When we think about how to measure volume in the market one of the key indicators is Market Profile. This indicator not only plays a role in determining what kind of day the trader will be confronted with but also provides us valuable clues and potential opportunities to trade. We will explore in this introduction to market profile these two issues.
What is Market Profile?
The indicator was the result of the ingenious work of J. Peter Steidlmayer that first suggested its use in the 1980s. The idea behind it was to understand precisely how different market conditions can be assessed through the use of three core elements: price, time and volume.
Throughout a trading day different orders to buy and sell a particular financial instrument – be it currencies, stocks, commodities, etc. – are placed on the market. This indicator uses a mathematical formula that tracks precisely how these moves occur.
Whenever these orders are placed on the market a value area is established. And this area represents an equilibrium between the forces of demand and supply. The distribution of these forces forms a normal distribution curve.
The main driver of changes within this distribution curve is, of course, volume. Pick periods during the day make the distribution curve move towards a different value area. And it is precisely these move that traders are concerned about.
The key to understanding the importance of market profile is, therefore, to follow the moves from value area to the new value area. The main driver of these moves is volume. And what new value areas allow us to understand are new ranges within which prices will tend to oscillate during that trading day.
If you want a free version of this indicator for Metatrader 4/5, you can download it here.
How it Works: The Formula behind the Indicator
Market Profile is constituted by what are called Time Price Opportunities (TPO). Within a specified time period – 30 mn, 1 hour, 4 hour, etc – a different letter is associated with a new condition of the market. These letters are in themselves representatives of volumes of orders.
The market picks at what is called Point of Control (POC) – this is the row where the most number of TPOs were registered with the most volume associated. And this is the area that traders should be carefully considering because it settles the value area that will most likely be associated with a particular day.
Prices will tend to pick at a particular POC, establishing a particular value area and then oscillate around those numbers.
Identifying Trading Days through Market Profile
But how can we use this indicator – is it at all possible? Throughout this text, some hints were already stressed on how to take advantage of this data but now is time to look at this issue in a bit more detail.
Whenever the day starts or whenever there is a big spike during the day established, for example, by a big news announced or some other event, it is commonly understood that these events will drive the value area to a particular point. The question becomes whether this trend will continue, whether the market will stay choppy or whether we will see a complete reverse of this trend.
Through the use of Market Profile we can, therefore, identify different types of days and these can be explained precisely because of the establishment of new value areas:
- Trend days – when a particular value area is constantly being redefined in the long direction or short direction
- Semi-trend days – when an events cause a sudden move in the market but the trend stagnates
- Choppy days – when no directional move in the market is recorded and the value areas do not change enormously throughout the day
- Semi-reversal days – when we see a directional move in one direction or the other but that move is completely shaken by a partial reversal. The day ends up being choppy but towards the opposite side of the initial move
- Full reversal days – the market makes a strong directional move that is completely nullified by a move towards the opposite side.
Trading Using Market Profile?
If traders need to be aware of different types of days – and can spot these different types of days through an analysis of the POC – they should also understand that trading using Market Profile demands a broader understanding of this indicator.
Market profile is particularly useful in trading ranges and reversals – it doesn’t do so well with trending days. It also should be used in intraday timeframes, from 1 hour and below.
As indicated, POC – and the associated value area – can change throughout the day. Surrounding the POC area are, however, extreme values. One could say that they represent the boundaries of price volatility during a particular day. Surrounding the POC are therefore two boundaries: the upper extreme and the lower extreme.
Traders can take advantage of this information and trade whenever price hits particular extreme boundaries. For example, a reversal trading opportunity would occur if price moves to the lower extreme and we see a drop in the eagerness to sustain this move further to the downside by traders. This drop would be registered in the Market Profile indicator.
Traders could place buy orders at this extreme with a very short stop loss just below this point. As a target, the other end of the extreme – in this case the upper extreme – should be used.
We strongly suggest however to align this approach with a more consolidated understand of other forces in the market, such as more immediate supply/demand signs. The use of market profile is therefore just one tool that can be looked at in order to fully optimize our investment opportunities. Other elements such as volume analysis should inform traders when they make trading decisions.
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We have just posted our newest article about the Commitment of Traders Report (COT). And what is the COT? It’s one of the most relevant pieces of information when it comes to understanding the role that volume plays in financial markets. It is published by the Commodity Futures Trading Commission and released every Friday, around 2.30 pm EST. Learn in depth what it is, and how to use it in trading:
Aussie Dollar (AUD) pairs are showing some temporary weakness in the 15 minutes to the hourly timeframe, which may result in a short-term reversal. In this post, I analyzed the market’s supply and demand on the 3 of the most traded AUD pairs: AUD/USD, EUR/AUD and GBP/AUD.
In this pair there was supply at new highs, which often pinpoints the beginning of a downtrend – in new (relative) market highs, there just isn’t trading due to old resistances, and so any supply sign tends to carry more weight. Before looking for a short I would like to see another descending top (lower than the last 2) on low volume, a downtrend confirmation.
Note: Non-farm employment change and unemployment rate numbers are coming out tomorrow for USD at 1:30 PM GMT
In EUR/AUD Hourly chart, the price is still moving in sideways, but the volumes are telling another story. They spiked on the market lows, which means there was mostly demand in the last 2 days. A low volume rally to 1.44 would be the trigger for a high probability long trade.
This pair is near a long-term support at 1.68, and just showed a major shake-out (blue dot). It’s probable that it may form an inverse head-and-shoulders, that given the accumulation, would show strength. Even if that doesn’t happen, though, a dip to around 1.687 (previous low) on low volume would still give a long opportunity with a favorable risk:reward.
In this trade, I went short after VSA gave a weak signal, together with the weak background + weakness nearby for quick 30 pips. It’s usually a strategy that works in London open, as volumes tend to spike at these hours.
Taking the VSA signal at London Open
- The background analyzes both the trend and supply/demand signs in the market. In this case, it was showing that the market was weak, which means you should be looking for shorts
- The market showed weakness behind, seen by the wide high volume (red) down bar, closing on the lows. This is a supply sign, that is even more important during a downtrend.
- Finally, a weak VSA signal (minor supply) triggered the trade, and a sell-stop was used at the bar’s low.
By the year’s end, volatility is certain, and coincidentally, there are usually many trading opportunities across Forex pairs. This year is no exception, and we found 3 trading opportunities among the 4 major pairs, which can possibly be taken by January/2017.
EUR/USD (-4.29% year-to-date)
Euro/Dollar just broke an important support at 1.05, and it’s very close to reaching parity, currently at 1.038. The support was broken following major supply in November, and it kept showing selling volumes on the way down, and during the breakout. After a short-term rally on low volume just before Christmas, it keeps heading lower. Despite the historical lows, solely based on the market’s supply and demand, it’s a good time to short it.
Daily background: Weak
GBP/USD (-17.15% year-to-date)
There was a selling climax, just before the October’s rally surged. Most recently, at November and December though, the Sterling/Dollar has been showing supply, and the short-term support 1.21-1.23 won’t probably hold. The ultimate support is 1.20, and if there are no significant changes such as VSA demand signals, aim to short in the breakout.
Daily background: Weak
USD/JPY (-2.05% year-to-date)
Following an accumulation consolidation, that lasted for 5 months, USD/JPY started a major uptrend. To trade the daily, there should be a retracement first, to around 114. There are no resistances ahead, and so an uptrend still has much room to go.
Daily background: Strong
USD/CHF (+3.00% year-to-date)
Similarly to the Yen/US Dollar, USD/CHF also went through an accumulation process mostly due to the strength in the US dollar. The rally has been showing good volumes, and as it’s just approaching an important resistance at 1.032, a breakout would be a trigger for a long trade. The next important resistance is at 1.17 which gives enough room for a favorable risk:reward.
Daily background: Strong
If you wish to trade EUR/USD with our indicators for free, you can try it here.
This trade was taken in the 5 minutes timeframe at the today’s London session. There were 2 things going for the trade:
- The background was strong at the time
- There were multiple demand signals nearby (strength)
But sometimes the market only gives 1 shot, and this was one such example – the opportunity was missed when there was a down bar with about average volume. The trade was taken when the rally was already underway, and the volumes were drying up.
Background (15 minutes): Strong
Euro/Dollar just broke out from an important accumulation pattern of the last few sessions, that peaked at 1.0418.
- At point 1, we can see that the breakout was on good volume. Together with the buying seen in the pattern’s lows, this shows strength, and we should be looking for a long trade at the moment.
- This was a testing bar, testing for supply at the resistance. If prices keep staying above 1.04182, there is probably not enough supply for a downtrend, and we can expect further rises in prices.
- Look for a low volume down bar, or a demand bar by tomorrow’s London session, for a long position. Make sure to close any trades before 1:30pm GMT, as unemployment claims and the final GDP numbers for US are coming out.
- If prices dip below the critical price 1.0418, re-evaluate depending on what happened during the most recent news.
If you wish to trade EUR/USD with our indicators for free, you can try it here.
Entry reason (1st trade): Low volume up bar on resistance, with weakness behind
Close reason (1st trade): Demand signal
Entry reason (2nd trade): Low volume up bar and failed test
Following up on last week’s post about Euro/Yen, upon reaching the resistance, this pair continued to show supply just above the zone at 123.44, and the background soon turned weak.
- First short trade on the break of a low volume up bar, inside the weak zone. Closed when there was a demand signal, and the traded end up being barely break-even.
- I took another short trade on the break of a low volume up bar. This was also a failed test, which showed further supply. Holding the trade until the support at 120.900, or further strength in the market.
We have just released the video explaining the most recent indicator, Congestions. It’s an indicator that detects certain supply and demand patterns which form buying/selling zones, and serve as supports/resistances.
This is an improvement over standard supports/resistances, that don’t really take real supply/demand into account to draw the resistance areas, which has to be seen by the volumes. This results in more reliable and predictable resistance areas.
You can check the video below: