Part 8: An Introduction to Market Profile

1 -The constant search for someone to give them a trading methodology or trading signals. Currently this seems to take the form of finding the current hot chat room that has the answers. In the past it was a market letter or advisory service, or someone promising the secret to trading by selling an expensive trading "school." It is natural to want to believe that someone out there holds the secret to the markets, and that they want to give away or sell that knowledge. It is also a comfort to want to belong to a larger group of like-minded traders. Seeking this type of comfort almost always works against trading success. Expecting someone else to provide the answer is unrealistic. Chat room moderators present themselves as expert and experienced traders. The truth is quite the opposite. Very few have been successful as traders. Some may indeed mean well, but most just want to get into your wallet one way or the other.

2 -Holding on to the belief that a certain indicator or methodology will produce profits even after rigorous objective backtesting proves that profitability is an illusion. It is amazing to see traders that are invested in a particular methodology stubbornly adhere to the claims of great profits if only they just have a little more screen time or take additional classes. It is difficult to give up on an idea when much time and money have already been invested. A key part of becoming a successful trader is knowing when to cut a loss short. No amount of screen time will create a winning approach from an unsound methodology.

3 -Looking outside of market generated information for the answer. I see many traders turning to approaches to timing the market that come from information that has nothing to do with the markets. Many believers of Gann, Elliot, and Fibonacci and those who turn to the moon and tides fall into this category. These traders must know at some level that chat rooms and indicators are not working for them. Instead of turning toward the market, they turn away and try to find a correlation between price action and unrelated causes. This type of approach is as old as there are markets, and has never, ever worked. And it never will, but traders will keep falling for the false claims until common sense returns, or their money runs out.

4 -Forming a belief that a market must reach a certain objective or move in a certain direction. This is actually a result of the first three items. Often an opinion will be formed based on some old tired chart pattern or indicator set-up, and the trader forms the opinion that a certain result must occur. Or it could be an Elliot wave count, or fibonacci retracement level with great confluence of support from past chart points. The market doesn't really care about any of this. Markets look forward to discount the future. The market can and will do what it wants to do, regardless of the position of the moon, a CCI divergence, or what George Soros says will happen next week. These patterns and formations are there for all to see. The gurus and forecasts on CNBC are all over the internet and known by all. What all can see cannot create an edge. The trader cannot tell a market what it must do. The job of the trader is to listen to what the market intends to do.

The antidote to the conditions above, in my opinion, is to try to understand and to interpret what the market is trying to communicate. And the best way to achieve this is to use the information the market is generating, rather than relying on derivative indicators, useless opinions, or non-market related events.

The vast majority of traders focus on indicators. Indicators can be useful tools, but they cannot predict where a market will go, at least not with enough consistency to generate trading profits over time.
When I got my first PC in the early 1980's, I purchased software and a huge database of commodity and stock index data. I tested every indicator I could get my hands on, and every trading system that could be programmed into the software. Nothing worked. I could not find any entry/exit rules and indicator combinations that would produce enough profit to overcome trading costs. I tested systems that were being sold for very high prices, systems that were under management at major brokerage firms, systems of my own development, and anything else I could get my hands on.

This at least had me consider viewing indicators from a more realistic perspective. It is easy to attach greater significance to indicators than they deserve. Most indicators have relatively simple code and can only do, or indicate, so much. It is unrealistic to think that a simple formula derived from price can actually lead the function from which it is derived. It is silly to think it can. It is also a mathematical impossibility. As much as I've tried to convince other traders of this, I get disbelief and an argument to the contrary. It is difficult to argue a mathematical fact to those who believe in the tooth fairy. Now I just smile and hope they don't give away all their money to those who know better. To be fair this concept of leading indicators had to have a basis for its origin. I believe that many think certain indicators can lead because at times, when the market is in a very cyclical mode, and if an indicator such as a stochastic has the correct input parameter, it can turn ahead of price. But it is important to remember that the indicator is not leading price. It is derived from price. It is to assume a lot that the market is trading in a nearly perfect sine wave, and that the indicator happens to have the perfect lookback period to track and turn up at its half cycle to give the appearance of leading. If the market were cyclically as stable as a light wave, then one could use an indicator with great success. In the real world, in real markets, this approach is doomed to failure. To believe otherwise is to believe in fantasy. Markets are constantly changing. They do not represent a stable sine wave. The cycles are constantly changing, and at times disappearing as trends develop.

If one were to accept some of the concepts as stated above, then what is the best method to gain insight into what the actual market is trying to communicate? Most traders would probably agree that volume might have some importance in the overall picture of market structure. But how does one look at volume? A bar chart will show the total volume of trading during the trading session. It can be useful to know if overall volume is increasing or declining. But how does one know what the volume represents? Is it just a large fund buying or selling for some reason unrelated to the developing structure? Is it shorts covering or new longs entering? Is it earnings related? Is it arb activity in the pits or new money entering long term positions? One can look at intra-day price bars such as on a five-minute chart, with volume bars under the prices. But every day will show a similar pattern of heavy volume at the beginning and end of each day, with a dip in the middle, drawing a pattern similar to the shape of a bowl. How does this help?

Peter Stiedlmayer developed a method of representing the distribution of volume during the trading day. He attempted to create a visual representation of the thought process of traders in the trading pits. Instead of using actual trade volume, he displayed a representation of volume as price over time. This is an important distinction. As price movement is displayed over time, a bell curve develops, and the areas of price acceptance and price rejection are readily apparent. Areas of market balance and imbalance become clearly visible. Changes in the direction of value provide more insight than changes in the closing price.

It might be helpful to think of the developing bell curve in terms of an auction, which is really what the market is. Picture an auction for a rare automobile with hundreds of bidders representing volume. Actual volume in this illustration would actually be one, as there is only one car being sold, but for the sake of argument, visualize volume being the number of bidders. If the auctioneer starts the bidding at $20,000 for the rare car, every hand would go up. Everyone in that room would be willing to purchase the car at that price, which everyone would believe to be far below value. As the price increases, at some point some of the hands go down. There is less volume at the higher prices, as some of the bidders perceive price is getting ahead of value. As price continues to climbs, more and more bidders drop out. Therefore, the high prices begin to shut off activity. At a certain price the transaction is complete with the seller responding to the high price by selling the car, with the buyer paying higher than anyone else was willing to pay. Value was probably established at some point in the middle of the bell curve, but the winning bidder had to pay far over what the auction determined to be fair value. If the auctioneer had suddenly put a price far too high, all activity would have shut off and prices would have had to come back down in order to facilitate the trade. Of course, in stock and commodity markets the trade is more two sided than a traditional auction, but the concept of the markets being an auction is still important to keep in mind.

Stiedlmayer created categories for various types of trading days, and the trading implication of the various days. It would be difficult to describe these profile types with words. A visual would be much more efficient. I have an expanded version of this article on my blog, along with several visuals explaining the various day structures. To view this additional information go to:

tuckerreport.com/articles/market-profile-a-primer/

In summary, the Market Profile is one way to listen to and interpret the market's intention. Many traders may prefer to view the market with traditional bar charts, or to simply read the tape, or trade from the action in the pits. In fact, many of the most successful traders of all time did not have the advantage of the computer and the market profile graphic. However, the concepts and thought process that the Market Profile represents were still in use by many of these traders. The concepts that Market Profile illustrates so well are the important consideration, even if one prefers a different method to display market activity. Market Profile often does not give specific entry and exit points. That is probably why the vast majority of traders rely on indicators. It is difficult to backtest objectively the Market Profile concepts. Indicators can easily be put into a formula and numbers can be crunched on past data in seconds. But remember that the vast majority of traders lose money. The greatest traders have a market understanding that goes beyond the obvious. There is no edge in what everyone knows.

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