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?

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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