Market Profile – A Comprehensive Guide

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?

 

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 Formula

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

Trend 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.

 

If you want to know more about how to trade using volume do subscribe us or try our volume indicators – and start your trading journey with us!

How to Use the COT Report – A Comprehensive Guide

COT Report (Commitment of Traders Report) is one of the most relevant pieces of information when it comes to understanding the role that volume plays in Forex. It is published by the Commodity Futures Trading Commission and released every Friday, around 2.30 pm EST. But why do so many people speak about the COT report? In order to understand this general question we need to address four issues in this guide: why is it relevant, where to find it, how to understand the COT report and, finally, whether or not a trading strategy is possible with information extracted from the report. Let’s start with the first question.

 

Why is the COT Report so Relevant?

When we are trading any financial instrument some of us tend to be concerned with the role that volume plays in driving price. But how can I have a better understanding of this issue?

If in markets such as stocks the volume can easily be identified by everybody, in other markets such as Forex there is no day-to-day indication of the volume that is affecting the market. One way to understand this is, therefore, by looking at the COT report.

Forex transactions are normally made over-the-counter. And this essentially means that they are done on a daily basis and without the formal registration in one big aggregator of data such as the Chicago Mercantile Exchange of the real players and real investments involved. Without the collection of this information, it becomes almost impossible to accurately understand where the volume in the market is.

What the COT report allows is, therefore, for an understanding of this question. And this is so because its main purpose is to register what happens in futures markets. These types of markets are ones where traders need to keep their positions open for more than one day – so it becomes inevitable that entities that regulate this market understand what is affecting price volatility and who is affecting price volatility.

By having to keep their positions open for more than one day, traders in these futures markets allow us to understand where volume is.

 

Where to Find and Terminology: the Commitment of Traders Report Explained

There are two ways to find the COT: the traditional way and the modern one. Let’s start with the first one.

The official report can easily be found in CFTC website through this link.

Once the document is downloaded – look for Currency Legacy Report / Chicago Mercantile Exchange – Futures Only / Short Format – don’t be scared with the information. Just search for the particular instrument you want to look at and that’s it.

 

Commitment of Traders Report in CFTC

Commitment of Traders Report in CFTC

 

More relevant is to decipher some important terminology in this report. Let’s do it here then:

Commercial – These are big businesses that use the futures market to hedge against some other investment.

Non-commercial – Mixture of retail, hedge funds and financial institutions that play the game not to hedge but to win.

Short – Number of positions open that are selling futures contracts

Long – Number of positions opens that are buying futures contracts

Open interest – These are orders that were not yet executed

 

But even though we would recommend you to go through this traditional route so you understand all the terminology used and get a better grasp of what really constitutes the COT report, there is another way that you can use.

A simple indicator can be used to understand how the COT report is affecting different currencies. This indicator can be accessed on Finviz.

 

COT Report Finviz

COT Report Finviz

 

What is showed here are different currencies and the weight each type of trader has in these different currencies.

 

How to Read the COT Report?

Once we understand key terminology it’s time to address probably the most important section of this article: how can I read the information contained in the COT report? The report gives us important information about three main players that represent three main market positions.

 

Hedgers or Commercial Players – These are all those that aim to protect their positions in futures markets because they want to hedge against some investment made in another financial instrument. Their interest is not to make money but to hedge a particular position.

These are contrarian traders and the reason for that has to do with their own self-interest –  for example, since they want to hedge a particular long position in a particular financial instrument, they understand really well when things can turn. Commercial players or hedgers are therefore bullish at market tops and bearish at market bottoms.

 

Large Investors. These are the traders you want to be following. They are the sharks of trading, and trade to make money on speculation. They also tend to add to their positions along the way – and this reinforces the powerful effect of the trend.

 

Small Investors – These are all those hedge funds or retail traders that own small trading accounts. The most relevant information about small investors is that they tend to be on the wrong side of the market.

They normally buy when the market is at the top of the trend, and sell when the market has no more room to go to the downside.

 

Is a Trading Strategy based on the COT Report Possible?

Can we use the Commitment of Traders Report for a trading strategy? Previously we have discussed three important questions regarding the Commitment of Trader’s report: why is it relevant, where to find it and how to understand the COT report and finally what is its main message for us as traders. The last important topic to address is the link between the COT report and trading strategies: can it be used as a tool to trade?

Like so many other indicators, the Commitment of Traders Report can, in fact, be used as a tool to trade if we fully understand – and read correctly – where volumes of the market are and where the different positions of the different types of investors that characterize this report are.

Having understood that this report allows us to identify three main types of traders –hedgers, large and small investors – we can use it in our trading in two particular occasions:

 

Reversals (Type One) – When the spread between commercial hedgers and large investors is big, then we should expect a market reversal.

This can easily be explained by understanding that large investors are normally accumulating their positions around key reversal points. When this happens this in and off itself is a sign of a potential reversal. If the spread between the Large Investors and Hedgers is high, and it reaches a peak, then it means that we are in a tipping point towards a potential reversal that we can catch in its infancy.

 

Large Traders and Hedgers Spread in COT Report

Large Traders and Hedgers Spread in COT Report

 

Reversal (Type Two) – A subtle trading strategy looks at the importance of large traders in determining where the market will go next. When large traders start to reverse their positions (i.e. the large investors line’s trend starts reversing), we can expect a market reversal most of the times.

 

COT Report Large Traders Trend

COT Report Large Traders Trend

 

Finally, what can we expect from this indicator? While it’s very useful to spot trends reversals, the COT report does not provide a holy grail to trading. First, this information is more relevant for long-term trades; second, it needs to be complemented by other information and knowledge of other forces that move the market.

 

If you want to further understand how to correctly identify these forces and to correctly understand market sentiment keep following our comments in the blog, or look at our indicators and take advantage of successful trading strategies.

EURUSD: Markdown

Dynamic trend: Turned up
Background: W1 – very weak; D1 – weak
Phase: Markdown
Support: 1.055
Resistance: 1.066

 

EUR

EURUSD Hourly

 

Point 1: There was a potential “Selling Climax”, with a very high volume and a wide range. The subsequent bar was an up-bar, which indicated buying pressure.

Point 2: Represents a “test” with low volume and a narrow range relative to point 1. The following up-bar confirmed the success of this maneuver. Low volume when breaking out the latest low, indicates no selling pressure

Point 3: There was a “Shakeout” with a normal volume and a wide range.

Conclusions: The recent action is bullish, and indicates market strength. However, we should wait for the confirmation of the 1.066 level”

 

Suggested Strategies

Strategy 1: Consider selling, if:

  • Price pulls back to the resistance level 1.066 and
  • «No Demand» appears (up-bar with a narrow range and a low volume) and
  • Price reverses down.

Strategy 2: Consider selling if:

  • Price breaks down the support level 1.055 and
  • «No Demand» appears.

Strategy 3: Consider buying if:

  • Price breaks out the resistance level 1.066 and
  • «No Supply» appears (down-bar with a narrow range and a low volume).

 

Tip

You may search for «No Demand» and «No Supply» signals in the lower TF.

Article: Do Tick Volumes Work in Forex?

It’s a widespread notion that tick volumes don’t represent real volumes and so they are too unreliable to be used. This new article looks into the numbers to reach a conclusion about their reliability:

Do Tick Volumes Work in Forex?