FIGURE 18-6 Daily Market Profile

ure 18-5 combines CTI 1 with CTI 2 and CTI 3 with CTI 4 to simplify the pattems attributed to each group. During ttie period shown in the figure, the combined categories 3 and 4 cause the maiket to move when their participation was greater than 30° o. Observation shows that these ttading points occur as prices move out of a previous area of sustained ttading.

Steidlmayer was said to have first developed this information for his own trading. He taught a course on how to apply his evaluation technique, and there were a number of books written on the subject by himself and others. He spent considerable time studjing and classifying formations and separating daj-s into three primary categories: normal, ttending, and nonttending. A normal day forms a standard bell-shaped curve with the widest point, positioned near the center, called the value area. On a ttending day, the value area is not as wide and appears closer to one end of the distribution. A nonttending day has neither of the two recognizable pattems.

There is an important philosophic basis for Steidlmayers work. It is a very credible attempt to explain how the maiket functions. He saj-s, "The maiket probes high prices to attract sellers and low prices to attract buyers." This creates a value area. By observing the pattems of intraday price dishibution, you can know whether there are countertrend opportunities, when prices reach the exttemes of perceived value on a normal day or ttend positions in the direction of current price movement.

Construction of Market Profile

The Market Profile is created in a manner very similar to a point-and-figure chart. You can list every price on the left scale or create boxes that represent a price range. This latter technique will make the distribution look more uniform by clustering the price activity in exactly the same way as a frequency dishibution.

The most common way of plotting intraday data is to begin by placing the letter A in the boxes alongside the price at which the market traded, if we use half-hour intervals, called time/price opportunities (TPOs), then all prices that were traded during the first half hour are marked with the letter A. The letter is used for the second half-hour period, the letter for the third period, and so on. At the end of the day we have a chart that looks similar to Figure 18-5.

Market Profile is also intended to be used over many days, identifjing Icng-term pattems as congestion areas or frending markets. To the extent that it accomplishes this distinction it can be very valuable. The ability to determine whether the market is directional or not is the greatest problem of the frader. In Figure 18-6, the Market Profile is consttucted by using numbers instead of letters to represent the range of prices traded over each day. The entire charl covers a period of 9 daj-s. Other than the substitution of daj-s for half-hour periods, the chart is created in the same way

Time/Price Opportunities

Time/Price Opportunities (TPOs) are the 30-minute blocks assigned letters on the Market Profile diagram. It is worth noting that the largest occurrence of TPOs at a single price does

Three bcfc on lJ.*ketPr..6le.7Te.*edm 1E*1 J Peter Steidlmayer, ieidlmayer on lJ.*k*» .1..1 Sbley & Sons), Eeviii .47, lJ.*ketE lOl (MLSPublislmia )lS.brillea..««e=.il6m4andDonddJones.W.efcns..fft*iafretIr..WeOTDa32S.L*»eSt,.n«c.ILeMB) The most complete

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Value Area Using Daily Data

Source. Jones. Figure 2,*locating value vriih auction market data," TechnicolAnafysis of Stocks & Commodities Ouly 1989).

not necessarily correspond to the price at which the highest volume occurred, as seen by referring bad; to Figure 18-5. This distinction is at the root of Market Profile, because it emphasizes the amount of time that traders accepted a price, rather than the volume traded at that price, which could have occurred during a single period. In the bond example given in Figure 18-5, the greatest volume was transacted at 9520, although the center of the value area, where there is the largest record of TTOs, is at 9523, three points higher. Clearly, the Market Profile analj-sis is seeking out a different way of observing the actions of traders. In the formation of a value area, if the market moves between two prices, such as 9520 and 9523, because those values bracket the current trading range, each traverse will cause the prices in between to be marked with the same letter, regardless of whether any volume occurred at those prices.

TPOs allow us to judge the potential direction for a move out of the current value area. This can tell a trader to buy sfrength or sell weakness. The market is said to favor the direction indicated by the upper or lower part of the value area that has the highest count. When performing the TPO count, you must have a well-defined value area and limit the count to within that range. Using Figure 18-5, with the mode at 9523, count the TTOs prior to the interval that begins j. There were 16 TTOs above 9523 and 21 below (not including 8$ and3Z). During time intervalJ, the balance shifted to the upside when it touched 9529, at which point there was a large increase in volume. This could be attributed to CTI 1 and CTI 2 exiting shorts and, to a lesser degree, going long. The locals were finally joined by groups 3 and 4, taking a long position at 9600. An imbalance in the TPO count expresses a willingness for the market to favor the direction given by the largest count, but applies to a normally disfributed value area only.

Tjpical Pattems

It IS generally accepted that the market spends the greatest time in a sidewaj-s, or congestion area, and a relatively small amount of time frending. The sidewaj-s period may be defined as an extended time/price relationship and the frending period as a brief time/price relationship. The extended period creates a value area where traders are will

ing to buy and sell, and this activity is reflected in higher volume. According to Market profile. 5

Value = price x time = volume

In this analjsis, called auction theory, the value area is the place that the market is willing to trade, and is seen in the time value. The value area represents about 70°o of the market volume. The center of this time value area is the price at which there are the most TPOs. Because market activity spends at least 80°o of the time in this value area, prices tend to rotate about the center. Rotation is the term given to price action that moves back and forth above and below this cenfral value, building the pattem of normal disttibution similar to a bell-shaped curve

What Are the Buyers and Sellers Doing?

The interpretation of the Market Profile is based on the concept that, under normal market conditions, prices rise to attract sellers and fall to attract buyers. There is a very active area of frading at a point called equilibrium where

commercial buyers and sellers exchange freely, because ttiey consider ttie price at value (Figure 18-7, panel a). If there are more buyers than sellers, the price rises to attract additional sellers who feel as though they are getting a price that is above value. However, as prices continue to rise there are fewer buyers, because they perceive the market as overpriced. In Figure 18-7, Day I (panel b) shows a buyers curve and a sellers curve ttawn on the frequency distribution of a normal trading day.

In this way the market is said to facilitate trade. When there are not enough buyers, the price falls; when the sellers are scarce, prices rise. Constructing the buyers and sellers curves for a sequence of daj-s can help understand the djuamics of trading in terms of both price expectations and volume. For convenience, the curves will be shown as straight lines, similar to supply and demand lines, in the following exanples.

On Day 2 in Figure 18-" (panel c), the buyers disappear faster than the sellers; therefore, the buyers curve is more horizontal and the sellers curve more vertical. On Day 2 (panel c), the sellers have held their position and the buyers are wining to move higher, retteating from their previous objective. This results in higher volume. Had the buyers moved lower and the sellers remained steadj, the volume would be expected to decline. If on Day 2 (panel d) the volume increased while prices traded in the same range and at about the same peak price level (value level), the buyers and sellers curves would have become more horizontal, indicating that both sides of the frade were holding firmly at the current level.

(Quantifj-ing the Value Area

The idea of a value area that is shaped as a bell curve, or an extended formation to represent a frending day, seems clear., unfortunately, pattems are rarely as clear as these examples. To help this process, Jones has applied overlaj-s to these patterns, using a standard deviation to measure them. In Chapter 2, we explained that, for a normal dishibution, the value of I standard deviation represents a clustering of 68° of all values around the mean; therefore, 34>o are on either side. Similarly, 2 standard deviations contain 95>o of all activity, 42.5>o on either side of center. In his analjsis, Jones has defined a value area as one contained within 2 standard deviations of the center using the TPO count to isolate the range. For example, if the entire chart contains 100 filled boxes, the price range is from 6615 to 6655, the center is right at 6635 and contains 10 filled boxes, then 2 standard deviations contain 90 x .425 = 38 boxes on each side of the center. This defines the value area.

FIGURE 18-7 Buyers and sellers curves for a sequence of daj-s.