If your curious about auction market theory and want to know how to apply it to your trading. Then market profile is a powerful tool for graphically representing the auction process on your charts.
The market profile is a charting tool that enables traders to observe the price versus time auction process. The market profile graphic forms a simple distribution that allows the user to quickly observe market activity at various price levels. Market profile is a powerful tool for building a contextual understanding of the market.
If you’re not familiar with auction market theory I suggest reading my post on ‘What is auction market theory?‘. It’ll give a solid explanation of the concepts behind market profile and will help you better understand the concepts discussed in this post.
This post is an introductory explanation of market profile. In later posts I with further explore in more detail the topics around market profile.
What is market profile?
In 1984, Peter Steidlmayer introduced the market profile as a way of graphically representing the movement of price over time.
Steidlmayer’s charting technique allows market time and price data to be visualized the same way as a Statistical ‘Sample Distribution’.
Unlike traditional charts that simply allow traders to track market price over time. The market profile allows users to observe the activity of the market at particular price levels.
It’s objective is to graphical present market data to make it easy to see how much time the market has auctioned at specific price levels. ‘Market value’ is defined as the range of prices the auction has spent the most time.
Market value and the distribution of price relative to time provides market participates with valuable insights into where price has preferred to trade. Also areas where prices are less favorable.
The method employs simple statistical analysis to interpret the data. The premise is based on simple sample distribution.
That is, any random sample data set when plotted as a histogram will form a distribution. These distributions can categorized as normal or non- normal.
For the purposes of market profile. The characteristics of these distributions can help interpret where the market sees fair value or where the market is unfairly priced.
Statistical measures such as standard deviation calculated from these distributions can also be used to determine value areas.
The following chart image shows on the left a segmented market profile chart at 30 minute period intervals. This is equivalent to a 30 minute bar chart. To the right is the same data presented as a market profile.
The market profile chart clearly illustrates preferred prices and market ‘value’ not immediately obvious on the conventional bar chart.
How to construct a market profile
Ok, so now we have an understanding of what is the market profile. Let’s describe how it’s constructed.
Price is plotted on the vertical axis and is variable. Whilst time plotted on the horizontal axis is divided into 30 minute intervals (Normally). Acting as an occurrence counter and considered constant.
If a certain price is traded during a particular time interval then this represents an occurrence. This price is marked with a letter that represents that 30 minute time interval. These letters are referred to as Time Price Opportunities (TPO’s).
The diagram below shows a daily segmented profile on the left (A) and a daily market profile distribution on the right (B).
The segmented chart (A) makes it easy to observe the range of prices traded in a single 30 minute interval. In this case interval A, price traded between 2834.00 and 2856.00. In interval B price traded between 2846.00 and 2858.00 and so on. This type of chart is equivalent to a 30 min price bar chart.
If however the TPO’s are collapsed to the left, the graphic forms a price distribution chart (B). This chart illustrates very clearly the frequency of time intervals that occur at a particular price.
Chart (B) is referred to as the market profile.
Parts of the Market Profile
There are several components of the market profile that are worth becoming familiar with:
What is TPO
Time Price Opportunity or TPO’s are the letters representing a defined period of time. Typically 30 minutes.
TPO’s can be displayed on a segmented profile and are equivalent to a time based price bar.
Or collapsed to the left of the chart to form a histogram or sample distribution to form the market profile. See the section ‘ How to construct a market profile’ above for examples.
What is the Initial Balance
Often referred to as the IB. The initial balance is defined as the first two 30 minute trading periods. Period A and B represent the first hour of trading after market open.
It’s considered an important reference since large Other Time Frame participates (OTF’s) who have already researched the market prior to open, look to place what is know as ‘market on open’ orders (MOO).
Most of the trading done by these large market participants (OTF’s) is done within the first hour of trading.
The first hour is therefore the first market auction of the day and is used as a guide for where price is likely to trade for the rest of the day.
What is the Point of Control or POC
The POC or Point of Control is defined as the longest row of TPO’s closest to the middle of the distribution range.
The point of control represents the price that most trading activity occurred for the distribution time frame.
The POC is an important reference node for the distribution. Rotating markets have a tenancy to return to the POC. It also has a tendency to act as an important support and resistance level.
What is the Value Area
The Value Area is the area that represents 70% of the profile or the first standard deviation in the profile.
It’s considered the range of prices where ‘market value’ can be found.
Basic Interpretation of the market profile – Market profile development
In the following sections I’d like to provide some of the methods for interpreting market profile development and how the profile can be used to aid trading decisions.
First lets define an important term in the context the ideas to be discussed.
What is the Other time frame participant (OTF)
An important definition in the context of market profile is defining the Other Time Frame participant or OTF.
The OTF is defined as the large market participant or institutional investor looking to place large positions. The OTF is the major influence in determining the market volatility.
Determining if and when the OTF is active can provide clues about the strength and direction of moves.
The Market profile development can be used to determine if and when the OTF is active.
Market profile day types
There are various distributions types that form over the course of a trading day. Very broadly these are categorized into 6 day types.
The development of these profiles can be used to assist traders in forming an understanding of current market context and the participation of the OTF.
Normal days are characterized by early participation of the Other Time Frame Participant (OTF).
This has the effect of creating a wide Initial Balance.
Normal days are normally triggered by a news event catalyst that triggers a strong OTF involvement early on.
After the large initial price move, the market eventually loses strength. For the remainder of the day price balances between the IB high and low – Day traders take control.
Despite the name ‘normal days’ have a low likelihood of playing out.
The implications of a large Initial Balance is a low likelihood of continuation and for the remainder of the day price will range.
Normal Variation of a Normal Day
A Normal Variation of a Normal Day are created by trading activity early in the session but is less dynamic than a Normal Day. It is typified by an average IB range.
However as the day progresses the OTF enters the market late and aggressively extends the auction range beyond the IB.
Only one side or the other of the IB range is broken. Not both sides.
This activity suggests the OTF is pricing in new information.
Normal variation of a Normal Day is the most common day and has the highest likelihood of playing out.
The trend day is identified by the high level of directional price movement one way or the other throughout the day.
The OTF remains in control of the auction from the open to the close.
The auction extends well beyond the IB range. There is very little counter trend rotation.
Activity suggests OTF is valuing new and important information from the open.
Double Distribution Trend Day
A double distribution trend day is the second type of trend day.
It is typified by a quiet open with a smaller than normal IB range. The OTF remains inactive during the first few hours.
Later in the session, OTF steps in aggressively to price new and important information.
This dramatically extends the range of the auction to a new price level.
The ‘double distribution trend day’ lacks the conviction of a ‘trend day’. After the initial range extension the market pauses and a new balance area develops.
Non trend days are characterized by a small IB range. With the IB high and low holding all day.
Non trend days are represent a complete lack of conviction by market participants.
Non trend days typically occur the day before an important news release. Market participants and OTF’s consolidate their positions in anticipation of new information.
When a neutral day occurs both the OTF buyer and sellers are active.
The market auctions back and forth. Both IB high and low are broken.
Both buyer and seller OTF’s are active but neither are motivated to push prices in direction or the other. Both sides are pretty close on where they agree values lays.
- Market profile is a graphical charting technique for observing market auction activity over a range of price levels.
- Market profiling employs common statistical methods such as sample distributions and normal distributions for presenting and analyzing market data.
- Market profile can be used for identifying the activity of large market participants (OTF’s).
- Market profile can be used for the analysis of market context to build a hypothesis of where and how the market is likely to trade.