Chapter 4
Competent
Let us think back for a moment to David, the aspiring pianist. David reached the third level of learning and became a competent pianist after many months of study and practicing the basics. He began to see each song as a whole, a certain expression to be performed with a definite goal in mind. He still played by reading the notes but achieved continuity in his playing.
In this chapter, we will complete the study of the basic concepts and theories behind evaluating market-generated information through the Market Profile. We will give a thorough discussion of practical applications to day and longer timeframe trading. By the close of Competent, more of the big picture will be revealed as the basics merge together to make you a competent trader.
Doing the Trade
All reasonings concerning the matter of fact seem to be founded on the relation of Cause and Effect....I shall venture to affirm that the knowledge of this relation is not in any instance attained by learning a priori, but arises entirely from Experience.
—David Hume
Knowledge arises from experience. Just as a musician practices diligently to become a concert pianist and an athlete spends uncounted hours on the court to become a great tennis player, a trader must gain experience through actual trading to become an expert trader.
Any effective performance is a combination of knowledge, skill, and instinct. With each trade, you put your knowledge, your understanding, and your experience on the line to be judged by the market. Clearly, it is necessary to “do the trade” to learn. Experience provides the confidence to overcome such barriers as fear, hesitancy, and inflexibility.
We introduce the psychological side of trading here for good reason. By the end of the Advanced Beginner stage you should be incorporating what you have learned and will continue to learn into your trading technique. We will continue the discussion of the “you” portion of trading once all the mechanical aspects of the Market Profile have been covered. Remember: Trading is the link to experience and knowledge.
Section I
Day Timeframe Trading
Mike Singletary of the Chicago Bears was the National Football League's Defensive Player of the Year during the 1988 football season. Considered by many to be the finest linebacker to play the game, Singletary's all-pro ability transcended his physical strength and agility.
As captain of his defensive team, he would attempt to, in effect, read the offense. As simple as this may sound, it is a complex process that involves both long- and short-term analysis. Singletary spent hours preparing for each game, studying play charts, game films, and player statistics. When the game started, he knew exactly which plays the opponent had used in every possible situation, what formations these plays were run from, and who the key players were in each play. In other words, Singletary did his long-term homework and, based on the opponent's past performances, entered each game with specific defensive plans in mind.
After the opening kickoff, however, Mike Singletary did not actively think about the charts and playbooks—he didn't have time. It is here that Singletary's expertise shined. The game films and technical information were, in a sense, a holistic image in his mind. He would act intuitively, recognize patterns, and quickly direct the defense. His expectations coming into the game served as guidelines, but he actively assimilated his play to the evolving offense.
The opposing team's offensive coach would change his strategy and composition of plays with every game in an attempt to throw players such as Singletary off guard. The ability to recognize such changes in time to stop the play is what makes an expert linebacker.
An experienced day timeframe trader follows the same sort of evaluation process Mike Singletary used to. He or she begins each day with a set of expectations that serve as guidelines, based on the market's past performance. The trader studies factors such as long-term market direction, recent value area placement, and the opening call (all topics to be discussed in this section). Once the market opens, the trader switches to a more intuitive mindset, molding expectations to the developing structure, such as the opening type, the open's relationship to the previous day's value, and the auction rotations. Like Mike Singletary, the experienced trader knows that the market will seldom develop patterns identical to those that have happened in the past. The ability to recognize these subtle changes as they occur in the marketplace is what makes an expert trader.
In this section, we will study important structural reference points in the order that they occur in the unfolding market, beginning with the open and ending with the close.
Day Timeframe Directional Conviction
Recall for a moment the two big questions introduced at the end of Chapter 3. The first was “Which way is the market trying to go?” The second was “Is it doing a good job in its attempt to go that way?” Both of these questions relate directly to the concept of market confidence and directional conviction. The sole purpose behind interpreting other timeframe activity is to find out which way the market is trying to go.
If you know which other timeframe participant is in control in the day timeframe (or that neither is in control) and with what level of confidence they have entered the market, then you can successfully answer the two big questions and position your trade accordingly. We will now discuss how to evaluate market confidence and directional conviction, emphasizing their effect on estimating the day's range. We will start with the first available measure of market sentiment, the opening call.
Opening Call
During one of our advanced trading seminars, a successful floor trader asked an intriguing question: “If the opening exceeds or fails to make its opening call, can that also be considered recordable initiative or responsive activity, even though the market never actually traded there?” The answer, as you will see, is clearly “yes.”
Day timeframe trading strategy begins with the succession of early-morning calls that indicate where the market will open. Opening calls can occur at any time—from two hours before, to just a few minutes prior to the actual opening. Observing the succession of calls as the market nears its open and the call closest to the opening bell is one of the first important pieces of information available to the day timeframe trader.
In the last few minutes before the day's actual open, the largest and most active accounts have direct access to the trading floor through on-floor telephone clerks. The telephone lines to these large accounts are often left open during this period, providing continuous and almost instant communication with the trading pit. As early indications of price ranges are relayed to off-floor accounts around the world, they often attract the attention of the longer timeframe traders, leading them to place orders. As these orders are signaled into the pit, they are seen and communicated to other off-floor accounts, which in turn may stimulate additional orders. In a sense, the auction is actually underway before the market opens. This preopening auction process, although invisible to most, is often as important to evaluating market direction as the day's actual trade, for it is composed almost exclusively of other timeframe participants.
If the early call is perceived as too high or too low, opening call price levels and the eventual opening price can change quickly. What the astute floor trader at the seminar recognized is that the information available before the opening is often as valuable as looking at a tail on the Market Profile graphic. For example, if the first call is an expected opening around 87 to 19, but the actual opening takes place at 87 to 12, there is, in a sense, a seven-tick, hidden selling tail. That tail will be responsive or initiative depending on where it is located in relation to the previous day's value area (just like a visible tail).
The Open
Experienced day timeframe traders start each trading day with a firm knowledge of recent market activity, much like Mike Singletary would study films and playbooks before each game. They have done their homework and watched the opening call to develop some idea of what to expect during the day's trading.
When the market opens, less experienced traders may wait for the initial balance to develop, thinking that there is little information or little to do prior to the development of structure. Seasoned traders, however, know that the first half hour of trade establishes one of the day's extremes in the large majority of cases. As accurate as this fact may be, it is of little value unless a trader can identify which extreme will hold throughout the day. The activity occurring during the formation of the initial balance (many times, just the first few minutes) often enables a trader to identify which extreme has the greatest holding potential. This knowledge alone can play a large part in forming a trader's day timeframe strategy.
The Open as a Gauge of Market Conviction
After the opening call, the first few minutes of the open provide an excellent opportunity to observe and evaluate the market's underlying directional conviction. With an understanding of market conviction, it is possible to estimate very early on where the market is trying to go, which extreme is most likely to hold (if any), and even what type of day will evolve. In other words, the market's open often foreshadows the day's outcome.
Four distinct types of opening activity provide a good indication of the level of directional conviction and which extreme is most likely to hold throughout the day. These labels are not carved in stone, however, and should be used only as a guideline for learning. Like the day types discussed in Chapter 2, the importance is not in the labels but in the level of market directional conviction that is displayed. The four types of opens are:
Open-Drive
The strongest and most definitive type of open is the Open-Drive. An Open-Drive is generally caused by other timeframe participants who have made their market decisions before the opening bell. The market opens and aggressively auctions in one direction. Fueled by strong other timeframe activity, price never returns to trade back through the opening range. Figure 4.1 illustrates the Open-Drive.
Figure 4.1 Open-Drive in Copper, April 7 and 10, 1989
Copyright Board of Trade of the City of Chicago 1984. All Rights Reserved.
On April 10, copper opened above the previous day's value area and promptly trended upward. The strong, driving activity on the part of the buyer indicated a high level of market confidence. Figure 4.1 shows an aggressive 12-tick initiative buying tail in A period that ignited a Double Distribution Buying Trend day. In the majority of cases, the extreme left behind after an Open-Drive will hold for the entire day.
The market's behavior during an Open-Drive open can be compared to a thoroughbred racehorse just as the bell sounds and the gates swing open. Both the market and the racehorse explode with confidence running high—their goals are obvious and their direction clear. If a trader expects to trade such a market, he must act quickly or be left in the dust.
Open-Drive activity sends clear signals to the trader regarding the type of day to expect—a Trend or Normal Variation day. It also enables the trader to enter positions earlier, before confirmation by structure. Examine Figure 4.1 again. Notice the difference between the trade location for longs entered during the A period tail or the B period pullback, versus longs entered with range extension in C period. On this day, both would probably have resulted in profitable trades; however, A and B period longs gained much better trade location. Understanding Open-Drive activity helps traders stay one step ahead of structure.
The extreme established by the Open-Drive remains a reliable reference point throughout the day. If the market eventually returns to trade through the open and erase the tail, the trader is alerted to the fact that conditions have changed and trades should be exited.
Open-Test-Drive
An Open-Test-Drive is similar to an Open-Drive, except that the market lacks the initial confidence necessary to drive immediately after the opening bell. During this type of open, the market generally opens and tests beyond a known reference point (previous day's high or low, bracket top or bottom, etc.) to make sure there is no new business to be done in that direction. The market then reverses and auctions swiftly back through the open. This activity, a failed initial test followed by a drive in the opposite direction, often establishes one of the day's extremes. An Open-Test-Drive provides the second most reliable type of extreme after the Open-Drive. Figure 4.2 illustrates an Open-Test-Drive occurring in soybeans.
Figure 4.2 Open-Test-Drive in July Soybeans, April 3 to 10, 1989
Copyright Board of Trade of the City of Chicago 1984. All Rights Reserved.
The Open-Test-Drive is a classic example of how the human elements so often influence market behavior. In Figure 4.2, soybeans had been balancing (as is evidenced by the successive days of narrowing, overlapping value), following a sharp break to the downside on April 3 that established a new long-term low at 708. When a market is in balance, there is little directional conviction among the participants. Traders need confidence if they are to participate in a sustained move in either direction. Thus, in the case of the soybean market on this day, before other timeframe buyers could begin an up auction with any degree of confidence, they needed to test below the 708 longer term low to see if lower prices attracted new activity (new other timeframe sellers, in this case). When the test below actually discouraged activity, buyers could then probe to the upside with conviction. The result was an Open-Test-Drive that brought in increased activity as soybeans auctioned higher. As the saying goes, sometimes markets need to “break to rally” and “rally to break.” Oftentimes, participants need the security of knowing what is below the lows or above the highs before they can move the market with confidence.
In hindsight, the soybean market activity on April 10 and the ideal trades that should have been entered are relatively easy to see and understand. In reality, however, pulling the trigger and placing a trade was an extremely difficult task. Let us evaluate the situation confronting soybean traders on this day. First, the long-term auction was down. Second, the previous five days had recorded basically overlapping value areas, indicating balance. And third, on the 10th, the initial breakout appeared to be to the downside. When the market opened and swiftly auctioned below the balance area lows, it was easy to assume that price was going to move substantially lower.
When price stalled around 704½, it was difficult to remain objective. The breakout to the downside was initiative activity, which should have brought in new activity and displayed immediate continuation—but there was no follow-through. When the breakout failed and price began to auction higher, longs should have been placed with the knowledge that the price probe below the balance area lows had actually shut off activity (longs should have been entered when price returned to the region of the previous day's value area, if not sooner).
This trade was extremely difficult to execute because it flew in the face of the most recent market activity. Even if a trader possesses a sound enough market understanding to recognize such an opportunity, the ability to execute still depends on the power of his or her own self-understanding. The anxiety created by the thought of placing a trade against strong opposing activity often influences a trader's ability to trade rationally. This is where the power of experience takes over. As you begin to personally witness and then experience more and more of these unique opportunities, you will gradually build the self-confidence required to become a player, instead of a spectator.
The strategy for Open-Test-Drive days is similar to that of the Open-Drive, with the understanding that the tested extreme has a slightly lower probability of holding. Again, look for a Normal Variation or Trend day to develop. The odds favor placing trades in the direction of the driving activity, as close as possible to the tested extreme. However, during this type of open (like the Open-Drive), placing the trade early is more important than the immediate trade location. If you wait to buy a pullback or wait to get perfect trade location, you will often miss the opportunity altogether.
Once price has driven in one direction, it should not return to the point where the drive began, because the participants who initially drove price should still be willing to act in that area. A return through the opening range often indicates that conditions have changed and the Open-Test-Drive extreme is no longer a reliable trading reference point.
In the Open-Drive and Open-Test-Drive, the initial extreme is established by the early entry of an aggressive other timeframe buyer or seller. Extremes created by such conditions are useful day timeframe reference points and indicate which way the market is trying to go. Unfortunately, these openings are not nearly as common as the Open-Rejection-Reverse and the Open-Auction, which lack clear-cut conviction. These final two types of openings are, however, equally important to day timeframe strategy.
Open-Rejection-Reverse
The Open-Rejection-Reverse is characterized by a market that opens, trades in one direction, and then meets opposite activity strong enough to reverse price and return it back through the opening range. The initial extreme is established when buying or selling in one direction dies out, the auction stalls, and opposite activity begins to auction price in the other direction. An Open-Rejection-Reverse type of open is less convinced of its direction when compared to the Open-Drive and Open-Test-Drive. Because of the lower level of directional conviction, initial extremes generally hold less than half of the time. This is not to say that opposite activity strong enough to return price back through the opening is insignificant. However, in terms of gauging the strength of an extreme and assessing the day type that will develop, the early entry of the other timeframe in the Open-Drive is stronger than the late entry of the Open-Rejection-Reverse. Figure 4.3 illustrates the Open-Rejection-Reverse.
Figure 4.3 Open-Rejection-Reverse in the Swiss Franc, August 29, 1987
Copyright Board of Trade of the City of Chicago 1984. All Rights Reserved.
In this example, the Swiss franc opened below the previous day's value area, traded lower, and eventually found responsive buyers below .6630. Buyers returned the price up and through the opening range in Z period. Such activity provided the trader with three important pieces of information:
The key to trading an Open-Rejection-Reverse type of day is patience. As is shown by early trade in Figure 4.3, shortly after the Rejection-Reverse the Swiss franc quickly auctioned higher. This is often the case following Open-Rejection-Reverse type of activity.
Through C period the market appeared strong and well on its way to a big move to the upside. Less experienced traders often get so caught up in the swift price movement that they jump on board, thinking that a prime buying opportunity might be slipping away. It is important to remember, however, that Open-Rejection-Reverse activity conveys a much lower level of conviction. Understanding this lack of conviction, combined with the patience and discipline to wait for the market to rotate back to you, will come through experience.
Open-Auction
At first glance, Open-Auction activity reflects a market with no apparent conviction at all. The market appears to open and randomly auction above and below the opening range. In reality, the conviction reflected by an Open-Auction largely depends on where the market opens relative to the previous day. An Open-Auction open that occurs inside the previous day's range conveys a different opinion regarding potential day timeframe development than an Open-Auction that occurs outside the range. In general, if a market opens and auctions within the previous day's value area and range, then a nonconvictional day will usually develop. If, however, a market opens outside the previous day's range and then auctions around the open, the conditions are markedly different. Here, the market has opened out-of-balance. In this case, while early Open-Auction structure may suggest nonconviction, the fact that the market is out of balance means that there is good potential for a dramatic price move in either direction. This type of Open-Auction activity often gives rise to Double Distribution Trend days. We follow with a discussion on both types of Open-Auction activity.
Open-Auction in Range
If a market opens within the region of the previous day's range and auctions, market sentiment has probably not changed. Initial extremes formed by Open-Auction activity are not established by aggressive other timeframe activity. Rather, the market auctions in one direction until activity slows, then auctions in the other direction. The other timeframe is not present with any large degree of confidence. Figure 4.4 illustrates Open-Auction in range activity.
Figure 4.4 Open-Auction (in Range) in September Treasury Bonds, June 29 and 30, 1988
Copyright Board of Trade of the City of Chicago 1984. All Rights Reserved.
An Open-Auction in range generally sets the stage for a Nontrend, Normal, or Neutral type of day. The low market conviction suggests that any extreme established early on has a low probability of holding throughout the day. Referring to the Treasury bond market for June 30th in Figure 4.4, after opening within June 29th's value area, price auctioned above and below the open with ease in B and C periods. Such seemingly random trade indicated that the bond market was in balance and that its participants held little directional conviction. Without this knowledge, however, a trader could have been fooled into selling with the C period selling range extension, thinking it meant that strong other timeframe sellers were present. The Open-Auction within range made it clear early on that a big day would be unlikely.
Open-Auction in range strategy is straightforward. Patiently wait for the market to establish its extremes and perceived value area, and then look to trade the value area extremes. If a good trading opportunity does not develop and a Nontrend type of day occurs, it is often wise to simply stand aside and wait for new activity.
Open-Auction out of Range
When a market opens outside of the previous day's range and then auctions around the open, one's first impression is that there is no directional conviction present. In reality, the mere fact that the opening is beyond the previous day's range suggests that new other timeframe activity has caused price to seek a higher or lower level. Given that the market has opened out of balance, there is a greater chance that directional conviction will develop than if the market had opened and auctioned within the range. On March 22 in Figure 4.5, for example, the Treasury bond market opens and auctions substantially above the value area and range for the previous day. In comparison to the Open-Auction in range example in Figure 4.4, the activity up to the first three time periods in Figure 4.5 (up to the point of range extension) appears very similar.
| March 30—Figure 4.4 | March 22—Figure 4.5 |
| A | B |
| AB | B |
| AB | AB |
| AB | ABC |
| AB | OBC |
| OBC | ABC |
| BC | ABC |
| BC | AC |
| BC | AC |
| C | C |
| C | C |
| C | C |
| O designates the opening. | |
Figure 4.5 Open-Auction (Out of Range) in June Treasury Bonds, March 21 and 22, 1988
Copyright Board of Trade of the City of Chicago 1984. All Rights Reserved.
However, it is evident in the two examples that an Open-Auction outside of range has the potential to be a big day, while an Open-Auction within value usually lacks conviction. This is evidenced in the fact that March 22 developed into a Selling Trend day, while June 30 resulted in a narrow Normal Variation day. This concept is discussed at further length in the next section of this chapter.
Summary
The labels we have given the four types of openings are designed only to make them easier to learn and remember. In reality, two openings will seldom look alike, and textbook examples are rare. What is important about the market's open is the notion that it is possible to evaluate market directional conviction very early in the trading session.
The analysis of the day's open should not be used in isolation, but as an integral part of understanding the big picture that gradually emerges as you learn and develop experience using the Market Profile. As a refresher, Figure 4.6 is a summary of the four types of opening activity.
Figure 4.6 Opening Type Summary. O designates the open.
Opening's Relationship to Previous Day—Estimating Daily Range Potential
In the large majority of cases, activity during any given day has direct and measurable implications on the following day. It is only on the relatively rare occasion when a market moves extremely out of balance that there is no correlation between two consecutive days. Understanding these implications enables a trader to more successfully visualize developing market activity.
The simple fact of whether a new day opens within or outside of the previous day's range helps a trader gauge two key day timeframe elements: (1) trade risk and opportunity, and (2) estimating, or visualizing, the day's potential range development. The salient concept here is market balance. The relationship of the open to the previous day's value area and range gives valuable clues to the market's state of balance and what kind of risk/opportunity relationship to expect on a given trading day. In short, the greatest risk and opportunity arise when a market opens outside of the previous day's range. This indicates that the market is out of balance. When a market opens out of balance, the potential for a dynamic move in either direction is high. Conversely, a market that opens and is accepted (auctions for at least one hour) within the previous day's value area embodies lower risk, but also less opportunity. The acceptance of price within the previous day's value area indicates balance, and therefore reduces the potential for a dynamic move.
We will discuss three different opening/previous day relationships, highlighting the potential trade risk, opportunity, and range development for each. The three relationships are:
Open within Value—Acceptance
When a market opens within value and is accepted (overlapping TPOs signify value, or acceptance), this generally indicates that the market is in balance and that market sentiment has not changed dramatically from the previous day. Trade risk and opportunity are both relatively low. The day's range usually will be contained within the previous day's range or overlap one of the previous day's extremes slightly to one side. It is a trader's dream to know ahead of time what the day's range will be. When a market opens and builds value within the previous day's value area, it is possible—very early on—to make a rough estimate of the developing day's range potential.
As mentioned before, the mere fact that a market opens and auctions within value indicates market sentiment has not changed significantly. Thus, generally, the developing range will rarely exceed the length of the previous day's range. If you are confident that one of the day's extremes will hold, to estimate the day's range potential you simply superimpose the length of the previous day's range from that extreme. For example, suppose that after several time periods on a day that opened within value, a buying tail supports the lower extreme and appears secure. The tail indicates other timeframe buyer presence and will probably hold throughout the day, thus forming the bottom of the day's Profile. If the previous day's range was 15 ticks, count up 15 ticks from the bottom of the tail to find an approximate limit for the day's high. While this is by no means a foolproof rule, it does provide a consistent approximation and contributes to the visualization needed to successfully trade in the day timeframe.
Before we proceed to an actual example, let us first present a few guidelines for estimating range potential:
Figure 4.7 illustrates range estimation for markets that open and auction within the previous day's value area. The vertical line denoted by Point A represents a completed day's range, with the black bar in the middle designating the value area. On the following day, the market opens and auctions inside the previous day's value area, as is evidenced by the auction rotations back and forth through the open. (The arrows at Point B represent auction rotations, not necessarily half-hour time periods. The market may rotate several times in any given time period.) What is most important is that the market is indeed establishing acceptance within the previous day's range and value area through time. This indicates that conditions have not changed significantly from the previous day, and the market will probably demonstrate similar range development (not necessarily the same high and low).
Figure 4.7 Open within Value—Acceptance. O designates the open.
Point C in Figure 4.7 denotes the initial estimation of the day's potential range. If the extreme left behind after the first auction down eventually forms an A period selling tail, it has the potential to be the day's high. If this is the case, the range is estimated to be the length indicated by the dotted line at Point C. The range potential is determined by super-imposing the length of the previous day's range downward, starting from the top of the selling tail. These early estimates, however, should be used only as a general guideline and must be monitored carefully for change. For example, as the day progresses in Figure 4.7, if the market auctions back up above the selling tail, a new range must be calculated. The probe to the upside in C period (denoted by Point D) creates the need to reestimate the range, for it extends above the initial high and leaves behind a B period buying tail on the low. Given the new extreme created by the up auction in C period, the new estimate would be about the length of the dotted line represented by Point E.
Let us now look at a real market example. Figure 4.8 shows S&P activity on September 23, 1988. The market opened within value, which suggested that conditions for the S&P had not changed overnight. However, immediately following the open in B period, price “drove out” of value to the downside, indicating a potential change in market sentiment. If early seller conviction had been genuine, the selling auction should have continued below the previous day's value area, and ultimately the previous day's low. However, other timeframe sellers did not successfully challenge the low of the 22nd, an important day timeframe reference point. In fact, in C period, the S&P market rotated back up into the value area and above the open, thus negating the apparent confidence that was reflected by the early Open-Drive selling activity. The fact that the market was spending time auctioning within the region of the previous day's value area (building multiple TPO prints) indicated that market sentiment had not changed and that, at best, overlapping value would develop. Moreover, based on the information generated through C period, it was unlikely that the day's trade would bring significant movement in either direction. For, while the seller was unable to sustain the opening drive, the buyer did not have the confidence of knowing what was below the 22nd's lows.
Figure 4.8 Open within Value—Acceptance in the December S&P 500, September 22 and 23, 1988. O designates the open.
Copyright Board of Trade of the City of Chicago 1984. All Rights Reserved.
Having already visualized the eventual overlapping value, and given the development of a B period buying tail, the trading opportunities in day timeframe longs should be visible. The rejection of the B period selling probe indicated the probable formation of a day timeframe low at 270.30. By adding the length of the 22nd's range (285 points) to the B period lower extreme, it was possible to estimate that the high on the 23rd would be in the area of 273.15. In this case, the range estimate proved to be exact (not a common occurrence). Longs placed during the slowing of price in D, E, and F periods had good potential to be successful trades.
Rejection (Breakout)
When a market opens within the previous day's value area and drives out during the first half hour of trade (does not build double TPOs to signify acceptance within value), the market could be breaking out of balance. If the early breakout drives price completely beyond the limits of the previous day's range, then both risk and opportunity are high and range estimation is unlimited in the direction of the initiative drive (Figure 4.9).
Figure 4.9 Open within Value—Rejection
A market that opens and is accepted within the previous day's value area is like a rubber ball bouncing along a level sidewalk. As long as the surface remains flat (or the market continues to open in balance) the ball will rebound off the pavement much like it did during the previous bounce. In contrast, if the sidewalk is cracked and broken (not “balanced”), it is impossible to determine how far or in which direction the ball will bounce (Figure 4.10). Similarly, if the market opens out of balance, it is difficult to tell which way the market will auction and with what force it will move. Over the next several pages we briefly discuss the remaining opening/previous day relationships and the potential range development for each. The guidelines introduced earlier for estimating range potential apply to these discussions as well.
Figure 4.10 Opening's Relationship to Previous Day—Market Balance
Open outside of Value but within Range—Acceptance
A market that opens outside of the previous day's value area but within range is not as balanced as an open within value, but the market is still bouncing on flat pavement. It is as if the ball simply bounced over a curb to land in the street. The ball will bounce about the same net distance, but the height will be reduced by the distance from the sidewalk to the street (Figure 4.11). Similarly, a day that opens within range but outside of value will generally produce a range that is similar to the previous day, but overlapping to one side. The risk on this type of day is slightly greater than the previous open relationship, but the opportunity is greater as well. Openings outside of value but within range indicate a market slightly out of balance and usually result in value that overlaps to one side.
Figure 4.11 Open outside of Value but within Range—Acceptance, Ball off Curb
The method for range estimation used for Openings within Value applies equally well here. The resulting range development will usually extend beyond the previous day's high or low, for the market opens closer to one of the previous day's extremes.
Rejection (Breakout)
On this type of day, the market opens above or below the previous day's value area but still within the previous day's range. If the market subsequently breaks out beyond the extremes of the previous day's range, then the market is coming out of balance and range potential is unlimited in the direction of the breakout (Figure 4.12).
Figure 4.12 Open outside of Value but within Range—Rejection
Open outside of Range—Acceptance
When a market opens outside of the previous day's range and is accepted, conditions have changed and the market is out of balance. At this point, one of two scenarios is possible: (1) the market will continue to drive in the direction of the breakout; or (2) the market will begin to auction back and forth at the new price levels (Figure 4.13 illustrates these two relationships). In both cases, as long as price does not return to the previous day's range, the market has accepted the breakout.
Figure 4.13 Open outside of Range—Acceptance
The greatest imbalance occurs in the first scenario, when a market opens beyond the previous day's range and continues in the direction of the breakout (Figure 4.13). The movement away from value is initiative and the other timeframe often moves price with great speed and conviction. Range potential is unlimited in the direction of the breakout, and a Trend day is usually the result.
This type of open offers the greatest potential to the trader who recognizes the opportunity early and positions him or herself with the breakout. However, it also poses the greatest risk to the trader who attempts to trade against the driving initiative auction.
A market out of balance is like a ball that ricochets off a piece of jagged concrete—there is no way to estimate how far it will bounce. Potential range development is unlimited and risk is extremely high for the trader who is positioned the wrong way. Accompanying increased risk, however, is also the potential for greater opportunity. An open outside of range offers the potential for a highly successful and profitable trade if market direction is detected early.
Rejection
When a market opens beyond the previous day's range and is rejected back into the range, the potential for a dynamic price move in the direction opposite to the opening breakout is set into motion. A typical example would be a market that opens too far above the previous day's high, fails to follow through, and is quickly corrected by responsive sellers who return price to previously accepted value. The day's range potential is still unlimited, for the market opened out of balance and could move significantly in the opposite direction. Figure 4.14 illustrates the range estimation for a market whose opening breakout is rejected.
Figure 4.14 Open outside of Range—Rejection
Summary
Simply keeping track of where the market opens in relation to the previous day's range and value area is valuable market-generated information. A market that opens within value is generally in balance and awaiting new information. A market that opens outside of value is out of balance, and carries with it greater opportunity and risk. By synthesizing the opening's relationship to the previous day with other market-generated elements, such as the opening type and initiative/responsive activity, it is possible to trade with a more objective understanding of the big picture.
While writing this segment of the book, a day developed in the market that exhibited many of the opening/value relationships we have just covered. April 13, 1989, will serve as a review and summation of the concepts introduced in this section.
April 13,1989
Before the market opened on Thursday, April 13, traders knew that the Retail Sales number would be announced at 7:30. In addition, five major figures were to be released on the following day: Merchandise Trade, Producer Price Index, Business Inventories, Capacity Utilization, and Industrial Production. And, as usual, a variety of predictions and contradicting speculations arose from all sides of the market. The anxiety among market participants was understandably high. To further complicate matters, Switzerland unexpectedly raised its interest rates soon after the foreign currency futures opened on the International Monetary Market (IMM). With all these external elements playing havoc in the market, it was difficult to remain calm and objective. However, traders with a firm understanding of the dynamics of opening/value relationships saw many good trading opportunities unfold on April 13. The following discussion focuses on the development of six markets: crude oil, S&P 500, gold, Japanese yen, soybeans, and Treasury bonds.
Crude Oil
In Figure 4.15, crude oil opened substantially above the previous day's high. Any such opening that is clearly above or below the previous day's range is known as a gap. A gap is the result of initiative other timeframe activity and indicates that the market is out of balance. In this example, however, the other timeframe buyer who caused the gap higher opening was unable to take control and continue the buying auction. In addition, the development of a narrow initial balance (Point A in Figure 4.15) alerted traders to the potential for a Double Distribution Trend day in either direction.
Figure 4.15 Crude Oil, April 12 and 13, 1989
Copyright Board of Trade of the City of Chicago 1984. All Rights Reserved.
Given that crude oil was out of balance and carried the potential for a Double Distribution Trend day, traders should have been ready to enter trades with range extension on either side of the initial balance. Buying range extension would signal a potentially big day to the upside. Selling range extension would indicate that the market had opened too far out of balance and that responsive sellers had entered to return price to value. The day's range potential was unlimited in both directions because of the open out of balance.
Responsive sellers did, in fact, enter and extend the range down. Traders placing shorts with the selling range extension were well positioned to take advantage of a dynamic downside move that ultimately retraced the previous day's range and closed on its lows.
S&P 500
In Figure 4.16, the S&P gapped open below the 12th's range (out of balance), indicating the potential for a big move to the downside or an “outside day” if price should return up to trade through the gap and retrace the previous day's range. In either case, the potential range development could be very large. After C and D periods failed to trade back into the previous day's range, it became evident that the market was indeed out of balance. The day's range expectations became unlimited to the downside, and optimal trade location could have been gained in the auction rotations of E, F, and G periods before the market broke swiftly in what resulted in a Double Distribution Selling Trend day.
Figure 4.16 June S&P 500, April 12 and 13, 1989
Copyright Board of Trade of the City of Chicago 1984. All Rights Reserved.
The previous four days in the S&P had recorded successively higher highs. On the 13th, many traders had this fact so firmly implanted in their minds that they responded emotionally to the price break, thinking it was a prime opportunity to buy a strong market below value. Over weighting or focusing on just one or two facts can lead to tunnel vision and inhibit one's ability to see the bigger, developing picture. On the other hand, traders who understood day timeframe structure could have recognized the imbalance indicated by the opening out of range and entered the short side of the market.
Gold
Gold on the 13th provided an excellent example of the value of range estimation. In Figure 4.17, the market opened and drove out of the previous day's value area and range, suggesting a potentially big day on the upside. However, in Z period gold auctioned back down to build double TPO prints in the 12th's value area, thus establishing value and limiting the day's expectations. When Z period was unable to extend below the open, thus confirming the Open-Drive structure and Y period buying tail, it was possible to estimate the range for the 13th by adding the length of the 12th's range to the Y period low. The range potential for the 13th, then, was roughly 392.60 to 397.20, give or take 10 percent. Using this range, longs placed in the Z period pull-back could have been successfully exited near the day's highs.
Figure 4.17 June Gold, April 12 and 13, 1989
Copyright Board of Trade of the City of Chicago 1984. All Rights Reserved.
The area around 393.00 in the gold market had been a support level in the past, and many traders were waiting for a breakout. The Open-Drive activity and quick buying auctions in Z and A periods might have suggested that a big move to the upside was developing, leading many traders to buy all the way up the range. However, traders who recognized that the day's range potential was limited due to acceptance within the 12th's value area could have curbed any high expectations and identified areas providing good trade location.
Japanese Yen
The activity in the Japanese yen on the 13th displays the significance of acceptance (or nonacceptance) within the previous day's range and value area. In Figure 4.18 the yen opened and auctioned just outside of the range of the 12th. In Z period, a selling auction into the previous day's range was flatly rejected, forming a buying tail. Despite the Z period price probe down, the base (initial balance) for the 13th remained relatively narrow. This fact, combined with the open out of value and the rejected attempt to auction down into the previous day's range, confirmed that the yen was out of balance and that buyers were in control. Because value was not established in the 12th's range (except for one tick), the expectations for the day were unlimited to the upside. Longs placed after the Z period rejection or with the A period range extension resulted in excellent day timeframe trade location.
Figure 4.18 June Japanese Yen, April 12 and 13, 1989
Copyright Board of Trade of the City of Chicago 1984. All Rights Reserved.
Soybeans
In soybeans on the 13th, the market opened in balance, immediately alerting the trader that sentiment had not changed significantly from the 12th. Figure 4.19 shows that in D period, soybeans were unable to auction price above the previous day's highs and subsequently returned down to trade through the open in E period. However, without the confidence provided by knowing what was beyond the 12th's highs, sellers could not be expected to auction price significantly lower. By superimposing the length of the 12th's range from the top of the D period selling tail, it was possible to estimate the developing range to be from roughly 723½ to 729½. Traders acting without this knowledge might have sold with the initiative range extensions in G and H periods. Shorts placed at these levels resulted in poor day timeframe trade location (near the day's lows), as was indicated early by the range estimate.
Figure 4.19 May Soybeans, April 12 and 13, 1989
Copyright Board of Trade of the City of Chicago 1984. All Rights Reserved.
Treasury Bonds
Treasury bonds opened in range and were accepted within the previous day's value area in Z period (Figure 4.20). While just two ticks of double TPO prints within the 12th's value area might seem insignificant because of the narrow range on the 12th, two ticks actually accounted for a third of the value area. This day developed into a trading day with no real conviction. Due to the open within value, it was apparent early on that this day would be similar to the 12th—a day in which it would have been best to stand aside and wait for directional conviction to develop.
Figure 4.20 June Treasury Bonds, April 12 and 13, 1989
Copyright Board of Trade of the City of Chicago 1984. All Rights Reserved.
Summary
We have now completed our discussion of the market's open: from the opening call to the actual open and its relationship to the previous day. As we proceed farther into the day, remember to consider each new piece of learning in relation to the whole. The big picture continues to unfold and more of the fogged window is becoming clear as you move closer to becoming a competent trader.
Day Timeframe Auction Rotations
Based on information we have covered thus far, let us review the process a trader might go through in developing his or her day timeframe strategy. The first signs of underlying market sentiment are formed during the succession of opening calls, which alerts the trader to possible directional conviction before the markets opens. He or she then monitors the conviction demonstrated by the opening, as well as the opening's relationship to the previous day's value area and range. At this point, which is generally within the first hour of trade, the trader should have a good feel for the confidence behind the market's initial activity and the likelihood of its continuation. The next step in the day's analysis develops as the market's auction rotations reveal other timeframe activity and control.
Think of the marketplace as a game in which the other timeframe buyer and seller are vying for control. In the simplest sense, when the buyer is in control, prices tend to rise. When the seller is in control, prices generally fall, like a vertical tug-of-war. When only one participant (usually either the other timeframe buyer or seller) is in control, the market is referred to as a one-timeframe market. A one-timeframe market is characteristic of a Trend day. Interestingly, a Nontrend day is also a one-timeframe market. During a Nontrend day, control is also in the hands of just one participant—the local.
If neither party is in complete control, price fluctuates up and down as one side pulls and tires, then the other, and so on. When both the other timeframe and the day timeframe participants are sharing control, the market is in a two-timeframe mode. Two-timeframe market conditions are common during Normal, Normal Variation, or Neutral days. During a two-timeframe market, the trader must exercise greater patience, for more time is required before other timeframe control becomes evident (if at all).
Consistent off-floor trading results are most often achieved by trading with the control of the other timeframe participant. Obviously, this requires that one be able to determine who (if anyone) is in control, and second, when that control may be wavering or reversing altogether. Monitoring the development of the day's half-hour auction rotations helps identify which participant is in control of price at a given moment in time. Before examining how day timeframe auction rotations help discern other timeframe control, let us first discuss the two basic forms of other timeframe market control in greater detail.
Two-Timeframe Markets
In a two-timeframe market, either the other timeframe buyer or seller (or both) share control with the day timeframe participant. Price rotates up and down without clear directional conviction, like a balanced tug-of-war. The resulting activity is similar to the formation of a day timeframe bracket. The Profile graphic in Figure 4.21 provides a good example of two-timeframe activity.
Figure 4.21 A Two-Timeframe Market
Copyright Board of Trade of the City of Chicago 1984. All Rights Reserved.
During two-timeframe market conditions, examination of the individual half-hour auctions (each time period viewed separately) does not generally reveal a dominance by either party. Notice from Figure 4.21 how successive time periods tend to rotate upon each other and fail to generate sustained price movement (B overlaps A on the low side, D overlaps C on the high side, etc.). Neither other timeframe participant is in control.
One-Timeframe Markets
In contrast, occasionally one participant gains the upper hand, causing price to auction (or trend) in one direction for a sustained period of time. The market is controlled almost entirely by either the other timeframe buyer or other timeframe seller. Such unilateral control is referred to as a one-timeframe market (a day timeframe trending market). A one-timeframe market is like an uneven tug-of-war in which one side is clearly stronger and steadily gains ground. The thin, elongated Trend day Profile, shown in Figure 4.22, is a good example of a one-timeframe market.
Figure 4.22 A One-Timeframe Market
Copyright Board of Trade of the City of Chicago 1984. All Rights Reserved.
Trend days signify a high level of other timeframe conviction and are characterized by range extension occurring in one direction during several time periods. Referring to Figure 4.22, notice that the downward rotations (Z, C, D, F, G, H, and I) are generally stronger than the rotations up (A, B, and E). One-timeframe seller control is evidenced by the inability of the buyer to successfully rotate price upward beyond the previous time period's auction high during two or more successive time periods. Successively lower rotations translate into repeated selling range extension.
Using Auction Rotations to Evaluate Other Timeframe Control
Determining which other timeframe participant is in control within the half-hour auctions, once again, falls into the two familiar categories: market structure and market time. Both play an important role in understanding and evaluating other timeframe control.
Structure
In the Advanced Beginner chapter, we discussed how to monitor other timeframe control using structural features such as the TPO count, tails, range extension, and initiative and responsive activity. In this section we take a closer look at evaluating other timeframe control through the market's half-hour auctions and their offspring—tails and range extension. Our goal is not to simply identify control, but also to determine when it may be changing intraday. This concept, called timeframe transition, will be illustrated following a brief discussion of time.
Half-Hour Auctions
By now, it should be clear that the half-hour auctions provide a vivid picture of the market's composure at any point in time. The half-hour auctions are illustrated in Figure 4.22.
Not only does the relationship of one auction (time period) to another reflect the ongoing status of control, but the auction is often one of the first structural features to signal when control may be shifting. Subtle changes occurring within the auctions are often the precursor to dramatic changes that do not appear until much later in the form of tails and range extension. As we noted earlier, if you wait to enter a trade until after the market commits itself, you generally will not gain the favorable trade location that is so important to making objective, rational trading decisions. Tails and range extension are strong indicators, but if you rely solely on them to judge timeframe transition, you will often be too late, for they are by-products of the market's auctions. Later, in the section entitled “Identifying Timeframe Transition,” we detail one approach to evaluating subtle changes in the day timeframe auctions.
Extremes
The extremes, or tails, often provide the most obvious evidence of other timeframe control. Tails are created when the other timeframe buyer or seller enters the market aggressively when they feel that price is away from value. Generally, the longer the tail, the greater the conviction behind the move.
In terms of other timeframe control, no tail on the extreme is also significant. The absence of aggressive other timeframe activity on an extreme indicates a lack of buyer or seller conviction. In terms of practical trading applications, consider a rising market that shows no tail on the day's low. Such a scenario suggests that it may be wise to take gains earlier than one might if a tail were present, for the market is subject to a possible reversal.
Range Extension
Range extension is another structural feature generated by the market's auctions that identifies other timeframe control and helps gauge buyer/seller strength. Multiple-period range extension is the result of successively higher or lower auctions. The stronger the control, the more elongated the range extension. If the range is extended in multiple time periods to the upside, for instance, it is apparent that the market is trying to auction higher and the other timeframe buyer is exerting a relatively high degree of control. It is important to monitor this attempted direction for continuation to determine the success of the market's attempts to go that way. Like all structural features, range extension is most useful when taken into consideration with the rest of the big picture, such as the auction rotations and tails.
Time
The second and perhaps most important ingredient in evaluating timeframe control is time. As we have noted before, time is the market's regulator and is responsible for creating the structures we later identify and interpret. Simply stated, the less time a market spends trading at a particular price level, the lower its acceptance of those prices. If the market moves very quickly through a particular price region, then there is strong other timeframe presence at those prices that they will generally serve as support or resistance in the future. For example, a selling tail is the result of swift rejection by the other timeframe seller at prices perceived to be above value. The quicker the rejection, the stronger the other timeframe presence at that price level.
Conversely, the more time spent at a particular price level, the greater the acceptance of that price. Greater time indicates that two-sided trade is occurring, and that both the other timeframe buyer and seller are probably active. It is important to note, however, that time can be a two-edged sword. If a market is not successful auctioning in one direction over time, control may reverse as the market seeks to facilitate trade in the opposite direction. If the market spends too much time at a given level, price will ultimately be rejected.
The ability to identify the difference between enough time and too much time is the key to anticipating a change in control. Understanding and interpreting market activity according to time—instead of relying solely on structure—improves one's recognition and execution speed. Time provides the signal, structure provides the confirmation. An understanding of time allows the trader to enter the market when control first begins to change, rather than waiting until it is confirmed by structure.
Time, however, is an intangible concept and is therefore very difficult to learn through a derivative source. Not until you personally observe the effect of time in the marketplace and gain experience through trading will you come to realize and respect the overwhelming power of time.
Identifying Timeframe Transition
Most trading days do not develop into a pure one-timeframe or two-timeframe market, just as most tug-of-wars are neither perfectly balanced nor a total upset. Day timeframe development generally involves a degree of give and take—one side rallies for a substantial gain, then the opponent responds with greater effort in order to balance the contest, followed by another rally, and so on. In a tug-of-war, it is possible to anticipate a change in control by listening to the participants on either team psyching themselves up for a new attack.
While varying noise levels on the exchange floor often signify change, it is not of much help to the off-floor trader. However, the Market Profile is a conduit for listening to the floor. By observing the developing structure of the Profile, it is possible to identify timeframe transitions as they occur. The off-floor trader might even have an advantage over the floor traders who are right there in the action and apparent chaos, for the Profile reflects composite market activity. In a crowded pit, traders may have access to only a portion of the total activity.
Although each day develops differently, there are a few general categories of timeframe transition that we can identify:
Not only do structure and time help determine who is in control, but they are also useful in identifying when control may be shifting. To demonstrate the interplay between time and structure when evaluating timeframe transition, refer to Figure 4.23 as we walk through the activity occurring in the Swiss franc on October 12, 1987.
Figure 4.23 Timeframe Transition. Segmented Profile in the Swiss Franc, October 12, 1987.
Copyright Board of Trade of the City of Chicago 1984. All Rights Reserved.
December Swiss Franc, October 12, 1987
Activity on this day was characterized by early-morning one-timeframe buying, a midmorning transition to one-timeframe selling, followed by a late return to one-timeframe buying. Using a running Profile helps traders visualize and monitor timeframe transition. A running Profile separates the day into selected time periods, starting with evidence of a change in control. The following points of discussion use Figure 4.23 to illustrate the changes in control that developed in the Swiss franc on October 12.
Y to E: One-Timeframe Buying
One-timeframe buying control prevails during Y through E periods. Notice the successively higher (or equal) half-hour auction periods. Buyer control translated into buying range extension in A, B, and D periods. The lack of significant downward rotation shows a conspicuous absence of the other timeframe seller.
E: Time
In E period, price slows. Buyers spent better than a full period near the high and were unable to extend the range further. Time, in this case too much time, provides the first indication that control may be shifting.
Y to F: Auction Test
F period sees the seller enter and rotate price down below the E period .6710 auction low. This deliberate opposite rotation is viewed as a test of buyer control. Markets, being controlled by people, often behave like people. Within any trend, markets need to pause, reflect on where they are, test in the opposite direction, and so on—all in an effort to determine if they have traveled too far, or have yet to probe farther. Temporary pauses amid strong price and value trends are a natural, logical part of the market auction process.
The question to be answered in succeeding time periods is: Does this initial rotation against the one-timeframe activity reflect a loss of buyer control, or is the buyer merely taking a breather?
G: Transition Confirmation
Double prints (two time period TPO prints) against a one-timeframe auction often confirm that the one-timeframe activity has ended. Double TPO prints indicate that the market has spent sufficient time rotating in one direction to justify a potential timeframe transition.
The FG double prints at .6702—double prints below the .6710 E period low—suggest that buyers were not just resting, but had relinquished control. The transition, in this case, is either to two-timeframe trade or one-timeframe selling. It is too early to tell, structurally, which will result.
Note, however, that even though timeframe control has apparently shifted, the seller was not aggressive enough to generate a selling tail on the high. The DE double TPO print on the day's high represents a high made by time, not aggressive opposite activity. This indicates a general lack of conviction on the part of the seller, and suggests that traders looking for an opportunity to sell this market should exercise caution.
E to H: One-Timeframe Selling
A running Profile starting with E period (when the one-timeframe upward rotation first slowed) indicates one-timeframe selling extending from E period to midway through H period.
H: Auction Test
In H period, buyers rotated price above the G period auction high, this time testing the seller's strength. The strong H period buying tail reflects staunch rejection of lower prices, and stands as an indication of aggressive other timeframe buying.
I: Transition Confirmation
Double HI prints at .6704 confirm yet another timeframe transition, this time from selling to buying.
H-J: One-Timeframe Buying
Following the double HI period prints, buyers tested and extended the range on the upside once again. Notice also that buyers had little difficulty extending the range beyond the .6716 DE previous high, an extreme established earlier by a nonconviction seller.
Summary
Two-timeframe trades did occur during the periods of transition (F and H periods); however, the speed of the transition indicates a virtual immediate transfer of control, rather than a tug-of-war scenario.
Auction Failures
We have mentioned the term follow-through quite frequently—in our discussions of trends, breakouts, initiative activity, during the open, and so on. In fact, follow-through is essentially the answer to the question “How good of a job is the market doing in its attempts to auction in a certain direction?” Without follow-through to the upside during a bull trend, the market, in effect, fails to auction higher. Without follow-through in a golf swing, the golfer fails to successfully hit the ball. And without follow-through in a business negotiation, even the most promising deal will likely fail. The point is that failure to follow through is just as significant as successful follow-through when monitoring market activity.
When a market auctions above or below a known reference point, one of two scenarios will develop: (1) new initiative activity will fuel continuation beyond the reference point; or (2) the auction will fail to follow through. After an auction failure, price is often rejected in the opposite direction with speed and conviction. The magnitude of this movement depends on the significance of the tested reference point. Known reference points exist in many forms: daily high/low, weekly high/low, monthly high/low, a break or rally point caused by an important news announcement, bracket top/bottom, and so forth. The greater the variety of other timeframe participants who are present at the tested reference point, the greater the potential magnitude of the auction failure. For example, if a selling auction fails to continue below a bracket low that has held for several months, day, swing, and other timeframe buyers will be brought into the market en masse, causing a high level of volatility. The resulting rejection of such a long-term bracket extreme could trigger a substantial rally and have a significant impact on the direction of the long-term auction.
Let us consider this example in greater detail. When price nears a bracket bottom, many traders wait to see if the previous support level will hold before entering the market. If the market should fail to breakout below the bracket bottom, these traders often respond quickly, causing the market to rally. Conversely, if price auctions through the bracket low and is accepted, the same traders may enter the market on the sell side, driving price lower, and adding fuel to a strong initiative selling auction. Such long-term auction failures are as important to the day trader as they are to the long-term participant. If a day trader is aware of long-term support levels and reference points, he or she is better prepared to capitalize on (or protect him or herself from) the dramatic day timeframe price movement common during a long-term auction failure. In fact, the longer the timeframe that the failure represents, the greater the profit potential (and risk) that is often present in the market.
Figure 4.24 illustrates a long-term auction failure in soybeans. On April 3, 1989, soybeans recorded a new long-term low at 708. The soybean market then came into balance, as is evidenced by the four consecutive days of overlapping value that followed. Figure 4.25, on April 10th, shows the activity that occurred shortly thereafter. Soybeans opened in balance at 710½, then quickly drove below the low created on the 3rd (708). However, the selling auction failed to generate new selling. Two events generally happen after such a significant failure: (1) the participants who auctioned price lower (generally the short timeframe or local) cover their shorts and reverse their position; and (2) other traders become aware of the lack of selling below a known reference point and enter the market with confidence (the opposite applies to a probe above a significant reference point). On April 10, after the auction below the balance area lows stalled, buyers responded and drove the soybean market higher. The result was a Double Distribution Buying Trend day. Traders who monitored the balance-area lows and the long-term reference point at 708 could have used the auction failure to secure excellent day timeframe trade location.
Figure 4.24 Long-Term Auction Failure Occurring in May Soybeans
Data courtesy of Commodity Quote Graphics.
Copyright Board of Trade of the City of Chicago 1984. All Rights Reserved.
Figure 4.25 Auction Failure Occurring in May Soybeans, April 7 to 11, 1989. O designates the open.
Copyright Board of Trade of the City of Chicago 1984. All Rights Reserved.
Auction failures at shorter timeframe reference points are generally more subtle and result in smaller price movements when compared to auction failures at longer timeframe reference points. However, the price rejection that follows a short-term auction failure can still be swift and substantial relative to normal day timeframe structure. Figure 4.26 shows a typical day timeframe auction failure occurring in the Treasury bond market. On May 16, 1989, bonds auctioned below the previous day's low (90.22) in Y period, but failed to follow through to the downside. The market auctioned lower looking for more selling business, but there were no sell stops or new activity to sustain the downward price movement. Armed with the knowledge that there was no new selling below the short-term lows, bonds traded higher for the remainder of the day and eventually closed on the highs.
Figure 4.26 Day Timeframe Auction Failure Occurring in September Treasury Bonds, May 15 and 16, 1989
Copyright Board of Trade of the City of Chicago 1984. All Rights Reserved.
Placing a trade after an auction failure is an incredibly challenging task. In the previous example, the most recent Treasury bond activity had been down, and the crowd was selling. When price slowed, indicating potential failure, it was not easy to enter the market as a responsive buyer. Again, the best trades often fly in the face of the most recent market activity.
Excess
To achieve its primary goal of trade facilitation, the market auctions lower to find buyers and higher to attract sellers. Ideally, the market finds a value range where both the other timeframe buyer and seller perceive price to be fair so that two-sided trade can take place. However, the market is effective, not efficient.1 Consequently, in its attempt to generate trade with all participants, the market occasionally creates excess by auctioning too far in a given direction.
Suppose that a local baker produces 1,000 loaves of bread daily, which he sells for 50 cents each. Business is good at this price, and he consistently sells every loaf he bakes. Because the demand for his homemade bread seems to have been on the rise, one morning the baker raises his price to 55 cents a loaf and still sells every one. Pleased with the results, he decides to charge 60 cents the next week, but finds he sells just 800 loaves—higher prices began to discourage buying. The baker quickly lowers the price back to 55 cents a loaf due to decreasing sales volume and shrinking profits. The point is, he had to raise prices too far above value to be sure that he had found a price that both he and the consumer perceived to be fair. The baker's pricing method created an excess of 5 cents, the difference between the 60-cent extreme and 55-cent value.
Similarly, the market must auction too high to know when prices are perceived to be above value and too low to know which prices are considered to be below value. The potential for market excess occurs any time price trends significantly out of balance, or away from value. Excess is created when the other timeframe recognizes an opportunity and aggressively enters the market, returning price to the perceived area of value. Evidence of the resulting excess, in both the day and longer timeframe, can be identified through market structure.
Signs of Excess
By definition, excess is useful only in hindsight analysis, for it is not identifiable until it has already formed. While this is, in fact, true, many of the structural characteristics reflected by the Profile help identify excess quickly. Tails, for example, are simply day timeframe auction excess. Day timeframe excess is illustrated in Figure 4.27.
Figure 4.27 Day Timeframe Excess. Japanese Yen, March 8, 1988.
Copyright Board of Trade of the City of Chicago 1984. All Rights Reserved.
In Figure 4.27, the other timeframe was active on both ends of the range, entering aggressively and creating day timeframe excess on both extremes. Price auctioned lower in A period and was met by a strong other timeframe buyer, establishing a buying tail. Conversely, an E period buying price probe was rejected by the other timeframe seller, creating a selling tail. Tails are perhaps the most common manifestation of excess, and they occur in a similar way in the long-term auction process. Long-term excess is covered later in “Long-Term Trading.”
Let's take a moment to look at excess from another, more conceptual, perspective. Any time a given price level is rejected quickly by the market, excess is formed. The single prints separating the two areas of a Double Distribution Trend day are a variety of excess. Just like a tail, they represent prices perceived as away from value by the other timeframe. A gap is also a form of market excess, for it is, in effect, an invisible tail.
The importance of any type of excess is that it represents an area that should serve as support or resistance to price in the future. As long as conditions have not changed markedly, the other timeframe participant that drove price so vehemently should react similarly at those same price levels. This is why a tail can be used to estimate range potential, for it is a reliable benchmark by which to gauge future activity.
The Rotation Factor
As we near the end of Day Timeframe Auction Rotations, we again address the question “Which way is the market trying to go?” Thus far, we have discussed concepts such as directional conviction, initiative and responsive activity, and other timeframe control—all of which provide bits and pieces of the answer to the first of the two Big Questions. In the day timeframe, however, we have yet to provide a finite, objective answer to the question of market direction. We present here a simple, objective means for evaluating day timeframe attempted direction based on the market's half-hour auction rotations. It is called the Rotation Factor.
At any point in time within the day, segmenting the Profile into half-hour auctions helps determine which other timeframe participant is currently in control (or that neither is in control). However, it is not always easy to determine which participant is exerting greater overall influence. The Rotation Factor objectively evaluates a day's attempted direction. Each auction rotation is measured step-by-step, allowing the trader to discern overall daily directional attempts. Figure 4.28 provides reference for the following discussion on how to calculate the Rotation Factor.
Figure 4.28 The Rotation Factor
The method for assigning a value to each time period's auction rotation is relatively simple. If the high of the current time period is higher than the previous period's high, then the rotation is given a +1. If the high is lower than the previous period's high, then it is assigned a −1. Similarly, if a time period's low is higher than the previous period's low, then a value of +1 is added. An auction bottom that is lower than the previous period's low receives a −1. And if both periods' highs or lows come out even, then no value, or 0, is assigned. The same process is performed for each subsequent time period, ultimately resulting in a number that can provide a good indication of day timeframe sentiment. Figure 4.29, for instance, shows the Rotation Factor for a day in Treasury bonds. The cumulative rotation numbers across the time period tops totaled +3, as did the figures across the auction bottoms. The net total for this day is +6, which exhibits consistent buyer attempts throughout the day.
Figure 4.29 The Rotation Factor. Application in Treasury Bonds.
It is important to keep in mind, however, that the Rotation Factor only answers one of the two Big Questions—that is, which way the market is trying to go. Before any conclusions can be drawn, you must also determine if the market is doing a good job in its attempts to auction in that direction. The answer to this second Big Question requires a much more sweeping analysis than that which can be provided by a simple measure of the auction rotations. As we proceed through this chapter, we will thoroughly detail the methods necessary for determining a market's directional success.
Monitoring the POC or Fairest Price
In the first edition of Mind over Markets the point of control (POC) was described as the longest line, reading from left to right, closest to the center of the range; this is the price that attracted the greatest amount of time. Price advertises opportunities and time regulates all opportunities; because this price was accepted over the greatest amount of time it can also be viewed as the fairest price at which business was being conducted during the session. Monitoring the fairest price is the best way to visualize what timeframe is exerting control of the market. On a day in which there is little influence from the other or long timeframes the fairest price is less likely to migrate very far from the center of the range. When the other timeframe becomes more aggressive we will likely begin to see the fairest price migrate either higher or lower.
Occasionally, a market will start the day in a two-timeframe mode but then develop into a one-timeframe market. The Profile structure might appear to be rotational when, in fact, either the other timeframe buyer or seller has taken control. This is often a difficult situation to identify quickly. Thus the trader must learn to recognize the underlying conditions that often precede such activity, and then monitor those conditions closely. A change of control often occurs when price auctions near or beyond the day's extremes and fails to follow through, causing the auction to reverse and auction aggressively (one timeframe) in the opposite direction. A running Profile starting with the time period of potential change (a tail or breakout) is an effective means for monitoring intraday transition. You should start a new Profile by splitting the current period away from the earlier periods.
The purpose in splitting the Profile is so that you can monitor the migration of the fairest price level. The most important aspect of monitoring the POC or fairest price level is the ability to visualize the potential change or no change in the fairest price level. A chess champion can visualize the huge complexity of potential moves to be made by both him and his opponent far in advance. Similarly, a successful day trader can visualize how different market activity will affect the migration of the fairest price level.
Using Figures 4.30 through 4.34, let us closely examine a day in Treasury bonds, discussing the visualization process that occurs as the trading session progresses.
Figure 4.30 9 : 30 a.m. (The Point of Control, Shown Here to Be at 99 to 00, Is Actually between 98 to 31 and 99 to 00.)
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Figure 4.31 Trading in Treasury Bonds—10:00 a.m.
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Figure 4.32 Trading in Treasury Bonds—10:30 a.m.
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Figure 4.33 Trading in Treasury Bonds—Noon
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Figure 4.34 Trading in Treasury Bonds—2:00 p.m.
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9:30 a.m. Figure 4.30
The fairest price or POC is actually between 99 00 and 98 31, for both prices have equal length and the center of the range is between them. Range extension to either side will change the POC (the longest line closest to the center of the range). Following range extension take the total range for the day and divide by 2 to find the center of the range. As you begin to watch the markets you will begin to visualize what effect, if any, range extension will have; if the market has spent too much time at a single level range extension it will not change the fairest price level; however, a combination of time and range extension can change fairest price level.
10:00 a.m. Figure 4.31
At the end of D period, the POC moves to 99 00, due to the single tick of buying range extension. A continual rise in the fairest price level indicates consistent other timeframe buying. Caution: Everything has to be continually viewed within context; the same developing market structure that occurs within the previous day's range is potentially less important than if it were taking place when the market was out of balance relative to the previous day's structure.
10:30 a.m. Figure 4.32
The POC moves higher in E period; it may seem improbable that the POC can move so quickly and cause such dramatic swings in implications; however, long or short inventory can be acquired or liquidated in a minimal amount of time, creating control shifts within a single time period.
After E Period, it is possible to start visualizing potential auction rotations. If F period trades at the POC (99 03) and auctions lower the fairest price to conduct business will decline. If F period begins to trade higher followed by G and H the fairest price will rise, indicating that timeframes beyond the day timeframe are continuing to push the market higher.
Noon Figure 4.33
Auctions in F, G, and H period raise the POC or fairest price at which business is being conducted; buyers beyond the day timeframe continue to press the market higher.
Price advertises all market opportunities, while time is the regulator of all those opportunities. In our current example, while price continues to press higher, time is restricting the advance. Notice how the POC or fairest price level to conduct business continues to become more prominent than the surrounding prices. A healthier market would see a more elongated Market Profile. The Market Profile gives the market a readable two-dimensional structure.
2:00 p.m. Figure 4.34
Notice that the fairest price level has not changed since noon, Figure 4.33. The POC and fairest price to conduct business are one and the same; it is easier to appreciate what is occurring in the market if you think in terms of the fairest price; for example, in the last two figures any buying that took place above the fairest price level saw buyers buying price above the fairest price. When this is occurring traders are taking above-average risk; when we trade we like to constantly think in terms of odds. Any selling, relative to the fairest price level, would be considered selling short-in-the-hole or selling price below value.
The Close
The last indication of day timeframe market sentiment is embodied in the day's close; far too much emphasis is often placed upon the close and what the close portends for the following day. The close does, however, often greatly influence overnight traders who continue to trade in the direction of the close. Overnight inventory will be covered in the final chapter, entitled “Expert.”
Day Timeframe Visualization and Pattern Recognition
Garry Kasparov, the world chess champion, once challenged 59 schoolchildren in separate games of chess—all at once. The competition took place in a Bronx gymnasium with the chess tables set up in the form of a large square. The expert strolled from board to board, selecting his moves. He spent very little time making decisions, while each of his opponents had all the time they needed. While a child is no match for the skilled Kasparov, taking on 59 children at once is a challenge to any one individual, regardless of skill level. Yet, he handily beat 57 of the students, while two proud young chess players managed to take him to a draw. How did Kasparov do it, particularly in such a short amount of time? Playing—not to mention winning—57 matches simultaneously requires something more than skill alone.
Over the course of his chess career, Kasparov has probably experienced nearly every conceivable arrangement of the game's playing pieces. There are a variety of known and recognizable chess strategies, openings, and so on. Quite possibly, Kasparov was relying on pattern recognition. He was speed-reading, or visualizing, the board, recognizing patterns and making decisions based on past experience in similar situations. Pattern recognition, or visualization, begins to materialize after extensive practice and experience in practically any endeavor, whether it be playing chess, predicting the weather, diagnosing a patient, or trading.
As a trader gains more and more experience observing and trading using the Market Profile, a number of recognizable patterns begin to surface in day timeframe structure. Virtually every structural feature of the Profile involves pattern recognition in one form or another, and most play a part in visualizing the developing day timeframe structure. For example, an Open-Drive outside of the previous day's range is a pattern that allows a trader to immediately visualize a Trend day scenario and sustained price movement throughout the day. Conversely, an Open-Auction in value is usually a good indication of a more balanced, trading type of day. This information enables a trader to visualize and estimate the potential extremes of the day's range.
Successful trading is assisted by successful visualization. Monitoring the opening call and open activity allows a trader to visualize the formation of the day's auction rotations. In turn, observing the evolving auctions makes it possible to visualize the type of day pattern that might emerge. Recognizing certain day types and structural patterns allows the visualization of trade facilitation and attempted market direction. All these factors contribute to the ongoing visualization process and make up the big picture for the day timeframe.
We will discuss here three distinctive patterns that have particularly interesting implications for day timeframe visualization: short covering rallies, long liquidation breaks, and ledges.
Short-Covering Rallies
Probably one of the market's most deceptive and misunderstood behaviors is known as short covering. Almost all rallies start with “old business” covering their short positions, which at least temporarily causes price to auction higher. If this rally is not accompanied by new buying, it is usually due solely to short covering.
Short covering often follows a day (or several days) of strong selling activity. As the market moves farther out of balance, participants simply become “too short.” A sharp rally, generally occurring on or soon after the open, follows as participants enter to cover (buy back) their short positions. The need to cover may be a result of: (1) locals simply selling so much that their inventories become too short; (2) profit-taking after an extended down move; or (3) other timeframe participants with short positions who are forced to exit. Like a kettle that whistles when too much steam has built up inside, a short-covering rally is a short-term event that relieves temporary market pressure.
After recent strong selling activity, the swift rally that is characteristic of short covering can be easily misinterpreted as aggressive other timeframe buying. However, if the rally is truly caused by short covering and not new buying interest, the market will often resume its prior course once the selling imbalance has been neutralized. Unfortunately, such quick and erratic activity can easily heighten market anxiety and cause traders to exit a trade far too early, or even exit shorts and enter longs. When identified and interpreted properly, however, short covering often generates a market-created opportunity to sell.
As illustrated in Figure 4.35, a short covering rally (that is not accompanied by new buying) resembles the letter P, or a half-completed Profile. Once the covering diminishes, price usually recedes and corrects itself, in effect, filling in the lower half of the range. The trader's first alert to potential short covering is the swift, excited rally that is immediately followed by the virtual disappearance of the buyer. The rally stalls almost as quickly as it got started. Short covering is caused by old business, not by new participants entering the market.
Figure 4.35 Day Timeframe Short Covering Occurring in Three Markets: Gold, February 24, 1988; Treasury Bonds, February 19, 1988; Japanese Yen, February 18, 1988
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This is not to say that every time a market rallies quickly and stalls it is the result of short covering. There are situations in which the market will rally, stall, then rally further. For example, the top of a bracket can offer sufficient resistance to slow price after a strong rally. Once price breaks through the bracket, however, the rally will generally resume with renewed force. Figure 4.36 demonstrates this scenario. How, then, can a trader tell the two apart? Let us refer to Figure 4.37 for illustration.
Figure 4.36 Exception to Short Covering Occurring in the Japanese Yen, March 7, 1988
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Figure 4.37 Short Covering Occurring in the March S&P 500, January 20, 1988
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In Figure 4.36, the P formation is evident through E period in the S&P market. The individual half-hour auctions for B through E periods are separated to show the short covering rotations, followed by the Profile for the same period, the B to H Profile, and finally the completed day. It is evident that after the initial rally in B period, each subsequent half-hour auction did a worse job of facilitating trade with the buyer. Nearly every successive higher auction was lower than the previous auction high. Compare this formation closely to the formation in Figure 4.36. In Figure 4.36, the buyer successfully managed to hold his ground, while in Figure 4.37 the buyer gradually lost ground.
Figure 4.37 projects the waning buyer strength. Through E period, the half-completed Profile is apparent, looking as if the market needs to rotate downward and fill in the other half. By F period, the short covering begins to dissipate, sellers reenter and the day's structure begins to close in on itself. In addition, Figure 4.37 illustrates a unique phenomenon not uncommon during short covering rallies. After the initial rally, the S&P actually switched to a one-timeframe selling mode beginning with the formation of the high during C period (each successive auction was equal to or lower than the previous half-hour auction without extending beyond the high).
Long-Liquidation Breaks
The opposite side of a short-covering rally is the long-liquidation break. The market forces that cause long liquidation are the opposite of those that trigger short covering. Due to locals who have gotten too long (bought too much) or a large number of other timeframe participants exiting their long positions after an extended up trend, the quick sale drives price swiftly downward. Again, this selling break is primarily caused by the liquidation of old long positions, not placing of new shorts. Thus, the liquidating break generally lasts as long as there are longs to cover (unless the selling break brings new business into the market and exhibits follow-through). Once the “sale” is over, the market begins to correct itself. The resulting pattern often takes the shape of a b (the inverse of the short covering P formation). Figure 4.38 illustrates a long-liquidation break.
Figure 4.38 Day Timeframe Long Liquidation Occurring in the March S&P 500, February 2, 1988
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In the S&P market on this day, the market opened and drove sharply lower through C period. As is characteristic of a long-liquidation break, subsequent time periods showed a lack of seller continuation and a transition to one-timeframe buying (in this case, through H period). This particular example is not nearly as perfect as the short-covering scenario highlighted on the preceding pages—and few are. Notice that in I period the S&P auctioned down near the C period lows once again. However, the seller's inability to auction below the C period lows reaffirmed the lack of seller follow-through and the continued buyer strength. Once the I period auction failed to attract new selling, buyers reemerged and completed the Profile.
The liquidation occurring on this day is a vivid illustration of the importance of visualization and pattern recognition. If you become too involved in the minute-to minute price movements, it is easy to fall victim to tunnel vision. The ability to visualize promotes the objectivity that is so necessary for developing a holistic view of the marketplace.
Summary of Short Covering and Long Liquidation
A Profile beginning to develop the shape of a P or a b does not imply that short covering or long liquidation is occurring. Remember, all facts are surrounded by other circumstances. Properly evaluating short-covering or long-liquidation patterns requires that the trader make careful note of the underlying conditions prevailing in the market and the requisite characteristics that signify each pattern. The main considerations are: (1) the recent market direction compared to the formation, (2) the open—near the low for a short covering and near the high for long liquidation, (3) the subsequent noncontinuation after a drive away from the open, and (4) gradually retracing auctions as the short-term buying or selling releases temporary pressure.
Ledges
A ledge is a rather strange, awkward-looking formation. In effect, ledges resemble one half of a normal distribution—as though someone chopped the Profile in two. Ledges form when a market repeatedly attracts the responsive participant in its attempt to auction in a given direction. Consequently, the market stalls again and again at one particular price level.
The half-completed structure of a ledge tends to make a trader feel uneasy. It seems as though something is bound to happen, that the day's Profile is still evolving. Logically and intuitively, the market is almost expected to spill over the ledge and fill in the day's Profile. However, if it does not and the ledge holds, the market may move significantly in the opposite direction. The key to successfully trading a ledge lies in monitoring the activity around the ledge for clues regarding which scenario will come to pass.
A ledge is often the result of short covering or long liquidation. The market moves in one direction with short-term conviction, then suddenly stalls. There is no follow-through to sustain the auction. The market auctions up, for example, and stalls once the participants who were long have covered their positions. As time goes on, one of two events can occur: (1) the lack of continuation to the upside gives sellers confidence to auction price below the ledge; or (2) the ledge offers support, and buyers enter to resume the up trend. A typical ledge pattern is shown in Figure 4.39.
Figure 4.39 A Ledge Pattern in June Gold, May 3, 1988
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The dynamics governing a day timeframe ledge are similar to those underlying a long-term breakout from a balanced area. Several days of overlapping value generally indicate that a market is in balance. A breakout in either direction is a sign that the market is coming out of balance, and trades should be placed in the direction of the breakout. Similarly, a ledge is an indication of day timeframe balance, and a breakout from the ledge indicates a departure from balance. In terms of trading applications, if price auctions more than a few ticks “off the ledge,” trades should be placed in the direction of the breakout (unless there are extraneous market conditions present—news events, etc.). In Figure 4.39, for example, shorts should have been placed at 4472 when gold dropped off the 4476 ledge in H period.
Summary
The three-day timeframe patterns introduced here are but a small fraction of the total number of patterns that exist in the marketplace. The different opening types each form their own identifiable pattern. As the market's half-hour auctions unfold, the patterns characteristic of the different day types begin to emerge. Almost every aspect of the market's auction process can be categorized as some sort of pattern, although not all of them are as specific as short covering, long liquidation, and ledge formations.
The importance of pattern recognition is not in the act of labeling different market structures. Rather, pattern recognition is essential for understanding current market activity, and more important, learning to visualize future market development.
High- and Low-Volume Areas
To conclude our discussion of Day Timeframe Trading, we will examine high- and low-volume areas and their use in identifying changes in market sentiment. Market change is accompanied by both risk and opportunity. The key to securing optimal trade location is the ability to identify market change as it is developing, before the change is confirmed by structure. By monitoring significant volume-generated reference points, a trader can anticipate market behavior and maximize trade location in the early stages of change.
High-Volume Areas
High-volume concentrations develop when the market spends a relatively large amount of time trading within a narrow range of prices. Both the buyer and seller are active, forming a short-term balance region in which price slows to accommodate two-sided trade. In other words, the market perceives that area to be fair, and volume builds over a period of time.
In the shorter timeframes, high-volume areas represent the market's most recent perception of value and, therefore, have a tendency to attract price. Naturally, all markets eventually undergo change and leave the high-volume area in search of new value. Should the market subsequently return to those price levels, the high volume region should once again attract (slow) price.
We caution that the market's memory is primarily short term. The longer price remains away from a specific region of acceptance, the less significance the high volume will have on the market as it reenters that region. However, with regard to day and swing traders, an area of previously established high volume should slow price movement long enough to provide sufficient time to enter or exit a trade.
For example, suppose the swing auction in Treasury bonds is up, but the market probes downward into an area of previous high volume. The slowing of price should provide time to enter a responsive long and then monitor it for the reemergence of the buyer. Similarly, when seeking to exit an existing long, a trader can be relatively sure that when a market moves up into a high-volume area, price will slow enough to allow time to liquidate the long position.
Identifying High-Volume Levels
Depending on the data vendor, day timeframe traders have three potential sources for high-volume price information:
Figure 4.40 High-Volume Areas. December Treasury Bonds, October, 25, 1988.
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Figure 4.41 Tick Volume Profile in June Treasury Bonds, May 30, 1989 Data Courtesy of Commodity Quote Graphics.
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High-Volume Examples
During late October, Treasury bonds were in the midst of a long-term buying auction. As is demonstrated by Figure 4.42, October 25 recorded high-volume prices in the 89 to 05 to 89 to 08 region. After a higher opening on the 26th, responsive sellers attempted to auction price lower during A and B periods. The selling auctions eventually slowed near the area of the highest volume concentrations of the previous day. Buyers then entered the market and returned price above the 25th's value area.
Figure 4.42 High-Volume Areas. December Treasury Bonds, October 25 and 26, 1988.
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Given that the long-term direction was up and that the bond market had opened higher, traders looking for a good location to place a long could expect price to slow if it auctioned down near the high-volume area of the 25th. If the buying auction was exceptionally strong, however, price would not have returned to the high-volume area at all. It is important to stress that traders should not expect the market to stop precisely at the high-volume levels—remember, high volume attracts price, but it is not a rigid floor or ceiling. It is logical for the market to trade around a high-volume area. Thus, the market could just as easily find support or resistance before the high-volume region as beyond it. The key to taking advantage of high volume is: (1) do not try to be perfect—first execute the trade; and then (2) place your confidence in the slowing properties of volume. If price had subsequently been accepted below the high-volume area, traders would have been alerted that market perceptions of value had changed. Long positions should have been exited immediately.
While October 26 did not evolve into a big day, it did show general continuation to the upside through higher value placement. Moreover, when the Treasury bond market attempted to auction lower in C period, price slowed and found support at the high-volume levels. Day traders could observe the downward testing to 89 to 10, place longs against that level, and rely on the slowing properties of volume should price probe lower.
Figure 4.43 shows Treasury bonds at the start of a potential short-term down auction. September 14 demonstrates a Normal Variation selling day, characterized by a strong responsive selling tail and late selling range extension in K period, resulting in a close in the lower half of the range. The unusually large selling tail alerted traders to potential buying excess on the high. Figure 4.43 shows the Profiles for September 14 and 15, along with the %Vol figures for both. The 14th's high-volume prices spanned from roughly 88 to 20 to 88 to 25, accounting for 53.7 percent of the day's volume. On September 15, bonds opened and auctioned within the area of the 14th's high-volume concentrations. The A, B, and C period rotations within this high-volume region demonstrated the time offered by high volume—time to enter or exit a trade. Traders may have chosen to use this particular opportunity in one of two ways, depending on their level of confidence in the start of the down auction:
Figure 4.43 High-Volume Areas. December Treasury Bonds, September 14 and 15, 1988.
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Low-Volume Areas
Low volume typically represents other timeframe directional conviction. Therefore, it is more likely to see low-volume areas occurring in unbalanced, trending markets. Low-volume prices are caused by the same forces that create excess and usually exhibit the same characteristics: gaps, single TPO prints, and tails (short and long term).
When the rejection demonstrated by a low-volume area develops, short-term strategy is to place trades using the area of price rejection for support or resistance. The low-volume area, like excess, should hold against future auction rotations. For example, single TPO prints separating a Double Distribution Selling Trend day indicate swift rejection of the initial distribution in search of a new, lower-value area. Shorts placed just below the single-print, low-volume area should offer good day timeframe trade location. However, if price auctions back up through the single prints, then market sentiment has changed and shorts should be exited. When price auctions through an area of previous low volume, the other timeframe conviction that initially influenced price has changed. Traders should heed the market's warning and exit any opposing trades.
Imagine a low-volume area as a balloon. The surface of the balloon offers resistance to the probing of the tip of a pencil. Once the pencil pierces the balloon, however, there is nothing to stop its motion in the direction of the initial probe. If a price probe penetrates the extreme of a low-volume region, then the subsequent price movement is often swift through the remainder of the low-volume area. However, like the balloon, the low-volume area “gives” before it breaks. Price must often trade substantially through the low-volume area before it no longer offers support or resistance.
The means to identify low-volume areas are similar to those previously covered in the high-volume discussion. The most significant measure is again found in the %Vol column of the LDB, followed by structural indicators, such as tails and single TPO prints, and tick volume. As an example of using real volume levels, let us examine the September 15 LDB, shown in Figure 4.44.
Figure 4.44 Low-Volume Areas. December Treasury Bonds, September 15, 1988.
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Two obvious low-volume price areas that came into play on this day span from 88 to 25 to 88 to 26, and from 88 to 12 to 88 to 16. The low volume at the upper extreme of the day's range represents rejection of the 88 to 26 high. The lower volumes in the center of the range suggest that aggressive other timeframe sellers drove price lower with conviction. These five prices add up to only 12.6 percent of the day's trade and represent a region where future auction rotations will probably be rejected rather than slowed. This rejection can assume one of two forms: (1) a dramatic reversal if the low-volume area holds, visually represented by a tail, or (2) swift continuation back through the low-volume area, commonly represented by single TPO prints.
Low-Volume Examples
At the time of this example, Treasury bonds had formed short-term buying excess at 89 to 09 on September 14 (circled in Figure 4.45) and were starting a down auction. September 15 developed a late-forming Double Distribution Selling Trend day (Figure 4.46), confirming the buying excess. Figure 4.46 displays the Profiles for the 15th and 16th, and their accompanying price/volume figures. Again, the low-volume area from 88 to 12 to 88 to 16 on the 15th represents swift continuation and other timeframe seller conviction. This territory should offer resistance during subsequent buying attempts, at least over the short term.
Figure 4.45 Low-Volume Areas. December Treasury Bond—Excess Data Courtesy of Commodity Quote Graphics.
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Figure 4.46 Low-Volume Areas. December Treasury Bonds, September 15 and 16, 1988.
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Two scenarios may confront a trader looking to sell on the 16th. First, assuming an unchanged to lower opening, good trade location would be gained just below the 88 to 12 to 88 to 16 low-volume region. Ideally, price would test higher and be rejected, providing an opportunity to place shorts near the 16th's highs. If the market is extremely weak, however, price may never auction that high. This brings us to the second scenario, again assuming an unchanged to lower open. If bonds show early selling via an Open-Drive type of opening, there will be no ideal opportunity for short placement. In such a high conviction situation, it is best to position shorts early and then monitor subsequent activity for continuation. Here, the low-volume area acts as a form of excess, giving credence to the developing down auction.
As Figure 4.46 illustrates, on September 16 bonds gapped open below the 15th's lows, indicating potential seller continuation. The lower opening proved to be too low, however, and responsive buyers entered the market to take advantage of price perceived to be below value. Subsequent time periods showed buyers struggling to auction price higher. Eventually, the buying attempts met with rejection at the 88 to 12 level—the bottom of the low-volume area separating the two distributions from September 15. The failure to auction back into the low-volume region offered traders an excellent opportunity to place short positions.
Ultimately, day timeframe resistance was found just below the low-volume area and the single print from the previous day's selling Trend structure. As with anticipating price slowing near high-volume areas, it is equally important that traders avoid trying to achieve perfect trade location near the region of low volume. The keys to taking advantage of low-volume areas are: (1) keep accurate notes of where they are; (2) know in which direction you expect to see rejection and monitor for signs of that rejection; (3) place orders ahead of time at price levels representing good trade location to insure execution; and (4) abandon low-volume strategies if price builds acceptance beyond previous low-volume regions (a price probe pierces the “balloon”).
Despite the obvious structural buying preference throughout the day's activity, September 16 resulted in lower values. This fact, along with the buyer's inability to auction price beyond the low-volume area from the 15th, suggested that other timeframe control remained in the hands of the seller.
Activity on the following day, September 19, shows an integration of the logical workings of both high- and low-volume areas. In Figure 4.47, the Treasury bond market opened at 88 to 09 and found early rejection just below the 88 to 11 and 88 to 12 low-volume prices that formed the highs of September 16. Sellers easily auctioned through the 88 to 03 level, despite its low-volume percentage (0.8 percent), increasing confidence in short trades. The fact that price auctioned through 88 to 03 on the 19th confirmed that this area that had supported the previous afternoon's buying auctions was no longer valid.
Figure 4.47 Low-Volume Areas. December Treasury Bonds, September 16 and 19, 1988.
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From a Profile standpoint, note that activity on September 19 generated an initiative selling tail directly below the low-volume region of the 16th. In addition, the high-volume levels of the 16th (around 88 to 06 and 88 to 07) slowed price enough to allow traders time to place shorts with initiative selling activity.
Summary
The following is a brief listing of the salient concepts involved in understanding high- and low-volume areas:
High- and low-volume areas do not represent “mechanical” trades. They do, however, provide useful reference points that enable traders to visualize potential future activity. The importance of such reference points lies in the detection of market change. By monitoring activity around high- and low-volume areas, a trader can determine whether or not directional conviction has changed since the area was formed. Through the detection of fundamental change, traders can better manage their risk and identify areas offering favorable trade location.
Summary—Day Timeframe Trading
Let's pause for a moment and imagine a vast desert with nothing but sand in all directions. A man walks along, his throat dry and his lips cracked. Suddenly, he sees before him a shimmering pool of water just over the next dune. He runs toward it, relief finally in sight. He reaches the top of the sand hill and jumps—only to land in more sand. The water was a mirage created by the sun and his overwhelming desire to find water.
It is important to keep in mind at all times that the market can easily create a day timeframe mirage regarding long-term market direction. When a trader is looking too hard for certain market conditions and the market exhibits some characteristics of what he seeks, the result is often a mirage that can leave a trader high and dry. For example, when a market opens substantially above the previous day's range and attempts to auction down all day, it appears as if the seller is in control. A trader with a strong bearish bias might jump into a trade, thinking his or her convictions were correct. However, if value is still established higher, then the buyer may actually be in control in the longer term. In this section we discussed day timeframe control—which way the market is trying to go in the day timeframe. In the previous example, the seller was in control in the day timeframe. In Section II, “Long-Term Trading,” we delve into an understanding of the long term that can prevent a trader from being fooled by day timeframe mirages—an understanding that will help a trader develop the ability to take advantage of long-term opportunity.
Section II
Long-Term Trading
In Section I, we compared Mike Singletary to a day timeframe futures trader. He studied charts and game films to prepare for each game, but operated solely in the present tense when he was on the football field. Similarly, the day timeframe trader studies recent market activity, but when the trading session begins, he or she acts purely on the day's evolving information. The academic knowledge becomes synthesized in the trader's mind to form a holistic picture, allowing for objective, intuitive decision making.
The long-term trader, on the other hand, is more like Singletary's coach. A good coach knows that winning games, or even division titles, does not insure long-term success. A football team may go undefeated one year but could easily suffer a losing season the following year if the coach does not consider the long-term effects of aging players, the upcoming draft, and the changing abilities of his competitors. The coach builds the strength of his team over time, bringing in new talent and constantly evaluating the long-term factors necessary to compile a winning record.
The futures market exhibits similar characteristics. The strength and duration of a trend is largely subject to the aging of its original participants, as well as the talent and conviction of any new business that is brought in. And, like a successful coaching career, successful long-term trading not only requires winning consistently in the day timeframe, but also a careful analysis of all the factors that affect the market's long-term performance. The discussions in this section are designed to help traders move from focusing on each individual day timeframe situation to a more holistic, long-term evaluation. Only through a synthesis of both can one compile a winning record.
Long-Term Directional Conviction
In “Day Timeframe Trading” (Section I), we studied the progression of the information generated by the market in the day timeframe. More important, we examined how a variety of structural and logical relationships produced by the day timeframe auction process help to convey the directional conviction of the other timeframe. Because each day auction is a contributing element to the long-term auction process, these same concepts apply equally well to long-term market analysis. Not surprisingly, our analysis of the long-term returns us to the same two all-encompassing questions: “Which way is the market trying to go?” and “Is it doing a good job in its attempts to go that way?” We will first discuss a series of facts that help us gauge attempted direction. Later, we examine the methods for evaluating directional performance. Finally, we unveil an easy, simple Long-Term Activity Record designed to assist a trader in forming a holistic image of the Big Picture.
Attempted Direction: Which Way Is the Market Trying to Go?
When either the other timeframe buyer or seller exerts a greater influence on price, a variety of observable, long-term directional changes are generated by the market. Each is listed below and then discussed in detail on the following pages. They are:
It is important to remember that these are merely attempted direction indicators. A complete understanding must incorporate long-term directional performance, which will be covered in the latter portion of Section II.
Auction Rotations
In Day Timeframe Trading, we detailed a quick method for evaluating the cumulative directional attempts of a day's auction rotations. This method, the Rotation Factor, enables a trader to measure attempted market direction by producing a value that represents the sum of each day's half-hour auction rotations. The theory behind the Rotation Factor is simple. If a greater number of time periods auction higher than lower, then the buyer is exerting greater control over price in the day timeframe—the market is trying to move higher.
The Rotation Factor is by no means an all-conclusive indication of future market direction. It is, however, a useful tool in determining which way the market is trying to go in the day timeframe. Since a long-term auction is composed of a series of day timeframe auctions, recording and comparing the daily Rotation Factor can help traders gauge the strength and relative change in a market's long-term directional conviction.
Range Extension
Range extension signals the entrance of the other timeframe participant beyond the initial balance. Persistent range extension in several time periods indicates that trade is being facilitated better in the direction of the range extension. Observing and recording continual range extension on successive days reveals a long-term tendency in the market. In Figure 4.48, for example, five consecutive days in the Swiss franc saw strong initiative buying range extension, which alerted traders to the presence of strong other timeframe buyers fueling the bull trend.
Figure 4.48 Range Extension Occurring in the Swiss Franc, October 22 to 28, 1987
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Long-Term Excess
Earlier, we defined short-term excess as the aggressive entry of the other timeframe participant as price moves away from value, creating a tail in the day timeframe. An example of short-term excess is evident in gold on May 2, 1989 (Figure 4.49). The six-tick buying tail in I period was generated by strong responsive buyers who quickly took advantage of a selling price probe (range extension) below value. Day timeframe excess not only provides continual, recordable clues regarding other timeframe directional conviction, but it also often stands as the pivot point marking a long-term directional move. The strong buying tail in gold, for instance, supported the market during subsequent trading sessions.
Figure 4.49 Long-Term Excess—Day Timeframe Tail Occurring in June Gold, May 2, 1989
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Long-term excess is caused by the same forces that create day timeframe excess. When a price level is perceived to be too low in the longer term, for instance, the other timeframe buyer will enter the market aggressively, forcing price to quickly auction higher. Prices that are deemed below long-term value generally form one of three types of excess: an island day, a long-term tail, or a gap. Refer to the daily bar chart in Figure 4.50 for the following discussion of the three types of long-term excess.
Figure 4.50 Long-Term Excess in the Japanese Yen
Data courtesy of Commodity Quote Graphics.
Island Days
January 3, 1989 (point A), displays the first of the three types of long-term excess, the island day. Island days are formed by aggressive initiative activity that causes price to gap above or below the previous day's range. The market spends the entire session trading at these higher or lower levels (attempting to validate price), but returns to previously established value on the following day, leaving behind an “island” of trade.
On the 3rd, the yen market opened 84 ticks above the high of December 30. After the gap higher open, the yen continued auctioning significantly higher, only to meet responsive sellers that were aggressive enough to reverse the day timeframe auction and close the yen on its lows. Because of the weak close on a day that had opened so far out of balance, the possibility was relatively high that long-term buying excess had formed. Buying excess was confirmed when the yen gapped some 50 ticks lower on the open of the following day, creating long-term excess in the form of an island. Island days are the most extreme form of excess and often provide lasting resistance against future auction attempts. Figure 4.50 displays another island day occurring in the yen on April 4 (point G).
Long-Term Tails
The second form of excess does not exhibit the violent gap activity that makes an island day so easy to identify. On a daily bar chart, this lesser form of price rejection looks more like a day timeframe tail at the end of a long-term trend. One such long-term tail is evident in the Japanese yen on January 19 in Figure 4.50 (point B). Compare the enlarged bar chart in Figure 4.51 to the segmented Profile of the day timeframe tail we described earlier in gold (Figure 4.52). The half-hour auction rotations are strikingly similar to the daily auction rotations. This is an excellent example of how the auction process applies to all timeframes. Day and long-term excess is created by the same activity occurring over varying lengths of time.
Figure 4.51 Close-Up of Excess in the Japanese Yen
Data Courtesy of Commodity Quote Graphics.
Figure 4.52 Segmented Profile of Excess in Gold, May 2, 1989
Referring again to Figure 4.50, the yen had been in a downtrend since the island day on January 3. On the 19th, the yen opened substantially below the 18th's lows. The gap lower suggested that the downtrend was continuing. However, the responsive buyer perceived price to be below value and entered the market aggressively, creating an unusually strong long-term buying tail. The close on the highs signified staunch rejection and that intermediate to long-term excess may have formed.
When using a standard bar chart, every new low or high, it seems, has the potential to be long-term excess. How does one know which is excess and which is actually a developing probe to new value? Much like the formation of a potential day timeframe tail that is not confirmed until the following half-hour time period, a long-term tail cannot be positively confirmed until the following day. However, as in the day timeframe, the market does provide reliable early clues regarding the formation of long-term tails. For example, examine the activity of January 13 and 18 (points C and D), two days with similar ranges. Both trading sessions recorded new lows, but they also closed near their lower extremes, indicating continual seller presence. In contrast, on the 19th the yen gapped lower on the open, but closed on the upper extreme. The yen had overextended itself to the downside, at least temporarily. The responsive other timeframe buyer entered and quickly auctioned price higher, establishing potential intermediate to long-term excess.
Another long-term tail occurred three trading days later on the 24th (point E in Figure 4.50), as the seller reentered the market after a substantially higher open and closed the yen on the lows. This price reversal, occurring so soon after the relatively strong rejection on the 19th, reasserted the strength of the downward trend.
Gaps
The final type of long-term excess is a gap. A gap is caused by initiative other timeframe participants who, between the market's close and the following day's open, change their perceptions of value. Price rejection, in effect, occurs overnight, as the market gaps above or below the previous day's extremes on the following day.
On February 9 (point F in Figure 4.50), for example, the yen gapped above the 8th's highs, igniting a buying auction away from the balance region that had formed from January 30 through February 8. During a gap, a market does not create the typical tail formation that so often signifies excess. Rather, the gap itself indicates swift price rejection (an “invisible tail”). In comparison to tails, gaps are actually a stronger, albeit less obvious form of excess. Note that island days are always confirmed by gaps.
Summary
Both short- and long-term excess, when properly identified, provide reliable indications of a market's directional conviction. The price levels at which the other timeframe participant enters the market and creates excess are valuable reference points for the long-term trader. Excess is most often used as support or resistance for long-term trade location. In addition, if the market returns and trades through the point of excess, a trader knows that the opposite activity is fueled by a high level of confidence and will most likely display continuation.
Buying/Selling Composite Days
A quick way to assess a market's attempted direction is known as composite analysis. Composite analysis simply evaluates where the majority of the day's trade took place relative to the day's open; it is performed by dividing the range into four equal parts. If the open is in the top or bottom one fourth, it is designated a “composite” day. A composite buying day occurs when the open resides in the bottom fourth of the day's range. Conversely, a composite selling day is characterized by an open within the top fourth of the range. An open in the center half indicates low directional conviction in either direction. Point B in Figure 4.50 shows a buying composite day in the yen. Figure 4.53 illustrates the composite methodology.
Figure 4.53 Composite Days
The logic behind this theory is relatively simple. If a market spends most of the day auctioning above the open, then the market is attempting to go higher. If the market trades below the open for most of the day, then it is trying to auction lower. Keep in mind that composite analysis does not consider the question “How good a job is it doing in its attempts to auction in that direction?” Remember the illusion that can arise from a market that gaps higher and auctions down all day, but develops higher value. Like all other directional measures, composite analysis must be evaluated in conjunction with value area relationships and the level of trade facilitation generated by the market's attempt to auction in a given direction.
Summary
Any combination of directional measures may be present on a given day. For instance, a particular trading session might exhibit composite buying structure, a positive Rotation Factor, initiative buying tails and range extension, and higher value—unanimous indications of a market that is trying to auction higher. On some days, however, the indicators will contradict themselves. When directional measures conflict, they cancel each other out, indicating a market less confident in its directional course.
Yet, the answers to the question “Which way is the market trying to go?” cannot stand alone. They must be considered in conjunction with the second Big Question, “Is the market doing a good job?”
Directional Performance: Is the Market Doing a Good Job in Its Attempts to Get There?
Let us return to our local grocer for a moment. Suppose that the grocer decides to expand his business by moving into a bigger building, in hopes of increasing his market share. In trading terms, his attempted direction is “up.” Once the move is made, the question then becomes “Will the expansion facilitate more trade?”
Over the ensuing weeks, the grocer finds that increased shelf space does not attract new customers. His business (and expense) has moved up, but transactional volume has not. Disappointed, the grocer realizes that the small community cannot support a larger store. Faced with rising overhead and dwindling profits, he moves back into his old building.
The futures market acts in a similar fashion. Relying solely on which way a market is trying to go can lead to financial disaster, unless you can also gauge the effectiveness of the market's attempts to go that way. Monitoring attempted direction for directional performance—determining how good of a job it is doing—is the key to a complete market understanding and long-term trading results. Once attempted direction is known, three comparative factors are useful in evaluating a market's directional performance:
Volume
As we get deeper into the long-term forces behind directional conviction, one element stands high above the rest when it comes to evaluating directional performance—volume. Not surprisingly, volume is also the best measure of a market's ability to facilitate trade. Once attempted direction is known, volume should be used as the primary means of determining directional performance.
Put simply, the greater the volume of transactions, the better trade is being facilitated. In our grocery store example, a larger store did not generate additional volume and consequently failed. Similarly, in the futures market, a price movement that fails to generate a fair amount of volume as it auctions through time will likely not continue for very long in the same direction.
Evaluating Changes in Volume
To determine whether or not volume is increasing, it is necessary to compare each day to previous volume figures. However, there is no standard number of day timeframe transactions in any market, for volume evolves with a market's changing activity. The key to recognizing change is to think of volume more in terms of market share than in the actual number of transactions occurring (except, of course, when the number of transactions drops below that which signifies a liquid market). Therefore, a trader must keep a running record of volume to be able to detect any significant departures from the current average. This average will vary depending on your trading timeframe.
Volume as a Measure of Directional Performance
Suppose that a movie theater raises the price of admission. In the subsequent weeks, ticket sales drop substantially. At higher ticket prices, the theater is not facilitating trade for the moviegoer. If the theater is going to stay in business, it will have to lower price. Decreased volume indicates a rejection of higher prices.
Volume plays the same role in evaluating the futures market's directional performance. For illustration, imagine that the market's attempted direction on a given day is up, based on a positive Rotation Factor and buying range extension. If the buying auctions are generating healthy or increased volume (relative to your determined norm), then the market is successfully facilitating trade with the buyer. Conversely, lower volume on a day attempting to move higher suggests that the market is not accepting the buying attempts.
Value-Area Placement
A structural indicator that helps us better refine the level of directional performance is value-area placement. Through an evaluation of the relationship of one day's value area to the next, we can move beyond simply determining if the market is doing a good job, to how good of a job it is doing. In other words, if attempted direction is up and volume is healthy, what impact does that have on value? Were buyers successful in placing value higher? How successful were they? Was value unchanged, overlapping-to-higher, or completely higher?
Let us briefly describe the different relationships that can exist between two trading sessions' value areas. First, value can form clearly higher or clearly lower, exhibiting obvious directional performance. Second, value can overlap to one side or the other, indicating a lesser degree of change. Third, when the value area is contained entirely within the previous day's value area, it is known as an inside day. The market is in balance and is not facilitating trade with either participant. Finally, an outside day occurs when a day's value area overlaps the previous day's value area on both extremes, and represents greater trade facilitation. Much like a Neutral day, if an outside day closes in the middle of the range, the market is in balance. If it closes on an extreme, however, there is a victor in the day timeframe battle for control. A close on the highs, for example, would indicate directional performance favoring the buyer. Figure 4.54 illustrates these common value-area relationships.
Figure 4.54 Value-Area Relationships
Value-area placement often generates signals contrary to day timeframe attempted direction. Figure 4.55 demonstrates such a scenario occurring in the Treasury bond market. On September 12, bonds opened unchanged to higher and spent the entire day auctioning down. The result was a negative Rotation Factor, selling composite structure, and continued selling range extension—clearly a market trying to move lower in the day timeframe. However, higher value was still maintained. While day timeframe structure indicated seller dominance, value-area placement suggested that the buyer was still in control in the long timeframe.
Figure 4.55 Directional Performance. December Treasury Bonds, September 9 and 12, 1988.
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Evaluating Directional Performance through Combined Volume and Value-Area Placement
Arriving at a final evaluation of directional performance is like baking a cake—layer by layer. First, we must define attempted direction. Second, we evaluate trade facilitation according to volume. And finally, we must determine the relative success of that trade facilitation according to its impact on value-area placement.
In general, if attempted direction is up, volume is above average (or at least average) and value is higher, then the market is successfully facilitating trade at higher prices. However, if attempted direction is up and volume is lower, then higher prices are cutting off activity—the buying auctions are resulting in poor trade facilitation. If the buying attempts also result in lower value, then the other timeframe seller is still in control of the market, despite day timeframe buyer dominance. The market must then move lower to resume balanced trade, much like the aforementioned movie theater. Figure 4.56 illustrates the combined effect of volume and value area in determining directional performance for the above two scenarios.
Figure 4.56 Volume/Value-Area Relationships
Listed in Table 4.1 are 30 different relationships based on volume, value-area placement, and attempted direction. Six of them are briefly detailed in the following discussion. Figures 4.57 to 4.61 include an inset bar chart to show the activity following the day highlighted by each example. In addition, note that the volume comparisons in these examples are relative to the previous day, not a predefined average.
Figure 4.57 Directional Performance. December Treasury Bonds, September 1 and 2, 1988. Data courtesy of Commodity Quote Graphics.
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Figure 4.58 Directional Performance. August Gold, July 28 and 29, 1988. Data Courtesy of Commodity Quote Graphics.
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Figure 4.59 Directional Performance. June Treasury Bonds, April 14 and 15, 1988.
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Figure 4.60 Directional Performance. December Gold, September 19 and 20, 1988.
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Figure 4.61 Directional Performance. September S&P 500, August 3 and 4, 1988. Data courtesy of Commodity Quote Graphics.
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Table 4.1 Directional Performance Relationships.
Table 4.2 Results for Six-Month Period in Treasury Bonds.
| Value-Area Width | Average Volume |
| 1 to 5 | 127,000 |
| 6 to 10 | 188,000 |
| 11 to 15 | 284,000 |
| 16 to 20 | 310,000 |
| 21 to 25 | 313,000 |
| 26 to 30 | 417,000a |
| 31 to 35 | 417,000a |
| a Small sample size | |
Treasury bonds gapped open above the previous day's range and drove sharply higher. Attempted direction was clearly up, as witnessed by an initiative buying tail, initiative buying range extension, a positive Rotation Factor and buying composite structure. Substantially higher volume and the resulting higher value confirmed that the directional performance of the buyer was strong.
The gold market on July 29th was clearly attempting to auction higher. And, although the buying auctions managed to build higher value, volume declined, indicating poor directional performance. Underlying market conditions were weakening. The inset bar chart shows the subsequent return to seller control.
After a lower opening on April 15th, bonds spent most of the day attempting to auction higher. Long-term traders relying solely on attempted direction might have bought, perceiving day timeframe buyer control and an opportunity to acquire relatively good intermediate-term trade location. However, the upward auction attempts actually discouraged trade and were unable to return value to the levels of the previous day. The buyer's directional performance on this day was very poor and indicated long-term control was in the hands of the other timeframe seller.
On September 20, gold opened and tested above the previous day's highs. When no continuation developed, other timeframe sellers entered the market and auctioned price lower all day. Attempted direction was down, accompanied by lower value and higher volume. Directional performance on this day clearly favored the seller.
Attempted direction was obviously down on this Open-Drive selling day. However, the day's selling attempts only managed overlapping to lower value and basically unchanged volume. This scenario generally indicates a market that is continuing but slowing and coming into balance or a market that is in the midst of gradual transition. Subsequent trading sessions should be monitored carefully for signs of directional conviction.
Value-Area Width
One drawback to day trading is that exact volume figures are usually not available until after the trading session is over. However, one practical way to gauge the level of volume as the day develops is through the value-area width. On days where volume is relatively low, the value area and the length of the range tend to be narrow. For example, in Treasury bonds on April 17, 1989 (Figure 4.62), the value area was only two ticks wide. Volume was at a scarce 120 thousand contracts. In this particular case, the lack of facilitation was due to the fact that traders had balanced their positions in anticipation of the Producer Price Index figure to be released on the following day. Conversely, value areas tend to widen on days exhibiting higher volume (Figure 4.63). On April 27, the value area was a healthy 16 ticks wide. Volume on this day was just short of 600,000 contracts.
Figure 4.62 Narrow Value Area. Treasury Bonds, April 17, 1989.
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Figure 4.63 Wide Value Area. Treasury Bonds, April 27, 1989.
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The logic used is that the wider the value area, the greater the range of prices at which trade is being conducted (see Table 4.2). This results in increased participation, for as price auctions higher and lower, different timeframes are brought in to the market as they perceive price to be away from value. The farther price travels, the better the possibility that new activity will enter the market, thus creating greater trade facilitation (and higher volume).
We conducted a limited study comparing total volume with average value-area width for Treasury bonds from December 14, 1988, through June 22, 1989 (Figure 4.64). As one would expect, the data clearly showed a marked increase in volume on days with larger value areas. For example, the average volume on days with a value area 1 to 5 ticks wide was 127,000 contracts. Days with value areas of 11 to 15 ticks, however, averaged roughly 284,000 contracts, while value areas of 21 to 25 ticks were regularly around 313,00 contracts.
Figure 4.64 Value Area Width Relative to Volume. Treasury Bonds, December 14, 1988 to June 22, 1989 Date courtesy of CISCO and Commodity Quote Graphics.
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Summary: Long-Term Activity Record
We have now covered a variety of ways to measure attempted market direction and directional performance. Keep in mind, however, that focusing on just one method can lead to tunnel vision and an incomplete understanding of true market conditions. It is necessary to synthesize all the elements of direction and performance to arrive at a holistic market understanding.
Figure 4.65 contains a simplified long-term activity record (LTAR) designed to help traders organize the answers to the two Big Questions addressed in this section. Figure 4.65 is left blank for you to pull out and copy if you wish. However, we encourage you to create your own long-term activity record that better fits your needs and trading timeframe. To illustrate the use of the LTAR, we have isolated a brief period in the soybean market, and recorded the attempted direction and directional performance for each day. Figures 4.66 through 4.74 show soybean activity from May 16 to 22, 1989, and the completed LTARs that correspond to each day.
Figure 4.65 Long-Term Activity Record
Figure 4.66 July Soybeans, May 16, 1989
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Figure 4.67 Long-Term Activity Record for July Soybeans, May 16, 1989
Figure 4.68 July Soybeans, May 16 to 17, 1989
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Figure 4.69 Long-Term Activity Record for July Soybeans, May 17, 1989
Figure 4.70 July Soybeans, May 16 to 18, 1989
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Figure 4.71 Long-Term Activity Record for July Soybeans, May 18, 1989
Figure 4.72 July Soybeans, May 16 to 19, 1989
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Figure 4.73 Long-Term Activity Record for July Soybeans, May 19, 1989
Figure 4.74 July Soybeans, May 16 to 20, 1989
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Long-Term Auction Rotations
The auction process is akin to a vertical tug-of-war, with price moving higher when buyers are in control and lower when sellers are in control. The auction rotations are, in a sense, the structural footprints of the rotational struggle between the other timeframe participants. In the day timeframe, the auctions take the form of either one-timeframe or two-timeframe market conditions. Long-term auction rotations are composed of the same form of activity. However, the “footprints” are recorded over a longer period of time. A bracket, for example, is a long-term two-timeframe market, while a trend is a long-term one-timeframe market.
Just as a day trader must be aware of timeframe control, it is crucial for a long-term trader to know whether the market is trending or in a bracket. The following discussion details the long-term trade applications of bracketed and trending markets. Our goal is to arrive at methods to objectively assess long-term market movement.
Brackets
In review, markets spend approximately 70 percent of the time in a trading range, or bracket, in which the other timeframe buyer and seller become responsive parties. When a market is bracketing, the other timeframe participants have similar views of value, and the prices at which they are willing to do business grow much closer together. As price nears the top of the perceived bracket, the seller responds and auctions price downward. In turn, the responsive buyer enters at the lower bracket extreme and rotates price back to the upside. As the market attempts to facilitate trade between the buyer and seller, price movements tend to be volatile, auctioning back and forth with no real long-term directional conviction (Figure 4.75).
Figure 4.75 Volatility
It is difficult to define a bracket in absolute terms. As with a trend, seldom do two traders have the same definition of a bracket, for all traders operate with a different timeframe in mind. The daily bar chart for Treasury bonds in Figure 4.76 can be broken down into myriad individual brackets. For example, the entire bar chart could be considered a bracket by a long-term trader, spanning some six months (point 1 in Figure 4.76). The long-term participant might seek to buy below 87:00 and sell above 91:00.
Figure 4.76 A Six-Month Bracket in Treasury Bonds Data Courtesy of Commodity Quote Graphics.
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A short-term swing trader, on the other hand, might break the bond market down into a smaller bracket, as shown by point 2 in Figure 4.77. This balanced region encompasses roughly a month. The swing trader would attempt to place longs around 88 to 00, then exit and go short above 89 to 16.
Figure 4.77 A One-Month Bracket in Treasury Bonds Data Courtesy of Commodity Quote Graphics.
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Figure 4.78 illustrates some of the many possible brackets contained within the bond market over this particular six-month period. There are brackets within brackets...within brackets, depending on your trading timeframe. At point 5 in Figure 4.78, a short-term trader might consider six days of overlapping value to be a bracket. A long-term trader, however, would consider that region to be a part of the long-term bracket at point 4.
Figure 4.78 Multiple Brackets in Treasury Bonds Data Courtesy of Commodity Quote Graphics.
Copyright Board of Trade of the City of Chicago 1984. All Rights Reserved.
Even if two traders agree on a balance area, they still may differ on the actual extremes of the bracket. In Figure 4.79, one swing trader might consider the bracket extremes to be created by recurring value-area tops and bottoms. Another swing trader might use price extremes (excess) to define the bracket, as in Figure 4.80. The point is, bracket definition is largely a product of time. There is no perfect bracket, just as there is no perfect trend. The important concept to remember is that to successfully trade in a bracketed market, it is necessary to clearly define the bracket in which you are trading according to your timeframe.
Figure 4.79 Bracket Extremes in Treasury Bonds Data courtesy of Commodity Quote Graphics.
Figure 4.80 Bracket Extremes in Treasury Bonds Data courtesy of Commodity Quote Graphics.
It is helpful to literally “draw in” the bracket extremes as you perceive them. This allows you to visualize future auction rotations and ideal trade location. When you clearly define a bracket, you are, in effect, testing your market understanding. Brackets do evolve, however, and it is important to constantly monitor for fundamental changes. By observing and continually reevaluating your view of the bigger picture, you will gain experience and further the learning process that is necessary to becoming an expert trader.
Trade Location in a Bracketed Market
Once you realize that you are in a bracketed market and have defined the bracket extremes, several guidelines can help you secure proper trade location, improve your trading performance, and manage your trade risk.
Rule 1: Monitor Market Direction and Location within the Current Bracket
All trades in a bracketed market should be placed responsively. We use the term responsive here in a more generic sense than has been previously discussed. Consider it this way: The distance from the top of the bracket to the bottom, regardless of the bracket's size, is similar to a day's range. Therefore, the value area is contained within the middle of the bracket. Longs placed below the bracket value area are considered responsive, as are shorts placed above. Any trade positioned in the middle of the balance area is initiative and offers poor bracket trade location.
At point 1 in Figure 4.81, for example, the responsive seller responds to price approaching the top of a bracket. Shorts entered at this point result in minimum upside exposure relative to downside profit potential. If the market continues up, movement to the upside should be slowed by resistance at the top of the bracket. This would allow a trader time to evaluate the trade and, if necessary, exit the short at minimal loss.
Figure 4.81 Simulated Movements within a Bracket
At point 2, however, activity is initiative and trade location is poor for short positions. Immediate upside exposure is equal to downside profit potential. A long placed here embodies even greater risk, for the current medium-term auction is down.
The market eventually auctions back to the top of the bracket at point 3. Longs placed here with the initiative buyer offer little upside potential with the risk of price returning to bracket lows. Shorts should be entered at the upper extreme with the expectation that long-term sellers will respond to price above value. If price auctions above the bracket top, however (point 4), the market may be poised to breakout of the balanced area. If price is accepted above the bracket, shorts should be exited and longs placed with the breakout activity. Conversely, if the upper extreme offers resistance and price is returned within the bracket, shorts offer excellent trade location. In both cases, trades should be monitored carefully, for movement is often swift coming off a bracket.
Rule 2: Markets Generally Test the Bracket Extreme More Than Once
If you miss an opportunity to sell a bracket top (or buy a bracket bottom), do not scramble to enter a trade for fear that you will not get another chance. Chasing a bracketed market only results in poor trade location. Over a large sample size, the market will return to test the bracket extreme on the average of three to five times before moving to new levels with confidence.
Rule 3: Markets Fluctuate within Bracketed Regions
A market generally will not auction from one extreme of a bracket to the other in a beeline. Rather, price fluctuates within the balanced area: from top to middle, middle to top, middle to bottom, and so on. Due to the price fluctuations, swing trades placed in the middle of a bracket offer poor trade location.
Rule 4: Monitor Activity Near the Bracket Extremes for Acceptance/Rejection
When price auctions near a bracket low, it is easy to let objectivity slip and begin to anticipate that the market will travel through the bracket. After all, recent activity has been to the downside—why should it stop now? However, it is extremely dangerous to place a short at the bracket low before the market has exhibited acceptance and follow-through below the bracket. If you are wrong, you have positioned yourself with the worst possible trade location, in a market that will most likely auction back to the bracket's upper extreme.
Remember, in a bracketed market, both the other timeframe buyer and seller are responsive participants. Responsive activity is generally much slower and more gradual to develop. A trader usually has time to monitor the bracket extremes for rejection or follow-through.
Transition: Bracket to Trend
All brackets eventually evolve into some form of a trend, just as all trends end in a balancing area, or bracket. It is an ongoing cycle. Because of the vast difference in trading techniques during a trend and a bracket, it is necessary to be able to identify when such a transition is occurring. Again, because every trader operates within a different timeframe, it is impossible to positively define a perfect transition rule. Traders with exceptionally long timeframes might consider a yearlong trend to be part of a larger bracket. Conversely, a swing trader might consider a week of consecutively higher value areas to be a trend. Identifying the transition from a bracket to a trend is a product of your personal timeframe.
In Day Timeframe Trading, we discussed transition in terms of one-timeframe and two-timeframe conditions. The same concept can be applied to the long-term auctions. When a market is in a bracket, both the other timeframe buyer and seller are present and active (over a longer period of time). There is no clear long-term directional conviction. A transition occurs when the initiative participants exert more control over price than the responsive participants.
In the long-term, transition is marked by the formation of excess confirmed by sustained follow-through in the opposite direction. The beginning of an up trend, for example, is usually marked by the aggressive entry of the other timeframe buyer, creating excess in the form of a long-term buying tail or a buying gap. The responsive buyer overwhelms the seller, and the market begins to trend upward, turning initiative as it passes through previously established value. In Figure 4.82, the buyer entered responsively at point 1 within a balanced area. The subsequent initiative buying gaps at points 2, 3, and 4 established strong long-term excess and confirmed the conviction of the initiative other timeframe buyer. This gapping activity began an upward trend that spanned some four months.
Figure 4.82 Transition from Bracket to Trend in Crude Oil Data courtesy of Commodity Quote Graphics.
In the intermediate term, a transition might take the form of a balance-area breakout. In Figure 4.83, for instance, the S&P had developed three days of overlapping value (February 1 to 3). On February 7, the S&P broke out of the balance area, indicating a transition to a trending scenario. The result was a Double Distribution Buying Trend day. Similarly, Treasury bonds exhibited an intermediate-term transition from bracket to trend on April 9 (Figure 4.84). After eight days of overlapping value, a multiple-distribution Trend day signaled the reentry of an initiative other timeframe seller with strong directional conviction.
Figure 4.83 Balance Area Breakout Occurring in the June S&P 500, January 31 to February 7, 1989
Copyright Board of Trade of the City of Chicago 1984. All Rights Reserved.
Figure 4.84 Balance Area Breakout Occurring in June Treasury Bonds, March 30 to April 9, 1987
Copyright Board of Trade of the City of Chicago 1984. All Rights Reserved.
Trends
A trend is the result of clear control and directional conviction by either the other timeframe buyer or seller. The stronger the conviction underpinning the trend, the greater the excess that usually sparks the trend's beginning. In other words, a trend of great magnitude will typically have an elongated long-term tail and/or a large gap (invisible tail) that creates a firm base from which the trend begins (Figure 4.85). It follows that early trend activity will tend to be more dramatic and pronounced, witnessed by more range extensions, elongated Profiles, and substantial tails.
Figure 4.85 The Beginning of a Trend Occurring in Crude Oil Data Courtesy of Commodity Quote Graphics.
Copyright Board of Trade of the City of Chicago 1984. All Rights Reserved.
Trade Location in a Trending Market
There is no such thing as good trade location during the early stages of a trend. If the market is truly trending, price will continually lead value. The key to trade location is simply to get on board early and then monitor the market for continuation. If a trend is strong, your position should soon be rewarded with follow-through and your trade location should improve. If not, then the trend is suspect and trades should be exited.
Early entry in a trending market is more difficult than it sounds, for it means that a trader must buy considerably above recent perceptions of value. Picking up the phone and saying “buy it” when price is quickly auctioning above the last several days' value areas can be a nerve-wracking experience, even for the trader who is usually calm and objective. When a trend emerges after a prolonged balance area, a trader must quickly reverse his or her trading perspective. It is very difficult to change from a responsive mode to the go-with, trail-blazing mentality of the initiative trader.
Later in the life of a trend, however, trades should be placed responsively, or when the market temporarily breaks during an up trend (or rallies in a down trend). Regardless of where you are within a long-term trend, it is safest to trade with the trend. You will save the cost of this book ten times over if you simply do not trade against a trend.
Monitoring Trends for Continuation
One useful way to monitor a trend for signs of continuation and/or slowing by comparing activity on up days against activity occurring on down days. While in an up trend, for example, determine which way each individual trading session is attempting to go. Then, compare the volume generated on down days versus the up days. If a trend is strong, up days should exhibit greater trade facilitation by generating higher volume than down days. When volume begins to increase on days against the trend, then the trend is aging and may soon begin to balance, or enter a bracket.
Transition: Trend to Bracket
A trend is officially over when the responsive participant is able to exert as much influence on price as the initiator. An up trend has ended, for instance, when the responsive other timeframe seller is able to create significant excess at the top of the trend. Once the trend is over, the market will begin to balance. As a market begins the bracketing process, traders should revert to a responsive mode, seeking to sell the top of the bracket and buy the bottom.
Examine Figure 4.85, containing the daily bar chart for crude oil. The long-term trend that began in late November 1988 began to balance when the responsive seller was strong enough to induce a gap lower opening on March 28, 1989. Although the resulting excess did not last for long, it indicated that the initiative buyer was weakening and a trading range was developing.
Figure 4.86 provides a second example of a transition from trend to bracket, although over a much shorter period of time. After two strong buying days on January 19 and 20, the Japanese yen began to balance. The inability of the buyer to establish continually higher value indicated the presence of the responsive seller. The yen had entered a short-term bracketing period as evidenced by responsive activity on both extremes of the bracket (see circled areas).
Figure 4.86 Coming into Balance. March Japanese Yen, January 19 to 29, 1988
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Detailed Analysis of a Developing Market
To bring the concepts of a bracketed market to life, we will now take a detailed look at the developing Treasury bond market from late October 1988 to early May 1989. We have specifically chosen this time period for its volatility. A volatile, bracketing market is a complex and emotionally difficult market to trade. In a trend, trade location is simply a matter of “Am I too late?” and “Can I buy above or sell below value?” Trading in a bracketed market, however, is much more challenging. To be successful, traders must mentally change gears quickly—literally trade from several different states of mind. Since markets generally spend between 70 and 80 percent of the time bracketing, such a challenge is the norm—not the exception—in futures trading.
In a bracketed market, the other timeframe buyer and seller are much closer together in their perception of value (see “Bracketed Markets” in Chapter 3). Both are actively probing to determine the condition of the marketplace. As an illustration, consider the development of the computer chip industry. Early on, when microchips were suddenly in great demand but only produced by a few suppliers, prices trended steadily higher. However, as new producers entered the marketplace and existing suppliers increased their output, the computer chip market entered a bracketing phase. Price began to auction back and forth between the long-term participants as their perceptions of value started to narrow. Buyers and sellers, in effect, were testing each other to determine the condition of the market. Attempts by producers to raise price were sometimes rejected as buyers found alternative, less expensive sources. Conversely, sometimes, higher prices were accepted due to a temporary flux of buyers.
Bracket Reference Points
To successfully trade a bracketed market, you must first recognize that the market lacks long-term directional conviction and, consequently, become more selective in your trading. In other words, it is essential that you develop both a hands-on strategy and a minds-on approach to evaluating the market's auctions. Because of the closeness of timeframes, the market's probes for acceptance of value appear to be extremely disorganized, often to the point of random rotation. We will show that in some cases this is actually true. However, there are many other times when the footprints of the market's auctions provide valuable information regarding short-term conviction, enabling alert traders to identify change in its early stages.
The key to selective trading lies in the understanding, recognizing, and recording of a few very basic reference points. Not surprisingly, these reference points are generated by many of the market forces we have already discussed—forces such as market balance, Nontrend days, balance breakouts, and auction failures. Before we delve into our detailed Treasury bond example, let us first recap a few of the forces that shape a bracketed market.
A market that lacks directional conviction spends the majority of its time in very short-term balance areas. Intermittently, the market will breakout of the balance region and make a swift directional move to a new price level, whereupon it again returns to balance. This chain of events happens again and again, until conditions change significantly and sustained other timeframe conviction surfaces. Until then, it is wise to maintain a relatively short trading timeframe. Generally, a trade should be held overnight only if there is substantial structural evidence in its favor.
There is little opportunity in the short-term balance regions, for they usually lack any semblance of directional conviction. The sharp price spurts between balance areas, on the other hand, last for a short period of time but offer a high degree of opportunity for the trader who is alert and prepared to take advantage of them. Because of the swift nature of a breakout, traders must not only be able to recognize the auction behavior that leads to a probe away from balance, but also have the foresight to enter orders ahead of time to take advantage of the potential breakout.
The key to early identification of a breakout lies in the concept of market balance. In a bracket, the market develops a series of short-term balance areas (brackets within brackets), or consecutive days of overlapping value. In most cases, the direction that the market breaksout of these short-term balance areas proves to be the beginning of at least a short-term auction. The salient concept is follow-through. Monitoring a breakout for continuation is the key to identifying other timeframe control.
In the large majority of cases, a breakout will begin with either a gap or an auction failure. After several days of overlapping value, a gap opening indicates that the market is out of balance and could be breaking out in the direction of the gap. A more subtle form of breakout occurs when the market tests one extreme, fails to follow through, and breaksout in the opposite direction, forming an outside day—a day that extends beyond both of the previous session's extremes. For example, consider a market that develops overlapping value on six consecutive days. On the seventh day, the market tests below the balance area lows, fails to follow through, and then auctions quickly to the upside, forming an outside day. The initial auction failure is the first indication that the market has the potential to breakout of balance, for it forms excess and establishes a known reference point. The frequency of this behavior is witnessed by the great number of substantial day timeframe price movements that are also outside days.
We emphasize, however, that observing market behavior and actually placing the trade are two entirely different actions. After several days of overlapping value, for example, it is easy to grow accustomed to the seemingly random, back-and-forth balancing. When the market finally tests below the short-term bracket low and fails to follow through, it is relatively easy to recognize the potential for an outside day. However, the ensuing auction back through the balance area appears to be the same activity that has lulled the trader to sleep during previous days. As one trader put it, “I can identify the auction failure and I know that there is a good possibility that the market will move substantially higher, but...I just can't pull the trigger. The phone gets extremely heavy.”
Trading a bracketed market is by no means easy, even with clearly defined reference points. As we stated earlier, you must do the trade in order to build the experience and confidence necessary to take advantage of a sound market understanding.
As you proceed through our dissection of the Treasury bond market, one fact should ring loud and clear. Overlapping value regions, auction failures, breakouts, and the resulting outside days happen over and over again. They literally form the backbone of a bracketed market. As you become more familiar with their formations and consistent behavior, what once seemed to be virtually random, unorganized behavior will begin to take on a new meaning, to make sense. You will realize that through these apparently random auctions, the market is actually organizing itself, fulfilling its purpose—facilitating trade. For the trader, these behaviors and resulting structural features draw the road map that is so critical to selectively taking advantage of the dynamic short-term price movements that characterize a bracketed market. The points discussed below are highlighted in Figures 4.87 through 4.90.
Figure 4.87 Detailed Analysis of a Developing Market, June Treasury Bonds. Region A. Data Courtesy of Commodity Quote Graphics.
Copyright Board of Trade of the City of Chicago 1984. All Rights Reserved.
Figure 4.88 Detailed Analysis of a Developing Market, June Treasury Bonds. Region B. Data courtesy of Commodity Quote Graphics.
Copyright Board of Trade of the City of Chicago 1984. All Rights Reserved.
Figure 4.89 Detailed Analysis of a Developing Market, June Treasury Bonds. Region C. Data courtesy of Commodity Quote Graphics.
Copyright Board of Trade of the City of Chicago 1984. All Rights Reserved.
Figure 4.90 Detailed Analysis of a Developing Market, June Treasury Bonds. Region D. Data courtesy of Commodity Quote Graphics.
Copyright Board of Trade of the City of Chicago 1984. All Rights Reserved.
Region A (Figure 4.87)
After a strong buying auction, the Treasury bond market recorded potential buying excess at 90 to 12 on November 1st. The selling gap denoted by point 1 confirmed the excess and set into motion a sustained move to the downside. Excess, in this case a long-term selling tail and a selling gap, should act as resistance to future long-term buying auctions. If price trades back through these areas of rejection, the condition of the market will have changed (the other timeframe sellers that initially drove price are no longer present).
At point 2, the Bond market came into short-term balance, as is evidenced by two days of overlapping value. On the third day, a probe above the balance failed to attract buying and was swiftly rejected. Armed with the knowledge that there was no interest in buying, the bond market then broke below the balance area to start a new selling auction. The result was a dynamic outside day. When it comes to being selective in your trades, these are the conditions that you should be looking for. Identify overlapping value/balance regions. Then, monitor the probes beyond these regions for acceptance or rejection. If they are accepted, the market will probably continue to auction in that direction, at least for a few days. If they are rejected, however, stay alert and get ready to reverse your trading state of mind.
Note that the failed auction created short-term excess on the day's high—remember, markets need to auction too high to know that they have gone high enough. Point 3 shows the same behavior occurring all over again. After three days of overlapping value, an auction above the previous two days' highs failed, resulting in yet another outside selling day. Following the breakout at point 3, bonds once again settled into balance, recording five days of narrowing, overlapping value (point 4). The bond market gapped sharply below the balance area on the following day, but failed to continue. Point 5 shows aggressive responsive buyers closed the market very near its high on this day, signaling the potential formation of selling excess. To confirm the excess at 89 to 06, buyers should show continuation out of this region.
Region B (Figure 4.88)
The day following the selling gap at point 5 opened higher, then auctioned down to test the at 89 to 06 low. Aggressive other timeframe buyers were still present and they again closed the day on its highs, confirming the selling excess at 89 to 06. This new buying was fueled by strong directional conviction, as was evidenced by the fact that buyers were able to auction price completely through the previous day's selling gap.
After a quick upward swing auction, point 6 shows that bonds opened and attempted to auction higher, but failed to take out the short-term excess that had previously been formed at point 3. On this day, bonds had opened above the previous day's range—out of balance. When the buying auction failed and bonds returned down into the previous day's range, traders were alerted that the market possessed unlimited downside potential. Anyone still long at this point should have exited. Versatile traders might even have entered short positions, monitoring carefully for seller continuation. The result was a dynamic, outside selling day.
Point 7 demonstrates how important it is to be able to mentally switch gears. After the swift outside selling day, sellers were unable to muster continuation. Bonds gapped higher, erased the short-term excess at points 3 and 6, and stopped directly at the excess created at point 2. The fact that the bond market stopped at this level is no coincidence. Gaps and other forms of excess are important reference points. By monitoring activity around them for follow-through or rejection, a trader can evaluate the market's directional attempts.
On the next day (point 8), bonds opened higher and began to auction into the selling gap established at point 1. However, buyers failed to auction completely through the selling gap and the market closed near its lows. The resistance provided by the gap created more than a month earlier was still intact.
After establishing potential buying excess at point 8, the market quickly came into balance, as is shown by the development of overlapping value on the following two days. On the third day, a test of the excess at point 8 failed (bonds closed on the low), which fueled an intermediate bracketing period bounded by excess at points 9 and 10. Note that in the bracketing process the selling gap at point 1 was erased. The only remaining long-term reference point to the upside was the 90 to 12 long-term high established on November 1.
Points 11 and 12 show the familiar overlapping value/balance formation, followed by a failed auction in one direction and the resulting dramatic price move in the other. Known reference points come into play again at Point 11. In this case, the outside day was a result of the seller's failure to attract new selling business below the previous day's low, and also the short-term selling excess generated back at point 9.
Region C (Figure 4.89)
The buying auction at point 13 erased the 90 to 12 long-term high, negating any probability of a long-term top to the bond market. Treasury bonds then entered a period of extreme volatility. Although price was migrating higher, there was a total lack of directional conviction. Traders should have day timeframe traded only until clear signs of conviction appeared. Bonds finally gapped sharply lower at point 14—the first indication of directional conviction in nearly a month. Point 15 shows a similar nonconviction period occurring in February and March.
The areas marked by points 15 and 16 exhibit a clear lack of excess supporting their lower reaches—another characteristic of a nonconviction market. Even though the market began a gradual buying auction at point 15, it was unlikely that buyers would move price substantially until high-conviction selling excess was recorded.
Think back to the last time you got into a heated argument with a good friend. Remember how the issues became emotional rather than rational? Market behavior during times of nonconviction is much the same. It is not clear which way the market's “argument” is heading, nor when the directional issue will be solved. A lot of unintentional hurt can be dealt when an argument reaches the emotional level. Similarly, an irrational, nonconviction market can inflict severe financial pain on those who are too stubborn to stand aside and wait for clear signs of conviction.
Point 16 highlights a balance period that was again tipped over by a failed auction. After six days of overlapping value, bonds opened higher (out of balance) but failed to follow through. Price returned to value and the market broke to the downside on the next day.
Point 17 is yet another outstanding example of the importance of known reference points. After breaking below the nonconviction region designated by Point 16, the market came into balance just above the long-term lows created at Point 5. Sellers were unable to generate continuation below the 89 to 06 low, which attracted the responsive buyer. Bonds closed in the upper half of the range on this day, signaling the potential formation of long-term selling excess. Note, once again, that the dynamic outside day was sparked by a failed auction.
Region D (Figure 4.90)
Region D provides several additional examples of why it is so important to be selective in your trading during bracketed conditions. Points 18, 19, 20, and 21 show dynamic outside days—two buying and two selling—occurring within a 10-day period. If positioned the wrong way, each could have dealt a serious financial blow. However, note that all four were preceded by the characteristic clues that often signal their formation: (1) overlapping value/balance, and (2) an auction failure.
Long-Term Auction Failures
An auction failure, for any timeframe, occurs when a market auctions above or below a known reference point and fails to follow through. Day Timeframe Trading detailed the forces that contribute to an auction failure and the characteristics of the rejection that often follows. The principal difference between a day and long-term auction failure lies in the magnitude of the tested reference point and, therefore, the magnitude of the subsequent rejection.
In Day Timeframe Trading, we described the implications of an auction failure—swift rejection and the opportunity to secure good day timeframe trade location during a day with the potential to generate significant price movement. We also mentioned that longer timeframe auction failures are usually followed by ensuing activity of greater magnitude. Suppose that a market auctions below a low that has held for several months but fails to attract new business. The ensuing reaction caused by the auction failure will often involve all timeframes and continue in the opposite direction for days, weeks, or even longer. Traders who are aware of the long-term reference points that exist in the marketplace are better prepared to secure good longer timeframe trade location in the event that a failure should occur.
The daily bar chart in Figure 4.91 illustrates two good examples of auction failures occurring in the Treasury bond market. The boxed area designated by point 1 highlights the activity leading up to an intermediate-term auction failure that occurred on February 21. Figure 4.92 expands the boxed area to include the daily Profiles for February 9 through 22. After aggressive other timeframe selling activity on February 9 and 10, the bond market came into balance, as is evidenced by the development of six days of overlapping value. On the 21st, Treasury bonds opened above the intermediate term bracket and attempted to auction higher but failed to generate continuation to the upside. Traders were alerted to the potential for an auction failure, because the test above the balance area failed to attract new, initiative buying. In addition, a narrow initial balance indicated the possibility for a Double Distribution Trend day. Shorts entered during the B period selling-range extension offered good day, swing, and intermediate-term trade location.
Figure 4.91 Auction Failure Occurring in Treasury Bonds Data courtesy of Commodity Quote Graphics.
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Figure 4.92 Auction Failure in March Treasury Bonds, February 9 to 22, 1989
Copyright Board of Trade of the City of Chicago 1984. All Rights Reserved.
Point 2 in Figure 4.91 identifies an auction failure following a probe below a long-term reference point. And, as would be expected, the subsequent activity is of much greater magnitude. On November 25, 1988, Treasury bonds recorded a long-term low at 86 to 09, forming long-term excess. After rallying to as high as 91 to 21 in late January, bonds eventually traded back down and approached the 86 to 09 excess on March 21, 1989—some four months later. On the 21st, price auctioned down and stopped precisely at 86 to 09. The selling probe failed to stimulate new activity, and the same responsive buyers were there quickly to buy below long-term value. In this particular case, the long-term auction failure sparked the beginning of a major long-term buying trend.
To experienced traders, known reference points serve as checkpoints on the market map. By observing market behavior at key locations, it is possible to determine the market's directional conviction before opportunity has slipped away.
Long-Term Short Covering and Long Liquidation
We discussed day timeframe short covering and long liquidation in Section I. The same forces that cause short covering and its converse, long liquidation, are also present in the longer timeframe. After a sustained down trend, for example, the anxiety level of participants who have been short for an extended period of time often begins to increase as their profits grow. Should something trigger covering, the ensuing rally could last for several days as traders scramble to buy back their short positions. Such swift buying can easily be interpreted to mark the end of the trend or even the beginning of a new trend in the opposite direction. However, if the buying is not accompanied by continuation and elongated Profile structure, the cause is probably short covering. Short covering is a result of old business covering positions placed with the original trend, not by new initiative buyers. The resulting Profiles tend to be short and narrow, often developing into the familiar P formation, indicating a lack of facilitation with the other timeframe buyer.
Figure 4.93 illustrates the beginning of long-term short covering in soybeans that was sparked by a selling auction failure on January 26, 1989. Following a 70-cent ($3,500 per contract) downtrend, sellers auctioned price near the long-term 740 lows (Figure 4.94) and were confronted by the responsive buying that commonly occurs at long-term reference points. This knee-jerk type of buying, combined with the seller's inability to extend price below 740, triggered a wave of aggressive buying that eventually developed into a Double Distribution Buying Trend day.
Figure 4.93 Long-Term Short Covering in Soybeans, January 25 to February 7
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Figure 4.94 Long-Term Short Covering in Soybeans Data courtesy of Commodity Quote Graphics.
Copyright Board of Trade of the City of Chicago 1984. All Rights Reserved.
The rally on January 26 put sellers of all timeframes in a tenuous position. Imagine having the long-term foresight and discipline to build up a 60- or 70-cent gain in a trade, only to watch the market reclaim 20 cents in just a few hours. Or even worse, suppose that you sold into the trend late and had gains of only a nickel, and then suddenly found yourself 15 cents underwater. In the face of a move as dynamic as that, which occurred in soybeans on the 26th, it is likely that many traders exited in order to conserve gains or to limit losses.
Once you have been forced out of a market by such a violent move, it is difficult to muster the confidence to place a new trade. However, it is during times like these, when market confidence is lowest, that some of the greatest opportunities are created.
When a market begins to move counter to the major auction, what is most important is not a lone day's structure; rather, how successful the market is at moving counter to the trend. The initial day of counteractivity may show directional conviction, but are subsequent days facilitating trade and exhibiting follow-through? In other words, “Is the market doing a good job in its attempts to go that way?” If not, the activity may be due to long-term short covering (or long liquidation).
Figure 4.93 shows the soybean rally on January 26, as well as the Profiles for the next seven trading days. After the strong rally, January 27 and 30 developed overlapping value areas just below the upper distribution of the 26th. If the soybean market was truly as strong as it had appeared to be on the 26th, these balancing days would have developed closer to, or even above, the January 26th 768 highs. February 1 and February 2 did manage to auction higher and establish value above 768. However, after soybean buyers had gained 30 cents in just one day, four more days of work netted only 9½ cents more. In addition, the fourth day (February 2) closed on its lows below the January 26 highs. Figure 4.93 illustrates the selling that continued through February 6. By the 9th, soybeans were again trading near the 740 lows.
If you look at January 26 through February 2 in isolation and without the benefit of hindsight, the short-term trend does appear to be up and higher value is developing. However, by overlaying the activity of each day onto the previous day (beginning with the start of the rally), a different picture begins to form. In Figure 4.95, we have combined the individual day timeframe Profiles into a Long-Term Profile.
Figure 4.95 Long-Term Short Covering in Soybeans Illustrated by a Long-Term Profile. The Xs corresponding to each price indicate the level of volume occurring at that price, relative to the highest volume price Data courtesy of CISCO.
Copyright Board of Trade of the City of Chicago 1984. All Rights Reserved.
Figure 4.95 shows the gradual development of long-term value in the soybean market, beginning on January 26 and running through February 9. These particular Long-Term Profiles were formed using the price/volume data from the Liquidity Data Bank, although they may just as easily be formed using TPOs. The number of Xs at a given price represents the volume that occurred at that price, relative to the volumes occurring at all other prices traded during the period selected. Thus, the Long-Term Profile for the January 26 to 31 period (four market days) shows the greatest value (volume) building around 760. In addition, we have drawn a line separating trade above and below 768, the January 26 high. Remember, the salient feature to observe in order to identify short covering in any timeframe is continuation. Any activity above the high for the 26th is indicative of buyer continuation.
Through February 1, soybeans auction higher and begin to build value above 768. However, continuation remains low relative to the magnitude of the initial rally. By February 2, there has been no further buyer follow-through, relative volume is beginning to decline above 768, and most notable, a P formation is beginning to form. In effect, long-term buying auctions are stalling, thus creating the noncontinuation structure found in day timeframe short covering. Higher prices are cutting off activity as old business has covered their shorts and new buyers have not entered the market. This is the first long-term structural indication of poor buyer continuation. The buying in the soybean market, in this case, was likely longer-term short covering, not healthy new initiative buying.
Applications
Suppose that you are one of the traders forced out of the market by the covering. It has only been a few days, and the memory of the swift rally is no doubt still fresh in your mind. If your intent is to reestablish your short position, by February 3 the Long-Term Profile provides some of the long-term information you need in order to enter the market:
At the right side of Figure 4.95, we have created a sequential Profile in which each time period represents a day (instead of half-hour auctions). This long-term Profile clearly exhibits the similarities between day and long-term short covering. The quick initial rally in 1 period is followed by weak buying-range extension attempts. Short-covering activity wanes and the seller resumes control in 8 period, eventually filling in the lower half of the Profile.
Corrective Action
Most great scientific discoveries are brought forth by a creative individual who looks at something old in a new and innovative way. Often using the same information that others have studied and researched for years, the inventor simply sees the data in a different light. It is easy to become entrenched in a mode of thinking or behavior. By locking our minds into a single mindset, however, we often fail to question what we think are the obvious answers.
Before we enter our discussion, take a minute to write down your first reaction to the following questions:
A common dictionary definition of the term correction is counteraction. For something to be corrected, an opposite action must take place. If your thinking is locked into the generally accepted definition, you might conceptualize a correction to be a situation where the market auctions lower after a sustained rally, resulting in lower prices. Or, in a larger timeframe sense, you may see a correction as a gradual sell-off resulting in several days of lower prices. The point is, a typical stimulus response to the question “What is correction after an up auction?” is often simply that price needs to move lower. We, however, define correction as counteraction. When viewed as counteraction, you will begin to see that corrective action can take a more subtle, and perhaps more powerful, form.
Traditionally, a correction after an up auction is assumed to be selling, or profit taking, that results in lower prices. This is not always true. Even though there are sellers in the market covering longs after an up auction, price does not necessarily have to fall. For example, a market may open higher and sell off all day, resulting in higher prices, higher value, and a higher close. On such a day, correction can still be taking place even though lower prices are not evident.
This sort of correction occurs when old buyers sell, taking their profits at the same time new buyers are just deciding to enter the market. Thus, responsive selling (profit taking) is met by initiative buyers entering new positions. If the initiative buying is strong enough, price may remain higher despite old businesses liquidating their original positions. Remember, however, that when the responsive seller is able to exert more influence on price than the initiative buyer, the up auction may be over (refer to “Bracketed Markets” in Chapter 3).
The Function of Corrective Action
Corrective action serves several purposes. First, it allows for profit taking—a vital ingredient in maintaining a healthy market. Profit taking eases the anxiety level of the market. Naturally, traders with well-placed trades often build up high levels of anxiety about being able to keep their profits. The way to reduce this worry and nervousness is to lock in your profit—to sell if price has been going up or to buy if price has been going down.
More important, counteraction also serves as a test of the strength of the buyer (or seller). If a correction is occurring in an up auction and the market still manages to establish higher value, then the underlying market conditions are very strong. A textbook example of such corrective action is provided by Treasury bonds in Figure 4.96.
Figure 4.96 Corrective Action in September Treasury Bonds, August 25 to 31, 1988
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Following a higher opening, traders holding longs were given ample time to sell all they wanted. The resulting selling-range extension and Normal Variation selling structure suggests that this is exactly what happened. Although lower prices were not the result, this selling is nonetheless a counteraction to the buying that had been occurring over the previous three days. Reviewing the Treasury bond activity prior to August 30, excess was created on August 25, which ultimately marked the beginning of an up auction. As the bar chart windowed inside Figure 4.96 shows, the buying auction continued with a breakout above a previous short-term high at 85 to 11. On August 30, the market opened above value and attempted to trade lower most of the session (until J period). However, the resulting value area and close were actually higher than the previous day. As the activity of subsequent days proved, within the sell-off of August 30 was the well-disguised correction for which alert buyers had been waiting.
Corrective action is important to the health of a trend. The fact that corrective selling attempts occurred at the same time value was being established higher indicated that the bond market was exceptionally strong. Old buyers had ample time to liquidate their positions at a favorable price, and new buyers had plenty of opportunity to place longs with good day timeframe trade location. Conventional traders relying mainly on price might not have recognized the correction, and instead reacted to the sell-off after the open by entering short positions. As Figure 4.96 shows, any short positions on this day soon became losing trades.
Whether talking about corrective action or any other natural market function, it is important to keep in mind that the most obvious behavioral clues, such as lower prices, are not always available. On August 30, creative, open-minded traders probably recognized that price did not have to go lower for a correction to take place.
Summary
Being able to identify corrective action without the benefit of an obvious price break or rally requires a level of creativity that can only come from the trader who is willing and able to look at the same information from more than one angle. Objectivity stretches far beyond this one isolated instance, however. Futures trading presents us with a formidable variety of such situations every day. As we gain more experience and draw closer to the levels of proficient and expert, our goal is to begin to consistently see the unusual—to develop the open-minded-ness that allows us to identify and take advantage of the unique trading opportunities that arise when the market deviates from the norm.
Long-Term Profiles
The truth knocks on the door and you say, “Go away, I'm looking for the truth,” and so it goes away.
From Zen and the Art of Motorcycle Maintenance, by Robert Pirsig
In today's complex world, we are continually confronted by the ever-changing demands and influences of society. It is difficult to remain cooly objective in the face of the shifting images produced by public opinion, the media, and noted financial experts. Occasionally, everyone gets caught up and loses sight of the big picture—whether it be in one's profession, family life, or trading. In such cases, it is easy to miss the proverbial forest for the trees, to tell truth to go away when it should be as obvious as a knock on the door.
How many times have you gotten so involved with the individual, day-to-day auctions that you lost sight of the real market? When you focus on the individual trees, you lose the long-term big picture. What is needed is a consistent method of recording the long-term auctions so that they can be observed objectively. A Long-Term Profile simply plots greater units of time in relation to price in order to form a long-term version of the day timeframe Market Profile.
The salient concept behind the Long-Term Profile is the fact that the principles of the market's auction process apply to all timeframes, from the shortest time period to the long-term auctions. Just as each day's Profile is composed of a series of half-hour auctions, a weeklong Profile would be composed of five-day timeframe Profiles. It follows then, that a Long-Term Profile develops the same structural manifestations of market activity, such as gaps, brackets, trends, high and low volume areas, excess, and tails.
Shown in Figure 4.97 are a typical day timeframe Profile, a 10-day Swing Profile, and a one month, Long-Term Profile. Notice the strikingly similar characteristics. To make the distributions appear more generic, the individually lettered TPOs have been replaced with common Xs.
Figure 4.97 Profiles across Timeframes
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Using Long-Term Profiles
The main strength of the Long-Term Profile lies in the clear definition of brackets and the migration of value. It not only provides a visual picture of the long-term structures of the market but also enables you to easily monitor elements that signify change. By identifying changing conditions through the Long-Term Profile, long-term traders are prepared to act in the early stages of opportunity.
Theoretically, if a Long-Term Profile was accumulated indefinitely, the ultimate result would be a giant, normal distribution curve that is of little value to anyone. Thus, to use the Long-Term Profile effectively, you need to begin building the Profile when a significant long-term change has occurred, such as a long-term high or low. As you witness significant market changes that influence your particular timeframe, you might consider a running Long-Term Profile, starting at the point of change in order to better evaluate continuation. When the market enters a new period marked by confirmed long-term change, you should begin a new Long-Term Profile. It is wise to keep your past Profiles as well, in order to keep track of long-term reference points that might have an effect on future auctions.
The Long-Term Profile in Action
We have illustrated the similarities between the day, swing, and longer timeframes throughout the book. In this section, we present an ongoing analysis of a Long-Term Profile for the Japanese yen during the first few months of 1989. The aim is to demonstrate how the Long-Term Profile accurately pinpoints the key long-term reference points that traders commonly attempt to glean from a daily bar chart. In addition, we show that through the added dimension of time (TPOs), the success of the long-term auction is easily discernible through a Long-Term Profile.
This period in the yen is particularly useful, because it also illustrates how markets evolve from trend, to bracket, then back to trend again (see “Trending versus Bracketed Markets” in Chapter 3). The example displays the usefulness of the Long-Term Profile during both types of market conditions.
The analysis is segmented into two regions. Each region is accompanied by a Long-Term Profile and the daily bar chart for the corresponding period of time.
Region A (Figures 4.98 and 4.99)
Region A displays a long-term selling trend that began with a breakout of a short-term bracket and then slowed when the market eventually came into balance near the .7600 level. Point 1 in the bar chart shows several volatile but basically overlapping days occurring in the .8000 to .8100 region. Point 1 on the Long-Term Profile vividly depicts the bracket resulting from this balancing process. Notice how the Long-Term Profile displays the bracket in a well-defined high-volume area bound by long-term tails (Figure 4.99, points 1a and 1b). Just like a day timeframe Profile, high volume represents acceptance and serves to attract price. The low-volume extremes indicate strong responsive other timeframe presence at the bracket top and bottom.
Figure 4.98 Region A, Japanese Yen Data courtesy of Commodity Quote Graphics.
Figure 4.99 Region A, Long-Term Profile for Japanese Yen. The Xs corresponding to each price indicate the relative number of TPOs occurring at that price, relative to the highest TPO price. Data courtesy of CISCO.
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The yen broke below the bracket with the sharp selling gap denoted by point 2. The gap is represented on the Long-Term Profile by the single prints directly below the bracketed region at point 1. (This particular Long-Term Profile assumes that some degree of trade took place and therefore records single prints in the area of the gap.) The excess created by the gap gave other timeframe sellers the confidence they needed to initiate the selling trend denoted by point 3. During a trend, the Long-Term Profile exhibits relatively low volume and elongated structure. In the bar chart, the trend is witnessed by the steady progression of lower prices.
After another selling gap at point 4 (the gap is less evident through the Long-Term Profile, because the yen had actually traded in the region of the gap four days earlier), the yen entered the second balanced area (point 5) evidenced by a high-volume region in the Long-Term Profile. This particular bracketing phase was caused by central bank intervention to slow the U.S. dollar's rise (which had a supportive effect on the yen). Note, however, that the long-term point of control continued to fall (Figure 4.99, points 5a, b, and c), indicating the long-term seller remained in control and was gradually establishing lower value. While strong excess above the bracket is shown by the Long-Term Profile through the gap and accompanying low volume at point 4, the lower extreme of the bracket does not display the aggressive rejection indicative of a high-confidence low.
Region B (Figures 4.100 and 4.101)
The Long-Term Profile in Figure 4.101 displays the entire down auction for February 15 through May 24. Readers should note that the price intervals used are now tens instead of fours so that the selling auction can be represented in its entirety on one page. In Figure 4.100, at point 6 in region B, the yen gapped below the bracket established at point 5, reigniting the strong selling auction and confirming the control of the other timeframe seller. After a short-term balancing period at point 7, the long-term selling trend resumed as other timeframe sellers auctioned price substantially lower. Much like a Trend day, when the long-term trend denoted by point 8 was underway, the Long-Term Profile never showed a significant accumulation of volume at any lone price. The trend is obvious in the bar chart. Two “acceleration” selling gaps, at points 9 and 10, present in both the bar chart and through the low-volume areas in the Long-Term Profile, illustrate just how quickly this market is auctioning through time.
Figure 4.100 Region B, Japanese Yen Data courtesy of Commodity Quote Graphics.
Figure 4.101 Region B, Long-Term Profile for Japanese Yen. The xs corresponding to each price indicate the relative number of TPOs occurring at that price, relative to the highest TPO price.
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Summary
The Long-Term Profile vividly illustrates how the auction process is the same in all timeframes. Just as changes in other timeframe control are evident in day timeframe auctions and structural development, the Long-Term Profile reveals other timeframe activity in a big-picture sense through the evaluation of high- and low-volume areas.
Special Situations
A high school teacher tells the story of a frustrating day in his career. He was lecturing on the bravery of the American soldiers during the fight for independence. On this particular day, he became quite dramatic and descriptive, vividly portraying the battlefields and the courage of our forefathers. He described the freezing cold winter, the meager rations, and the eloquent words of Washington that kept the men's spirits high. The teacher was trying to give his students a feeling for what it was like to fight for one's country, the self-sacrifice that led to our freedom from England so many years ago.
The class was nearing its end when a student raised his hand. “Yes,” the teacher said.
“Will this be on the test?” he asked.
The teacher was trying to give his students an understanding of the cost of freedom, but the boy who raised his hand was so worried about what he had to know for the test that he missed the point entirely. The student wanted to be given the answers. He did not want to have to actively think for himself. By focusing on what he thought he had to know, he did not hear what the instructor was really teaching.
It would be nice to know the answers, to rely on a little certainty. We would all be rich and successful if someone would come up with an answer that would tell us when to buy and when to sell. But if we are dogmatically given the answers, we will never truly understand their roots. In the words of Heraclitus, “Much learning does not teach understanding.” Many traders do not want to actively think and make their own decisions. They want steadfast rules to guide their trading.
However, market-generated information, when observed and interpreted through the Market Profile, will at times reveal unique situations that offer a high degree of certainty. We call these high-probability occurrences Special Situations. We will introduce six of these market-created opportunities. They are:
There are no guarantees, but one of the comforts of a Special Situation is the identification of a mechanical trade—a trade that almost has to be done (under the right market conditions). And, while the limited studies that we have performed reveal encouraging results, it is important to note that the success of a Special Situation trade lies in the trader's understanding of the market conditions influencing that trade.
3 to I Days
Probably the best-known Special Situation is the 3 to I day. A 3 to I day is characterized by an initiative tail, TPO count, and range extension. Thus, a 3 to I buying day would show an initiative buying tail, initiative buying TPOs, and initiative buying range extension. Figure 4.102 displays a 3 to I Buying Trend day in soybeans (TPOs always favor the trend).
Figure 4.102 3 to I Day Occurring in Soybeans, May 4 to 8, 1989
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Over a large sample size, the trading session following a 3 to I buying day should open within value or higher. Thus, traders holding longs placed within the previous day's value area should have an opportunity to exit within the same region (the opposite applies to a 3 to I selling day). In sum, 3 to I days often provide an opportunity to hold a highly leveraged position while incurring minimal risk.
We conducted a limited study evaluating the opportunity embodied in 3 to I days by observing their continuation into the first 90 minutes of the following trading session as well as through to the day's close. Specifically, we recorded whether the subsequent day's trading took place at prices better than, within, or worse than the previous day's value area. For example, if the day following a 3 to I Buying day opened higher, then activity was given a better reading for the initial 90 minutes of trade. Conversely, if the session following a 3 to I Buying day closed below the previous day's value area, then it was given a worse reading in the Next Day's Close category. For purposes of the study, we also examined 2I to 1R days—days possessing a responsive buying tail instead of an initiative buying tail (Figure 4.103). The results, compiled from Treasury bond data over the June 24, 1986, to May 29, 1987, period follow Figure 4.103.
Figure 4.103 2I-1R Day in the June Japanese Yen, May 4 to 8,1989
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The results suggest that, over the period studied, 3 to I and 2I to 1R structure identified relatively low-risk trading opportunities with astounding reliability. We note, however, that these findings are derived from one market studied over a limited period of time. Other markets behave differently, and all markets change over time. A few of the significant findings are highlighted below.
A 3 to I develops when three specific factors indicating a day's attempted direction—tails, range extension, and TPOs—all point the same way. When these three elements are generated in unison, they alert the trader to the potential for a high-probability trade, a trade that almost has to be done.
Neutral-Extreme Days
A Neutral day indicates day timeframe balance and is characterized by range extension on both sides of the initial balance. In a sense, both other timeframe participants are active in a day timeframe vertical tug-of-war. If the market closes near the middle of the range, then control is even. If, however, the close occurs on one of the day's extremes, there is a clear victor, and the following day is likely to open in the direction of the closing activity.
Next Day Initial 90 Minute.
To test this Special Situation, we studied Treasury bond activity from June 24, 1986, to August 12, 1987. Like the 3 to I day, we evaluated Neutral-Extreme days for their continuation into the first 90 minutes of the following session, and also through to the day's close. Over the yearlong study, the continuation properties of the Neutral-Extreme days were almost as impressive as those represented by 3 to I days.
Neutral Day Closing on an Extreme.
In 92 percent of the cases studied, the market traded within or above the previous day's value area during the initial 90 minutes of trade. Sixty-four percent of the time this activity occurred above the value area during a Neutral day closing on the highs, or below the value area on a Neutral day closing on the lows. These figures dropped to 73 percent and 45 percent, respectively, when compared to the following day's close.
In terms of trading applications, suppose that Neutral structure develops, and it is apparent that the market will close near the highs. A long placed within the value area will usually offer good trade location into the following day. In the majority of cases, you will have time to monitor early activity for continuation during the next day. If directional conviction reverses, 92 percent of the time you will have an opportunity to exit your long within the previous day's value area.
Again, we note that that these findings are derived from one market studied over a limited period of time. Other markets behave differently and all markets change over time.
The Value-Area Rule
We have mentioned many times the slowing properties of volume. Unless something significant has changed, price movement will often slow upon reentering an area of previously accepted high volume, as the market spends time trading there again.
The value area represents the range where the greatest volume of trade took place in the day timeframe. If the market opens outside the value area on the following day, then the previous day's value area has been rejected by other timeframe participants. Due to the presence of the other timeframe participants who caused the initial rejection, the top of the previous day's value area generally provides support against price probes back down into value, and the bottom of the value area will offer resistance against auction attempts to the upside. However, if price should be accepted (double TPO prints) within the previous day's value area, there is a good possibility that the market will auction completely through that value area. We have deemed this Special Situation the Value-Area Rule.
Entering an area of established value represents a test of the market's most recent assessment of value. If the test results in acceptance, it is only logical that market participants will conduct trade throughout that region of value. For example, in Figure 4.104, the soybean market opened below the previous day's value area, reentered value and proceeded to trade completely through it, closing on the high.
Figure 4.104 The Value-Area Rule in July Soybeans, May 26 to 30, 1989
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Monitoring the market's close after value has been penetrated and price has auctioned all the way through is a subtle nuance of the Value Area Rule. If the market opens lower and trades up through the previous trading session's value area, a close on the highs is an indication of market strength (just as a close on the lows below the previous day's value area after a higher open is a sign of market weakness). On the day following our soybeans example in Figure 4.104, the market had to trade higher to find sellers and cut off buying.
The Value-Area Rule does not suggest that every time the market pierces the bottom of the previous day's value area (from below) you should blindly buy. It is equally important to objectively evaluate overall market conditions and specific circumstances before employing a Special Situation trade. The following considerations should be taken into account before executing a Value-Area Rule trade:
Summary
If a trader enters a Value-Area Rule trade without evaluating other market conditions, the probability that price will trade all the way through the value area is little better than a flip of a coin. The power of the Value-Area Rule lies in your interpretation of surrounding market conditions. Through an understanding of the confluence of balance, value-area width, and market direction, you can identify the situations during which the Value-Area Rule offers a high degree of reliability.
Spikes
A spike is generated when price trends swiftly away from established value during the last few time periods of a trading session. Specifically, a spike begins with the time period marking the breakout. For example, in Figure 4.105 the S&P market broke away from value during N period on May 5. Therefore, the spike's range extends from the top of N period (311.00) down to the day's low at 308.00.
Figure 4.105 Open within a Spike—Definition of Range, June S&P 500, May 5 to 8, 1989
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Ordinarily, a breakout from value can be monitored for continuation in following time periods. However, when it occurs at or near the end of the trading day, the crucial element of time (Price × Time = Value) is absent. Thus, the trader must wait until the next day to judge the price movement for follow-through and conviction. Where the market opens and subsequently builds value relative to the previous day's spike sends clear signals regarding the underlying directional conviction of the market.
Acceptance versus Rejection
Whenever price moves quickly away from value, it takes time to validate the new levels. If price subsequently slows, allowing volume to “catch up” and TPOs to accumulate, then value has been accepted at the new price levels. Thus, a market that opens within a spike created during the previous day indicates confirmation of that area. The price spike is also accepted if the following day opens beyond the spike—above a buying spike or below a selling spike. An open in the direction of the spike indicates the probe is not yet over. The market will likely continue to auction in the direction of the spike, seeking new value.
Conversely, a spike is rejected if the subsequent trading session opens in the opposite direction from the spike. For example, after a buying spike, an open below the base of the spike would constitute rejection of the upward price probe.
Openings within the Spike
An opening within the spike indicates that the market is balancing. Thus, two-timeframe, rotational trade will likely develop within or near the spike's range for the duration of the day. In Figure 4.105, for example, the S&P market opened at 308.20 on May 8, 1989—within the 308.00 to 311.00 selling spike created on the previous trading day. The market then balanced, confirming the previous day's probe to lower value. In a second example in Figure 4.106, the S&P opened at the bottom of the May 2 selling spike. Price auctioned higher and found resistance near the spike's highs (311.00), providing several opportunities for alert traders to place shorts with good day timeframe trade location.
Figure 4.106 Open within a Spike, June S&P 500, May 2 to 3, 1989
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On a side note, during days that open and accept value within a spike generated on the previous day, we use a variation of the Range Estimation rules (introduced in Section I) to estimate the day's range. Normally, the entire previous day's range is used to estimate the current day's range potential. In the case of an open within a spike, however, the spike is treated like a “new day.” Thus, when estimating the range on a day that opens within a previous day's spike, we use the length of the spike as our estimate, not the whole day's range. In Figure 4.106, for example, the spike on May 2 extends from 311.30 (the top of the breakout period) to 309.30, a range of 200 points. The following day recorded a range just one tick short of 200 points.
Openings outside the Spike
Whenever a market opens outside the previous day's range, the market is out of balance. The same general rule applies to openings beyond the spike's range, but the magnitude of the imbalance varies depending on where the market opens relative to the direction of the spike.
Bullish Openings
An open above a buying spike signifies a market that is extremely out of balance—initiative buyers are in obvious control. Ideally, a trader should seek to place longs near the support offered by the top of the spike. In Figure 4.107, crude oil opened above the price spike on the 3rd and established substantially higher value. The opportunity to secure excellent trade location for longs was created when B period met resistance at the 20.15 spike top. Be aware, however, that if the market should auction down into the spike, thus negating its supportive top, price could move very quickly.
Figure 4.107 Open outside of a Spike—Bullish (above a Buying Spike), Crude Oil, May 3 to 4, 1989
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When the market opens above a selling spike (rejects the spike), sentiment is still bullish for the day timeframe, but for different reasons. This sort of conflicting activity often occurs when price has gotten ahead of the market, inviting the responsive participant to auction price back into previously perceived value. A case in point is crude oil activity following a selling spike on May 8th. On May 9th, crude oil opened above the 8th's 19.36 to 19.60 selling spike (Figure 4.108). After auctioning down three ticks and finding strong support at the top of the spike, the market auctioned higher for the remainder of the day.
Figure 4.108 Open outside of a Spike—Bullish (above a Selling Spike), Crude Oil, May 8 to 9, 1989
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Bearish Openings
When a market opens below a selling spike, day timeframe sentiment is extremely bearish, as is the case with Crude Oil in Figure 4.109. When crude oil opened below the spike, traders were alerted that the previous day's selling spike was leading value. The eventual development of a selling Trend day exhibited the clear acceptance of lower prices. An open below a buying spike represents rejection of the spike and is also bearish for the day timeframe, but not to the extent of the scenario outlined above.
Figure 4.109 Open outside of a Spike—Bearish (below a Selling Spike), Crude Oil, May 5 to 8, 1989
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Spike Reference Points
During the trading session following a price spike, the spike's extremes often provide useful day timeframe reference points (Figure 4.110). After a higher open, for example, auction rotations are often supported by the spike's top. Similarly, the bottom of a price spike offers resistance on days that open lower. However, it is important to note that the spike extremes are only valid reference points for the first price probe into the spike. If the market returns to test the spike several times in the same half-hour time period, then the chances are good that price will eventually auction through the spike extreme. An additional test into the price spike in a subsequent time period would create double TPOs, in effect establishing value within the spike. In crude oil on the 8th (Figure 4.109), double TPO prints above the 19.98 spike bottom would negate its reliability as a resistance level.
Figure 4.110 Spike Reference Points
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Balance-Area Breakouts
Imagine a large stone precariously balanced on a mountain peak. In a gale force wind, the stone might come loose and tumble down the mountainside. When it falls, it falls quickly in one direction. If the wind is less forceful, the stone may rock to one side and then tumble in the other direction. A balanced market acts in a similar fashion. And, financially speaking, a market that is breaking out of balance can be just as dangerous as a falling rock.
The identification of a balance area depends largely on your timeframe. For example, a ledge (see Section I) may constitute a balance area to a day trader. To a swing trader, however, a balance area might be five days of overlapping value. A long-term trader might consider a major bracket to be a balance area. When something upsets the balance, price moves are often sudden and forceful.
Balance area breakout strategy is straightforward—go with the breakout. Thus, if price is accepted outside the balance area, place trades in the direction of the new activity. In Figure 4.111, Treasury bonds had recorded basically eight days of overlapping value within a relatively well-defined balance region spanning from 97 to 03 to 98 to 16. On April 9, a narrow initial balance forming near the short-term bracket low alerted traders to a potential Double Distribution Trend day. When C period broke below the balance-area lows set on April 3 at 97 to 32, traders should have entered short positions. Buy (exit) stops should have been placed a few ticks above the point of breakout, for a price return into the balance area would indicate rejection by responsive buyers.
Figure 4.111 Balance Area Breakout Occurring in June Treasury Bonds, March 30 to April 9, 1987
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Occasionally, the market rocks one way, then breaksout in the opposite direction. This sort of activity often occurs when the locals or short-term traders auction price beyond a known reference point (in this case a balance-area high or low), to see if there is new activity to sustain the price movement. If there is no response, then the opposite participant can enter the market with confidence, driving price with strong directional conviction. On February 6 in Figure 4.112, price auctions below the three days of overlapping value in the S&P market. Since the rule of this Special Situation is to go with the breakout, traders should have been short when D period auctioned below 297.20. When no follow-through developed and price traded back into the balance area, however, shorts should have been exited at minimal loss. With the knowledge that there was no activity below the lows, traders should have been prepared to buy a breakout to the upside, which occurred on the following day at 300.40. A balance-area breakout is a trade you “almost have to do.” Risk is minimal and profit potential is very high.
Figure 4.112 Balance Area Breakout Occurring in the March S&P 500, January 31 to February 7, 1989
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In hindsight, a balance-area breakout trade looks like such an easy trade to make. However, when you have spent the last few days watching price move sideways, it is not so easy to enter the market initiatively. It feels as if the trade is late, for technically, better trade location could have been secured on previous days. In reality, a breakout is usually the start of a much bigger move, and trades placed with the initiator are ultimately early. Taking advantage of these market-created opportunities is essential to gaining the confidence and experience that are vital to becoming a competent trader.
Gaps
The last Special Situation we will discuss is the gap. A gap is an opening outside the previous day's range, signifying a market out of balance. A gap is created when the other timeframe perceives price to be away from value and enters the market aggressively, forming excess in the form of an “invisible tail.” The salient feature of a gap (that holds) is that it should offer significant support or resistance to price, and it therefore stands as a valuable guide for day traders and an important reference point for long-term traders.
Gaps fall into three broad categories: (1) Break-away gaps, (2) Acceleration gaps, and (3) Exhaustion gaps. Briefly, a Break-away gap occurs when the market is in the early stages of a long-term trend. This sort of gap is fueled by new, initiative other timeframe participants possessing strong directional conviction. An Acceleration gap develops within a trend and reaffirms the conviction and strength of the trend's direction. Finally, an Exhaustion gap will sometimes mark the end of a trend. In the final stages of a buying trend, for example, more and more participants are gradually convinced that the market is indeed trending. Eventually, practically everyone is a buyer. The final consensus is so strong that the market gaps higher as the last doubters jump on board. Once everyone is long, however, there is no one left to buy and the trend is effectively over.
Whether or not a gap is a Break-away, Acceleration, or Exhaustion gap will greatly influence the likelihood that it will hold. However, what we are concerned with here is the Special Situation properties of gaps. Thus, the following discussion treats all gaps the same by evaluating each in the present tense.
Day Timeframe Significance of Gaps
Generally speaking, most gaps are eventually filled—some on the same day. In the day timeframe, if a gap is going to be retraced (filled) by responsive participants, the rejection will usually fill the gap within the first hour. The longer a gap holds, the greater the probability of its continuation.
The Special Situation rule for trading gaps is to trade with the initiative activity that caused the gap, placing stops at the point where a price rotation would effectively erase the gap by trading completely through it. Figure 4.113 represents an ideal gap trade in crude oil. Shorts placed in the first half hour of trade with the gap lower and subsequent Open-Drive activity resulted in good trade location during a selling Trend day. Shorts should have been exited if price had filled the gap by trading back above 19.98.
Figure 4.113 A Selling Gap Occurring in Crude Oil, May 5 to 8, 1989
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Not all gap days are quite so ideal, however. Like the Value-Area Rule, there are outside factors that influence the way a gap should be traded. In Figure 4.114, the Swiss franc opened 26 ticks below the previous trading session's low. Such an extreme gap should have alerted traders to the possible entry of the responsive buyer. The farther away from the previous day's range a market opens, the greater the likelihood that the market has temporarily overextended itself. When this occurs, the responsive participant will often narrow the gap by auctioning price toward the previous day's value. When a market gaps significantly away from the previous day's range, the prudent action is to monitor activity soon after the open before placing trades. In the case of the Swiss franc in Figure 4.114, if the responsive buyer enters, traders should wait until the initiative seller reappears, monitoring the gap for support. When responsive activity waned and two-timeframe trade developed with the downward rotation in A period, shorts should have been entered and buy stops placed at 59.87 (the gap erasure point).
Figure 4.114 A Selling Gap Occurring in the June Swiss Franc, April 28 to May 1, 1989
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Again, successfully using Special Situations involves a synthesis of market understanding, time, and experience. It is difficult to explain the ideal point at which a gap trade should be entered. In many cases, blindly placing a trade in the direction of the gap will eventually result in a successful trade. However, without monitoring early activity, a trade placed too early might suffer undue exposure if price temporarily auctions against the position.
Starting out with poor trade location can be both financially and mentally taxing, often to the point that the trader is forced to exit what would have developed into a good trade. Our Swiss franc example provides a good example of how this can occur. A trader who sold immediately with the selling gap could easily have been forced out of his or her short position, given that the Swiss auctioned against the position for better than the first half hour of trade. Traders who anticipated responsive buying after such a sharp break from value would have probably waited for a return of the selling auctions before entering shorts. With the responsive buying over (at least temporarily), traders placing short positions would have had more confidence, and therefore a better chance at completing a successful trade. In this case, notice that both scenarios would have ended in similar trade location. The difference between the two trades is the level of accompanying anxiety.
Gaps do not hold every time. On some occasions, the buying or selling auction that produced the gap will fail, inviting responsive participants to return price to previous value. When this occurs, however, there are usually clear signs that the gap will be erased. In the case of the gold market in Figure 4.115, gold gapped below the previous day's range. After a quick test to the downside, the responsive buyer entered and drove price up through the gap and into the value area of April 28th. All of this activity occurred during the first half hour of trade. Traders who sold with the selling gap should have covered when gold auctioned above 379.60 in Y period.
Figure 4.115 A Filled Gap Occurring in June Gold, April 28 to May 1, 1989
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Gaps are created by aggressive other timeframe activity. They are significant reference points as long as they hold. If, however, responsive participants overcome the initiator and return price through the gap, then conditions have changed and the gap is no longer a significant trading guide.
Summary
Special Situations are not fail-safe answers, but they do offer a trader some degree of comfort and security. Still, your imagination should not stop at these limited examples. By incorporating the different methods for evaluating directional conviction and performance, a trader can identify other circumstances that offer high leverage and low risk. To put it simply, the big picture is made up of many small, more specific components. By synthesizing these factors into a more all-encompassing market understanding, you will increase your chances of success. Consistently successful trading is the result of a unique combination of opportunity, experience, and market understanding.
Markets to Stay Out Of
Special Situations are useful for identifying trading opportunities that possess a relatively high degree of security. On the opposite end of the spectrum, but no less important, are those times when one simply should not trade at all. A trader who forces a trade when there is no real opportunity in the market is like a basketball player who forces a shot when he is off-balance or heavily guarded—the chances of scoring are low. A good basketball player who does not have a clear shot will generally not shoot the ball. Similarly, experienced traders who do not see a clear market opportunity do not force the trade. The harder you have to look, the lower the potential for a good trade. In such a situation, it is best to stand aside and wait for an opportunity to develop.
The following discussion covers four market situations that signify the existence of relatively little trading opportunity:
Nontrend Days
The most obvious market to stay out of is the Nontrend day. On a Non-trend day, the market is not facilitating trade with any participant and opportunity is low, for the day's range is small and activity is scarce. Figure 4.116 shows a typical, low-volume Nontrend day that occurred in bonds on May 8, 1989.
Figure 4.116 A Nontrend Day Occurring in June Treasury Bonds, May 8, 1989
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Nonconviction Days
A less obvious type of low opportunity market is a Nonconviction day. Structurally, a Nonconviction day often appears to be no different than a Normal, Normal Variation, or Neutral day. However, the Nonconviction day exhibits none of the other timeframe directional conviction that these standard day types typically display—there are no recognizable reference points for a day timeframe trader. During a Nonconviction day, the open is often of the Open-Auction variety, occurring within the previous day's value area. Price rotates randomly back and forth with very little confidence throughout the day.
In hindsight, a Nonconviction day's range can be misleading, for it appears as if a number of good opportunities should have been generated as the day progressed. In the thick of such low-confidence activity, however, traders are provided no real reference points by which to base their trading decision. Consequently, traders often end up forcing trades that just aren't there.
Figure 4.117 provides a good example of a Nonconviction day in the gold market. After an Open-Auction, gold spent the remainder of the trading session auctioning back and forth with no apparent directional conviction. The completed Profile looks like a Normal Variation day, but at no point was there a clear indication of other timeframe presence. On such a day, it is relatively easy to lose objectivity due to the lack of market sentiment. When a Nonconviction day develops, it is best to stay out of the market altogether, for any trading decision would be based on conjecture and random price rotations.
Figure 4.117 A Nonconviction Day Occurring in June Gold, May 24, 1989
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Long-Term Nontrend Markets
On a larger scale, long-term activity may at times exhibit a lack of directional conviction. While long-term traders should not have positions in the market, there may still be plenty of opportunity for day timeframe traders. In Figure 4.118, for example, crude oil exhibited extremely erratic behavior for several weeks, auctioning back and forth with no long-term conviction. Although this was clearly a market to be avoided by long-term traders, the resulting price spikes and gaps offered several high-percentage trades for day timeframe traders.
Figure 4.118 A Long-Term, Non conviction Market. Crude Oil, May 2 to 8, 1989
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News-Influenced Markets
The final “stand-aside” scenario is a day prior to a major news announcement. Generally, many other timeframe participants have balanced their positions prior to a scheduled news announcement. Thus, the day or two just prior to the news is often left in the hands of the locals and other shorter-term traders. The resulting low-volume environment can be dangerous, for rumors and predictions can cause price to rotate wildly.
Summary
Staying out of a market is more difficult than it sounds. When there are few clues regarding directional conviction, it is easy to lose objectivity. Sitting in front of a quote monitor all day without placing a trade requires a tremendous amount of patience. Even the most experienced traders begin to hear that little subjective voice: “It has got to break. TPOs favor sellers . . . sell it.” When the market has no confidence, stand aside until new activity develops. Not only do bad trades lead to losses, but they also keep you from entering a good trade when opportune conditions finally arise.
News
The release of a major news announcement (such as Gross National Product, Merchandise Trade, or Producer Price Index) often creates a violent knee-jerk reaction by the market's participants. Trying to anticipate the news item and how it will affect market sentiment is a highly dangerous gamble. Once the news information is out, price moves so violently and with such speed that it is nearly impossible to make a rational trading decision (or locate your trade where you want it). This is due to the manner in which the news is generally announced. The initial number usually causes a sudden price reaction, depending on early estimates that form market opinion. Soon after the actual announcement, however, there is often a revision of previous periods' figures, which can cause further erratic movement. Finally, the components that make up the economic figure come out, often causing yet another reaction to the number. All of this activity takes place in an extremely short period of time. The resulting sporadic price spurts can wipe out a substantial amount of capital in minutes.
Long before a piece of news is ever announced, the market's participants form expectations that begin to influence market activity. The consensus opinion (available in Barron's and various news sources) is, in effect, built into the market prior to the news announcement. If a trader is aware of the market's preconceived notions regarding the pending news, then he or she can evaluate the true strength or weakness of the market by observing the reaction to the actual numbers.
Let us look at a real market example. Before the Producer Price Index (PPI) was announced on May 12, 1989, the bond market was expecting a number between +.06 percent and +.08 percent. Due to bearish expectations, bonds had been in a short-term down auction, as evidenced by point 1 in Figure 4.119. The direction of the major auction, however, was up (point 2). The actual number released was +.04 percent, which indicated lower inflation than expected, a bullish sign for bonds. The market immediately rallied some 16 ticks (Figure 4.120). Shortly after, it was announced that an increase in oil contributed +.07 percent of the figure. Thus, had it not been for oil, the PPI would have actually been negative. This extremely bullish news caused bonds to rally nearly two full points to 90 to 26. Many market participants lost money because they had anticipated a bearish number. It is extremely difficult to trade during the volatility created by a news announcement.
Figure 4.119 A News Event's Effect on June Treasury Bonds Data Courtesy of Commodity Quote Graphics.
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Traders could have gained valuable information on the 12th if they had entered the market prepared with the following information:
The direction of the major auction was up, despite the short-term selling rotation due to bearish expectations. The market had broken below several days of overlapping value (not in view) on May 9, establishing two important reference points: the 9th's high (89 to 16) and the point at which the market broke lower (89 to 04). As previously mentioned, the consensus opinion was that the PPI should have been between +.06 percent and +.08 percent. When the number was announced as bullish for bonds, the market auctioned through the first reference point (point 1 in Figure 4.120) easily, and slowed at the highs for the 9th (point 2). The subsequent announcement of the PPI's components was also bullish, and the market exploded to the upside. Despite the recent down auction, bonds had no trouble auctioning two points higher on May 9. It became apparent that underlying market conditions were strong.
Figure 4.120 A News Event's Effect on June Treasury Bonds. May 8 to 15, 1989.
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The following list displays the basic news/market sentiment relationships, and our previous bond example is illustrated by the third scenario (denoted by an asterisk). The major auction was up, the news announcement was bullish, and the market reacted by auctioning substantially higher in the day timeframe. These circumstances indicate a market that is strong and continuing higher.
Summary
Instead of getting emotionally and/or financially whipped back and forth along with the market during a major news announcement, traders can use the news to their benefit by following these steps:
Beyond the Competent Trader
Let us look back to David, the aspiring pianist, and his path to becoming an expert musician. When he reached competency after years of learning and practice, he had mastered the technical and mechanical aspects of playing the piano. Yet, he had not transcended the physical notes on paper to become an expert. Similarly, a good market understanding is only part of the equation for achieving expert results. Many traders who develop a solid academic background still do not make enough money to justify being in the market.
To progress beyond the average, beyond the middle of the bell curve and into the upper extremes of excellence, you must achieve self-understanding. To become a proficient trader, it is necessary to become so intimate with the mechanical aspects of the market that they form a holistic pattern in your mind. Only then can you begin to understand how your own personal strengths and weaknesses directly influence your trading performance. As Adam Smith said in his book The Money Game, “If you don't know who you are, the market is an expensive place to find out.”
We have reached the end of the Competent chapter. The study of the basic theories behind evaluating market-generated information through the Market Profile is now complete. We have covered a tremendous amount of information in a relatively short time. So before we move on to the next step in the learning process, take some time to review and solidify the concepts we have discussed. Observe the market. Test and apply your market understanding. Build the experience that will clear the fogged corners of the window to reveal the big picture.
Note
1. J. Peter Steidlmayer and Kevin Koy, Markets & Market Logic (Chicago: The Free Press, 1986).