Analyzing the Market Profile Is Easier Than You Think!

 

Even if you don't take intraday trades, or don't have any idea about Market Profile whatsoever, being able to predict the smart money activity can be a massive benefit to your trading and investment.

It's important to understand that two herds exist in the market:

1.      Smart Money and

2.      Dumb Money

"Smart Money" refers to institutional investors, big sharks who have money and information power who give direction to markets. In the Market Profile world, we call them as Other Time Frame (OTF) participants.

"Dumb Money" refers to nonprofessional traders, retail traders who often want to quick money.

Market Profile helps us identify and differentiate the activities of the "smart money," and hence we can identify many profitable trade opportunities.

 

Introduction

 

Market Profile is a technical concept with a unique charting technique developed by Peter Steidlmayer when he was trading at the Chicago Board of Trade (CBOT), and it was open to the public in 1985. Market profile is a style of plotting price on the Y-axis and time on the X-axis (Generally 30 minutes is considered as one session), which most of the time form a bell-shaped image as the body of the profile.

The three essential components of the auction process are (in the same order of importance):

1. Price—it advertises all the opportunities.

2. Time—it regulates all the opportunities.

3. Volume—it measures the success or failure of all the advertised opportunities.

 

Market Profile gives more importance to "TIME" as compared to "VOLUME." There are many reasons for this:

·        Volume is essential as 80% of the trading volume is given by 20% of the big players. However, time also plays a crucial role, because a price that is not accepted over time is the sign of rejection of that price level.

·        A spike in volume can only be seen after a big move in the price. Hence, many times intraday traders and short term traders may not be able to reap the benefits.

·        In intraday trading, the opportunity is inversely proportional to time. Day traders, especially options traders, should know the importance of time. Option buyers will lose the money if the price doesn't show a quick move, and similarly, the Option seller will lose significant money if the price shows a rapid movement.

·        On any trading day, long -liquidation or short-covering rally generally happens due to the result of time running out for day traders, rather than a lack of volume. Very rarely, these situations are caused by a combination of both factors.

 

This article aims to give market profile outsiders a no-nonsense four-step in detailed explanation to understand the market profile in a better way.

 

Step-1 Candlestick vs. Market Profile chart

 

Many traders don't understand the influence of time on both the price and opportunity. An attractive opportunity to buy the below value or sell the above value will not last long as smart money will act very quickly, and their position size pushes the price very soon to the other side.

 

Image 1: Candlestick chart.

In a candlestick chart, Price variations are plotted in 'Y' axis against the Time 'X' axis. In this type of chart, time remains constant throughout the price variations, which means we are not using the time parameter effectively.

Assume one person wanted to travel from Delhi to Mumbai, and you are allocating 2-hours for this journey. Another person wanted to fly from Delhi to Melbourne, and again you are assigning 2-hours for this journey. It is not a wise move as Melbourne is very far as compared to Mumbai from Delhi, and definitely, the second person needs more time allocation to reach that place.

However, for the first person, 2-hour is enough to reach Mumbai from Delhi on a flight. In other words, it is sensible to allocate the time based on the distance to be covered in the journey and not just giving fixed time to all journey irrespective of the distance.

 

Image 2: Nifty 20-12-2018 30-min candlestick chart showing the same time allocation.

Image 2 shows a Nifty 30-minute candlestick chart for the day 20-12-2018. In the middle of the session, we have a small candle with an entire range of 10 points, and in the end, we have a big candle with a big range of 46 points. If you look at the time axis, the amount of time allocated to both these candles are the same! It gives just a 2D view on the price auction with respect to time.

In the first case, 30-minutes price auction resulted in a 10 points range, and in the second case, 30-minutes price auction resulted in 46 points. Do you think price auction with respect to time is the same in both cases? Don't you think we are missing some crucial information? Just recall Delhi to Mumbai and Delhi to Melbourne's journey example in the previous paragraphs.

 

Image 3 – Nifty 20-12-2018 Market Profile chart showing different time allocation.

Now look at the same day in a market profile chart in image 3, it is evident that the time has been allocated effectively based on the price variations. It gives a 3D view of the price auction with respect to time. Also, you can see the Value Area, unfair high, unfair low, and even point of control (POC).

Point of Control (POC) is the price level in which maximum time was spent (Price Profile) or maximum trading activity (Volume Profile) occurred on any day.

Value Area (VA) is the 70% price range around POC. It is the fair price of the Nifty on this particular day. VAH and VAL are the upper and lower boundaries of Value Area respectively.

The construction of a market profile chart is easy. Click here if you want to know how to construct a market profile chart.

 

 

 

 

 

Step-2 Edge in Market Profile

 

The marketplace is full of different players like long-term buyers, long-term sellers, scalpers, intraday traders, swing traders, Positional traders, etc. The combined action of these players together is the main reason behind price fluctuations.

 

Image 4: Market activity in a day.

Big buyers and big sellers (two entities of smart money) will execute their plans at different price levels, and they cannot trade with each other at the same price level. Other participants (most of them are retail traders) act as a bridge between these two payers by providing liquidity for both these players, as shown in the above image 4.

Let's say a script is trading at 100. Long-term buyers will have a plan to buy this script only below 50, and long-term sellers will have an intention to sell this script just above 150. If we restrict the trading activity in this script only to long-term buyers and long-term sellers (OTFs or two entities of smart money), the price will be stuck at 100 as both of them don't have plans to trade at this level.

If we allow other players such as scalpers, retail traders, swing traders etc. then they provide liquidity to the market. Their participation will take the price to either 150 or 50 depending on the combined effort of all other traders except the OTF's (smart money).  If the price reaches 50, long-term buyers (OTF Buyers) will pitch in, and if the price reaches 150, long-term sellers (OTF Sellers) will pitch in to initiate their trades.

The entry of these big players can be identified through certain Market Profile concepts such as Extremes, Range Extension, TPO Count. All these concepts indicate that whether the price is getting accepted or rejected.

If you want to get success in intraday trading, then you have to stop taking trades in between the value. Besides, one can look for smart money entry patterns at the critical price levels. The next step explains this concept in detail.

 

Step-3 Initiative and Responsive Activities

 

On any trading day, it is essential to know whether smart money is acting on their initiative, or they are just responding to excellent opportunities. It can be done using current day price auction with respect to the previous day value area/range.

 

What is Responsive Activity?

 

It is a good idea to explain this concept with a real-life example first.

For a moment, assume you are an iPhone dealer, and your main job is to buy and sell iPhones. Besides, also imagine there will be enough buying opportunities and selling opportunities (as we are comparing this example with the market and there will be enough buying and selling opportunities in the markets too).

Currently, iPhone 6S is trading in the range of Rs. 25,000 – Rs.30,000 in India. This price might vary in different parts of India based on the availability and due to many other reasons. However, we consider this is the price range for iPhone 6S. It is the Value Area for iPhone 6S.

Image 5 – Responsive Activity

 

In normal situations, whenever the price trades at Rs 25,000 (or below), it is a good idea to buy as the price is near the lower band and you can expect price movement up to Rs 30,000, and you will get a profit of Rs.5,000 or more if you sell at (or above) Rs 30,000. It is one type of Responsive Activity, and more specifically, it can be called as Responsive Buying.

Similarly, when the price trades at Rs 30,000 (or above), it is a good idea to sell your holdings, and you can also go short. You will anticipate the fall of up to Rs 25,000, and you will make a profit of Rs.5,000 or more if you close your position at Rs 25,000 (or below). It is also another type of Responsive Activity, and more specifically, it can be called as Responsive Selling.

This situation will continue until some significant news breaks out. It can create an imbalance in the price, and those imbalanced situations lead to the Initiative activity later on.

 

What is Initiative Activity?

 

We will continue with our iPhone example, and we have to make one assumption. Imagine, suddenly, Apple has decided not to supply iPhones to India (for some reason) for next year. As a premier dealer, you got the information from a closed source, and this information is yet to come in the news.

Now, what do you think, and how do you react to this situation?

Do you think buying more iPhones even at a higher cost (to accumulate for one year) as demand will increase due to the shortage of supply, and thereby you can sell it at the time of shortage even at a higher price, right?

However, the current market price of the iPhone 6S is already at Rs 31,000. Do you still buy it at this price level?

If your answer is YES, then it is called Initiative Activity and, more specifically, Initiative Buying!

Image 6 shows the explanation for the Initiative Buying scenario.

Image 6 – Initiative Buying

Now, it's time to make one more assumption. For some reason, the central government has decided to ban the iPhone 6S!

However, the price is trading near 25,000.

What do you do at this moment?

Do you buy iPhone 6S, or do you sell at any price?

I am sure you decide to sell iPhone 6S at any available price, right?

It is another form of Initiative Activity and, more specifically, Initiative Selling!

Image 7 shows the explanation for the Initiative selling scenario.

Image 7 – Initiative selling

 

Step-4 Smart Money in Action!

 

If you can differentiate the Initiative activity and Responsive activity, then you can easily predict the plans of smart money. In most of the situations, an Initiative action is more potent as compared to Responsive Action (except at major reversals). Hence, it is good to spot Initiative Action so that traders can apply trending strategy to take the trades in the direction of Initiative activity to get the maximum benefits. Besides, they can deploy the mean reversion technique for responsive activity.

As you know, when the price opens above previous day value area or previous day range, it attracts Responsive sellers (at the moment we are not sure whether its smart money and their real intention to cause it) and price auction downwards until it draws the buyers.

Image 8 – Price open above previous day range

Image 8 shows that the price is opened above the previous day range, and this indicates that some Initiative buying has been involved in this process before the open, but we don't know their real intention.

As the price is opened above the previous day range, it immediately attracts Responsive Selling.

Now, after 15 minutes from the open, the price is still trading above previous day range, what this indicates?

It indicates that the Responsive Sellers are absent or Responsive Selling is not as powerful as Initiative Buying!

As explained earlier, the market profile gives more importance to time over volume as the price level, which is not accepted over time, will be rejected. Also, time is the most critical parameter for an intraday trader as compared to volume.

In the above case, the price opened above the previous day range, and it advertised an opportunity for responsive activity. However, the price stayed above the previous day range for 15 minutes. It indicates the absence of responsive activity or lack of strength in responsive activity. It confirmed that the initiative buyers are involved in this process to drive the prices up.

So in this case, taking a Long trade, keeping stop-loss a few points below the open or previous day high makes sense. One should carry their trades until End of Day with trial stop-loss concept as Initiative activity always gives their close at peaks.

Image 9 – Responsive Selling with open-high and open-test-drive-down

Now in a similar scenario, if the price opens above (or near) previous day high and if it shows open-high or open-test-drive-down open on a 15-minute chart, then it indicates the failure of initiative buying as the price is getting rejected. It confirms only responsive selling is the remaining option for the rest of the day. Hence, intraday traders can plan a short trade below the low of the 15-min candle, keeping a strict stop-loss above 15-min candle high or above few points above the previous day high, and they can target value area low or previous day low as the target.

The proper knowledge of the price auction around a reference point is very crucial to differentiate an initiative and responsive auction and to make successful trades. If you want to become a successful intraday trader, then you should deploy a trend following trading technique during initiative setups and mean reversion trading techniques during responsive trade setups.

 

Do you think you get some fundamental clarity on the market profile?

Do you still have any doubts?

If yes, please leave your comments!

 

Indrazith Shantharaj is Market Profile Trader and Author of two Trading books, "Trade and Grow Rich" and "Mind Markets and Money."