An Introduction to Market Profile

By Ned Robinson

As many room traders know, I use Market Profile to help organize price data so that I can pinpoint high probability winning trade entries and trade exits. I have found that when I do this in conjunction with certain MegaBar setups that my winning percentage is very high. I have been refining this technique since joining the room 3 months ago. In fact, using the E2 setup (http://oiltradingroom.com/key-patterns-used-in-the-oil-trading-room-for-success/) and the 30 minute stats that Rob, Mike Wilt (another member of the Oil Trading Room) and I have been compiling, give me a great edge to make money trading crude oil futures.

What is Market Profile? I think that many people have been exposed to MP but either found it too difficult to understand or could not find a way to apply it to being a successful trader. This is certainly what happened to me as I struggled to find a good system for trading MP. It took me years to develop my current approach. Years of study and hours upon hours of looking at charts. My goal here is to distill the most important aspects of MP and show you how it can be used to become a profitable trader.

Obviously, this will not be accomplished in a single blog post but the journey has to begin somewhere. So join me in this first step in unraveling the mysteries of MP so you can find your winning edge!

The Auction Process

The overriding principle behind MP is that all electronically traded markets follow the auction process. We can, of course, extend this principle and say that all transactions that exchange something for something follow the auction process. When you go to the supermarket, you are engaging in the auction process. For example, you go to the freezer section to buy ice cream. (I love ice cream and have to avoid the freezer section myself so I don’t gain 100 pounds!) You are expecting to pay $3.99 for a half gallon but today you see that there is a sale on ice cream and you can get a half gallon for $3.89. For a split second you wonder why they would put ice cream on sale but you quickly dismiss that thought and put 2 half gallon containers in your shopping cart.

ice cream

You have just passively participated in an auction. Maybe the supermarket had too much ice cream, maybe the ice cream was getting close to its expiration date. For whatever reason, the supermarket had to drop the price to a point where it could increase its sales of ice cream. It used price to find a level where it could increase sales. Price became the advertising mechanism for the opportunity for you to buy ice cream.

MP theory says that over a given period of time, this auction process can be seen as a bell curve. That over this period of time, there will be a normal distribution of price. When price drops, more buyers will enter the market and price will rise. When price rises, sellers will enter the market and price will drop. In the simple bell curve shown below, price is on the vertical axis and time is on the horizontal axis.

Normal Distribution

Of course, this is what the expected price distribution will look like after the trading session is over. The trick is to use this knowledge to your advantage during the trading session to make profitable trades. And since life does not usually follow such symmetrical drawing, there are 3 important variations to the bell curve above that will be discussed in future blogs that you must know to keep you on the right side of the trade. They are the P shape, the B shape and the Vertical. Make sure to check back for those very important articles.

30 minute Bars

Before we move on, I want to discuss the 30 minute bar and why it is so important to MP. We will probe this topic in more depth in future articles when I discuss the TPO chart. J. Peter Steidlmayer, the father of Market Profile, said that in the electronically traded market, the 30 minute time period was the absolute best time frame to use to organize data. Jim Dalton, who can be credited with bringing MP to the masses, once told the class I was in with him that after he met Steidlmayer, he spent a good amount of time trying to disprove the 30 minute bar. Dalton was already a successful trader and managing multimillion dollar portfolios. He said that he tried 27 minute bars, 15 minute bars, in fact many different time frames. In the end, however, he realized that the 30 minute bar was king.

I know a lot of traders who avoid the 30 minute bar because they think it is too slow. They think that if you use a 30 minute bar that you can only trade after the 30 minute bar closes. They are worried that they will miss a good trade. Let me say that this is not true. Using time frames less than 30 minutes introduces too much noise and will not give you the trading edge that you need.

Balance and Excess

Balance

MP theory says that price during the auction process moves between 2 states, balance and excess. This is a critical statement and you need to really digest it and incorporate this into your trading. This is the key to being a profitable trader. Seeing balance and excess will allow you to be a winner in the auction process. This will allow you to choose the correct strategy for the current trading environment and will give you the confidence to switch strategies when price moves from one state to the other.

Balance is the state when there is total agreement on price by both the buyers and the sellers. Some call this state consolidation, ranging, or sideways movement. I like the term Balance because for me it removes all bias from my thought process.

When a market is balanced, price moves inside a price range. That range can be small. Let’s say 20 ticks, or large, say 40 ticks. Whatever the range is, the characteristic is that when price gets to the bottom of the balance area, buyers enter. When price gets to the top of the balance area, sellers enter. Price then moves in this balance area for an extended amount of time.

Balance is actually an unstable state for price in electronically traded markets. The longer price balances, the higher the odds that price will break out of balance. If the market balances for too long, traders will lose interest and look for other trading opportunities. Electronically traded instruments demand balance to move to excess in order to keep the traders engaged and the market healthy.

Below are 2 chart fragments. One shows balance on a 5 minute chart and the other shows balance on a 30 minute chart. The 5 minute chart has a range of approximately 50 ticks and the 30 minute chart has a range of approximately 100 ticks. This is why I like the term balance. It allows me to keep an open mind and use a balance trading strategy. Always use the right tool for the job. As long as you have a good system for trade management, and Rob can help you with that, you can have successful trades both buying and selling the balance area. And good trade management will protect you when price moves out of balance and into the other state which is Excess.

Distributions

Excess

Balance leads to Excess. This is because a healthy market has to attract both buyers and sellers and give them both an opportunity to make money. As balance continues, the pressure builds for price to break out of the balance area. But price doesn’t simply break out. It has to probe higher or lower. It has to advertise the opportunity for more buyers or sellers to enter the market and move price out of the balance area. Excess is what shows up on the price chart to show that this has occurred.

Excess

Price enters a period of excess until it has probed enough to find buyers or sellers to stop the probing. This is how the auction process works (check out this YouTube video: https://www.youtube.com/watch?v=JzbMAFHZY0s and watch a live auction). There is almost always a price where the opposite side will be willing to take a position. It may be a long way off but MP says that there will be a point where the advertising will find the sweet spot and the probing will end. What happens when the probing stops? Balance. Excess leads to balance and balance leads to excess. The 2 states of all markets in the market auction process.

The 2 States of Balance and Excess

MP theory says that during the balance period, there is agreement on price and during the excess period that there is no agreement on price. As a trader, which state do you think is more volatile? MP says that the balance area is more volatile because at some point, price will have to start probing and enter a state of excess. On the other hand, while price is probing, you just hop on the trend and stay with it until it ends.

How do you know when the probing has stopped and price is ready to enter the state of balance? For that, we look at the developing profile and find where the price advertising worked and the probing stopped. That shows up as buying and selling tails on the chart and always defines the edges of the distribution profile.

Buying and Selling Tails

On the 30 minute chart below, I have extended the last chart to show what happened next. On the first probe down, price went below 67.00 and then found buyers. You can say that the advertising campaign was successful and buyers entered the market. The area below where I drew the black line is called the buying tail. Recognizing and then trading these tails will give you an incredible advantage when trading. It is how I entered two 100+ tick winning trades last week. Identifying these tails is why Rob, Mike and I have spent so much time running 30 minute bar statistics.

The buyers then stepped in and bought. Price came back into the previous balance area but was quickly rejected when more sellers stepped in. The excess on the top created a selling tail. That excess on top was enough to stop all buying. Price then spent very little time balancing and probed lower. However, the probing didn’t last long and buyers stepped back in, creating another buying tail. Price then entered a longer balance phase.

Balance to excess and excess to balance. Now visualize the chart below in a bell curve. Compress it in your mind until you can see it clearly. This is the normal distribution of price over time that is the key to understanding MP. See the excess at the top and bottom. Look for it on other 30 minute charts. Almost every session ends with excess at the top and bottom. Over an 8 month period, less than 2% of the daily sessions had no excess at one end. And we can use those few instances when there is no excess at the top or bottom to trade to our advantage.

I will tell you now that trading these tails takes practice. Look at the first buying tail. The market looked like it was in a freefall. Buying at 67.00 is very scary, for sure. It takes a lot of practice. That is why using the Oil Trading Rooms MegaBar charts is great and will help you confirm these tails so that you can enter profitable trades yourself.

buying and selling tails

Conclusion

Market auctions. Time, Price and Opportunity. Price advertises the opportunity and time regulates it. Balance and excess. Buying and selling tails. This article has just scratched the surface of Market Profile theory but I hope it has given you some insights into many of the topics we discuss in the room every day. I plan on writing many more articles that will delve deeper into the mysteries of MP so that you can become a successful trader, develop your own trading edge and share your successes with the oil trading room.

Please feel free to post any questions here or in the room and I will be happy to answer them.

3 thoughts on “An Introduction to Market Profile”

  1. Thanks for the great article Ned. Since the room is now interested in 30 min bars, just wanted to share that the break of or a reentry into a thirty min previous range is a strategy I have been using for awhile. But I’ve never had any stats for extension possibilities,or % chance close in high/low range. Now I do and can’t wait to see how this new info helps. Up to now I’ve been profiling 30 min ranges (also 60min). Looking for support resistance at previous POC’s or low vol areas. Here’s a screenshot, note arrows showing support or resistance. I’ve also noticed E2 trades can be right at reversals, so would not be with trend. But together with profiling I may be more inclined to take them. (note in screenshot, poc’s and high/ low of 30 min range are extended until further intersection)

    http://content.screencast.com/users/navigator77/folders/Jing/media/7af9b92e-f06d-42be-9005-d4250315a12b/2014-12-07_1310.pn

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