. Range exten­sion up indicates longer term buying while range exten­sion down indicates longer term selling. However, there are occasions when both the longer term buyer and sell­er are active at a range extreme, but not at the same price and time (recall that longer term buyers and sellers gen­erally do not trade with each other). For example, if an extreme is formed after a range extension up, the market moves up first to shut off buying and then moves down to shut off selling. This is an example of both longer term buyers and sellers trading in the same price area but at different times. Both kinds of activity at the extremes are identified to evaluate the impact of longer term buying and selling (see Figure B.7: Panel #2—Coffee).
3. The Value Area is determined each trading session by price rotations around the modal price (i.e., the price with the highest TPO count or the fairest price). The value area is computed by counting 70% of all TPOs sur­rounding the fairest price. In other words, the value area is an estimate of fair value which is approximated by one standard deviation of the session's trading volume (recall the student example earlier). When a longer term trader makes a trade in the value area, he is buying low or selling high in relation to a longer term view, not in relation to today's value. This behavior creates an imbal­ance in today's value area. Longer term trader activity is measured by counting TPOs. The following procedure can be used to determine which side contains the longer term imbalance, 1) a line is drawn through the fairest price, and 2) TPOs are counted on either side of the fairest price until a single print is encountered. The imbalance is assigned to the side with the smaller num­ber of TPOs because the longer term trader activity rep­resents the smaller percentage of total trade in the value area. For example, if the TPO count was 22 above and 12
below the fairest price, that would indicate net TPO sell­ing with a mild bias toward lower prices (see Figure B.7: Panel #3—S&P 500 Index). Note that TPO buying and selling in the value area is not applicable on trend days, as the market is still in search of a fair value area.
After identifying and evaluating longer term trader activi­ty correctly in today's profile graphic, the user can readily deter­mine whether longer term buyers or sellers were in control of the current trading session.
• Influence beyond today: The profile graphic also helps identify longer term trader behavior beyond today's range development. A key goal of the trader is to determine whether the current market price trend will continue or is likely to change. A change in market direction is a reversal of the current price trend. The standard technical approach to trend assessment, without Market Profile, is to draw an appropriate trendline and monitor subsequent price action against it. Unless the trendline is violated, the current price trend is expected to continue. Trendline analysis is the most important of basic technical tools, particularly given its uni­versal usage and applicability to different time intervals (i.e., hourly, daily, weekly, monthly, etc.).
Market Profile, on the other hand, offers an alternative approach to traditional trend analysis by evaluating market activity over different time periods. In its simplest form, an evaluation of the profile graphic on consecutive days can help define the start or continuation of the short term price trend. For example, if today's value area is higher than yes­terday's value area, then the current market price trend is up. Moreover, if tomorrow's value area is higher than today's, then the current market uptrend has continued. By monitoring market activity in this fashion, the trader is able to readily identify trend continuation or change. Similarly by combining daily consecutive profile graphics into a larger cumulative profile graphic, an evolving picture of longer term balance or imbalance emerges. The profile graphic in Figure B.5 (Sugar) on page 483 illustrate this
point. A cursory review of the individual sessions (2/10­2/13) in the upper panel suggest an uptrending market without a hint of reversal. When these four (4) consecutive sessions are combined (lower panel), however, a cumulative balanced picture springs forth. Once balanced, a market moves to a state of imbalance which, more often than not, begins after a final test at the fairest price.
CONCLUSION
The Market Profile method can be used to analyze any price data series for which continuous transaction activity is available. This includes listed and unlisted equities, U.S. government notes and bonds (prices or yields), commodity futures and options, where applicable. The profile graphic presents the movement of prices, per unit of time, in two dimensions—vertically (i.e., directionally) and horizontally (i.e., frequency of occurrence). When price action is viewed in this way, a picture of price discovery unfolds which is unavailable in the traditional one dimensional (vertical) bar chart.
The profile graphic offers unique advantages over the stan­dard bar chart:
· The symmetry attribute of the profile graphic allows the trader to assess the market's state of balance (or imbalance) in any timeframe. When a market is symmetric, a condi­tion of balance or equilibrium exists between buyers and sellers. A market imbalance implies price trend continua­tion, as the market works toward a new equilibrium. Market balance, however, is fleeting and implies market change or a directional move (either up or down) is likely to occur, a signal for traders to consider employing trend fol­lowing methodologies.
· Every trend change occurs at a single moment in time, not conveniently at the end of the hour, day, week or month. The profile graphic can be used to more accurately identify that specific time where control changed hands between
buyers and sellers. By pinning down such control shifts, the profile graphic allows the trader to identify key support and resistance levels.
In short, the profile graphic provides a substantial amount of price information per unit of time, allowing the trader to iden­tify patterns and dynamics which would not be readily apparent using other methods.