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- Tips on Technicals - Market Profile

By Michael N. Kahn

Market Profile is a unique way to analyze trading activity from the point of view of the floor trader. Instead of basing liquidity solely on price, it also uses time. This second variable adds a second dimension, and theoretically an edge, for the user.

According to its creator, Peter Steidlemayer, a trader on the Chicago Board of Trade, the theory behind Market Profile is that the market regulates itself in terms of price and time. Together they equal market activity. When the market offers participants an opportunity to buy or sell at a certain time and price, it creates a time-price opportunity (TPO).

The Market Profile itself breaks the trading day into half hour units. Some traders use a daily or intra-half hour time frame but the majority use half hours. The more half hour units the market spends in a specific price range, the more that range becomes the fair value price for that day. Steidlemayer chose this time frame because it was short enough to produce enough resolution in his analysis, yet long enough to give him time to act.

The display of the profile looks like a histogram on its side. Each half hour segment is assigned a letter. Whenever the market trades at any given price during a given half hour, that half hour's letter is recorded next to the price. If that price is traded a half hour later, that new letter is recorded next to the first and so forth. Opportunities are created when price moves away from an established value area.

The key to profile trading is the ability to recognize the type of trading day early enough to give the trader an idea of which trades are more likely to be successful. There are three basic types of days: the normal day, the trend day and the non-trend day (see chart for the first two plus their corresponding tick charts).

The normal day's profile looks like a bell curve which represents a normal distribution and occurs about 80% of the time. The central price, sometimes called the mode and sometimes called the mean, represents the price with the most TPOs (the most letters) and hence the price where a trade was most likely to be completed.

Figure 1

On trend days, the distribution takes on one of two shapes. The first is long and flat. This usually indicates a smoothly trending market. The second shape is a double or even triple bell curve which indicates consolidations during the move. Trend days occur about 15% of the time.

Non-trend days have short profiles in which almost every half hour period is represented at every price. The market trades in a range and never really has any trend or defined value area in place.

Market Profile Components
Value Area A range of prices where 70% of the day's trading activity takes place. Prices tend to gravitate towards this range on normal days so TPOs outside the range have a better risk-reward rate. When volume is not available on an intraday basis, trade count is substituted and is nearly as accurate as true volume.
Pioneer Range The range of prices covering the first full hour of trading. This area is also known as the initial balance area.
TPO Each occurrence of price and time is considered to be a Time Price Opportunity where a trade could have been made. The TPO count above and below the mean (mode) yields further information about the type of the day. Single TPOs at the extremes of the profile are not used in the TPO count, presumably because the opportunity to trade there was minimal.
Spectrum Profile This term is specific to ProfitCenter and refers to the volume histograms accompanying the Market Profile letters. Other products simply display the total percentage of trades (or volume) occurring at a given price. The Spectrum Profile color codes the trades to match the half hour in which they occurred.

Using Market Profile

The size and shape of the profile is dependent on the number of half hours in a trading day and the range of prices traded in any given day. Items like US Treasury Bonds generally trade in a one point range or less for a vertical size of 32 prices. Items like TSE 10 year JGBs may trade the same range but are in units of .01 for a vertical size of 100 prices. Some traders may group two, five or even ten prices together for a better view of the profile shape.

In order to view each trading session on its own, such as the day vs. Globex, profiles can be split at a specified time. This sets up complete profiles for each session. Some products can even split profiles by every letter creating a chart that resembles a tick or a point and figure chart with the added dimension of TPOs.

Michael N. Kahn is a columnist for Barron's Online based out of Florida. He also writes a free technical newsletter. To subscribe to this service, please visit www.midnighttrader.com. The complete collection of Michael Kahn's "Tips on Technicals" is available in Real World Technical Analysis.

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