The Ray Wave I

One essential point to bear in mind about the Ray Wave is this: its primary function is to manage risk; it leaves trading, entry, exit etc to the Barros Swing and Market Profile. Unlike the Elliott Wave, the trend of a timeframe is defined not by a 3-wave or 5-wave structure, but whether a market is making higher swing highs and higher swing lows (in an uptrend) and lower swing highs and lower swing lows in a downtrend.

RW is a risk management tool in that it provides a structural roadmap as well as possible termination targets. To arrive at the theory, I borrowed liberally from the Elliott Wave. If you are unfamiliar with the theory, here is a good primer:

http://www.acrotec.com/ewt.htm

There are major differences between the Ray Wave and the Elliott. In the Ray Wave:

  1. Impulse structures can be 3-wave or 5-wave structures. The depth of Wave-2 provides a good indication of whether we can expect a 3-wave or 5-wave structure.
  2. In a 5-wave structure, wave 2 and wave-4 have to be within 20% of one another (i.e. they must have symmetry).
  3. 3-wave and 5-wave structures use different ratios and anchor points to define end of moves.
  4. The corrective waves differentiate between the differing wave structures. Whenever a correction exceeds 20% of wave-2, a new (larger structure begins).
  5. Structures begin at the swing low of the First Higher Timeframe and end either when we breach a swing low (in an uptrend) or swing high (in a downtrend) or there is a line turn in the First Higher Timeframe.
  6. In complex corrections, a new swing extreme that retraces beyond the Primary Zone of the preceding swing is treated as the ‘B’ leg of the of the correction.

Let’s turn to an example, the S&P as at January 04 2008:

03-10-2008-figure-13w-sp.jpg

FIGURE 1 S&P WEEKLY

In Figure 1, the first thing I did was place a 13w swing and Time Price Labels on the swing extremes. I then noticed that the correction in March 03 looked larger than the first 13w swing. So, I placed Time Price Label there and found that it was. For this reason, I included it in my count.

I now had to distinguish the differing degrees and separate the impulsive and corrective waves in any complex structures. I start with the largest correction and work downwards. In Figure 1, we have the following corrective sizes (in chronological order):

  1. 166.40 +/- 20%
  2. 102.9 +/- 20%
  3. 94.1 +/- 20%
  4. 104.25 +/-20% (symmetry with [2]?)
  5. 92.30 +/- 20%
  6. 183.7 +/- 20% (symmetry with [1])

I decided that:

  • [1] and [6] were symmetrical.
  • [2] and [4] were not symmetrical because they failed the Rule of Alternation; see http://www.acrotec.com/ewt.htm)
  • None of the other waves showed symmetry.
  • There was one complex correction.

In Figure 2, I have placed a rectangle around the complex correction.

03-10-2008-figure-13w-rw.jpg

FIGURE 2 Ray Wave Count

Let’s apply the counts step-by-step. My nomenclature hierarchy is:

  • Impulse Waves: Capital Roman numerals []. (), ‘no brackets’; Arabic numbers []. (), ‘no brackets’; Small caps Roman numerals []. (), ‘no brackets’.
  • Corrective Waves: Capital letters [], (), ‘no brackets’; Small caps letters [], (), ‘no brackets’.

On the first pullback of 166.4 points, I automatically labeled it on a weekly chart as a [I], [II]. The deep retracement suggested a 5-wave structure. Once the market accepted above the maximum extension of Wave-[I], I applied the First Shock Ratios to project targets for Wave-[III] and Wave-[V].

At the next correction, we had a pullback of only 102.90 points. There was no symmetry, so I could label this Wave-(I) & (II). At the next correction, we had a complex correction (‘C’ accepted below the Primary Sell Zone of ‘I to A’). This pullback was less than 102.9 +/-20%. So, we could label it Wave I & II.

The next correction 104.25, the second largest correction to date, caused a problem. Firstly, it was within 20% of 102.90. However both were simple corrections so that once the market accepted above the Maximum Extension of 1331.7 to 1227.45, I could safely label the structure as being one independent of 102.90 +/- 20%. Once I formed that opinion, I need to re-label the chart. The re-labels are the ones in Figure 2.

We then had a correction at 1465.95. But since this was smaller than 104.25 +/-20%, it was a wave of a smaller degree.

At 1561.35, we have a correction of 183.7; this is within 166.40 +/-20% (wave-[II]). Since Wave-[II] was simple, we could expect a complex correction. When the market broke above 1586.8 and accepted below the Primary Sell Zone of 1561.35 to 1377.65, we knew:

  1. This could be an Upthrust Change In Trend pattern but this was of a lower probability than the wave being Wave-[B] of Wave-[IV].
  2. Because Wave-[III] was so extended, and because 1576 to 1578 was target area to complete the structure, a Failed Wave-[V] was probable.

Once the market went to 1408.5 and in the process fell below the most likely Running Correction retracements for Wave-[C], we had more evidence of a probable Failed Wave-[V] to come.

On the week of December 7, 2007, the S&P got to the top of the Value Area of the complex Correction and gave a clear rejection signal. This signaled the probability that the structure that began in the week of March 7 2003 was now complete. At the very least we could expect a line correction in the 12-M (i.e. correction of yearly swing line).

However since the 12-M itself gave a possible Upthrust Change In Trend signal of the uptrend that began in 1982, the minimum target, once a 12-m bar confirmed the Upthrust was the Primary Buy Zone – labeled in Figure 3.

03-10-2008-12m-upthrust.jpg

FIGURE 3 12-M Upthrust

You’ll notice that nowhere in this analysis do I speak of Trends, Zones, Setups etc. The Ray Wave is a risk management tool. It assesses the probability of the continuation of the current structure. It leaves it to the Barros Swing and Market Profile to trade.

The Ray Wave: An Introduction

My tools span the range of the discretionary spectrum:

  • The Barros Swing (Nature of Trends material) is essentially a reactive set i.e. we wait for a pattern to form on a chart and then respond. There is little by way of anticipating of what the market will do.
  • The Market Profile has some anticipatory elements but largely depends on present tense information for its efficacy.
  • The Ray Wave lies at the far extreme – its nature is largely anticipatory. It’s best to use it only when you have disciplined yourself to judge reality for what it is rather than what you’d like it to be.

To develop this theory, I have borrowed liberally from the Elliot Wave, added an idea from Michael Gur’s ‘Symmetry Waves’, and finally, I inputed my own experiences. The result is a wave theory that is better than most in this respect: Place 10 Ray Wave practitioners in a room and generally, they will all have the same wave count. They may differ on what to do about the count but the count will be the same for all. I don’t know of another wave theory that can claim this.

Why did I develop the idea? Because the tool suits my nature. The Ray Wave provides a road map of how a market structure should develop. When the market does something different, it’s providing information, information we can use to our advantage, For example:

  1. The RW will tell me if I should expect a simple (straight-line or zig-zag) correction or a more complex one e.g. a sideways market.
  2. It will warn when a move is likely to end – whether that move is impulsive or corrective.
  3. It provides a context for my sentiment indicators and so on …

The RW performs best in trending markets; in congestion markets, I prefer to use the Market Profile; so when a market moves into congestion, I use the Market Profile zones etc to trade it until there is a breakout.

I don’t use the RW to define a trend – the Barros Swing does a great job of doing that. On Monday, I’ll introduce some of the essential ideas. You’ll see that my trading edge comes from the synergy between the Barros Swing, Market Profile and the RW.

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Non-Farm tonight. Gold, ES and Crude Oil are in critical phases. Please take care!

Present Tense Information

In 20 years or so of mentoring, one mistake newbies make stands heads and shoulders above the others: they mistake the map for the territory. What did Ray say? What map, what territory?

The map is the best guess we make about future market direction; the territory is the reality of what the market is doing. Add to this mistake, the human tendencies of hindsight bias and selective perception and we have the reason why so many of us fail at trading.

Let’s see how the errors operate. I’ll use the analysis on the video to illustrate the points I am making (http://www.tradingsuccess.com/stcuser/market-profile/03-03-2008/mp.html). The analysis for trading of March 4, 2008 was:

  1. I had interpreted the price action until the ‘J’ period as one where there would be trend day down.
  2. On the video, I expressed concern that the new low had lacked ‘downside umph’. For me this raised the red flag that the analysis was incorrect. I know the ‘K’ period for the ES often produces acceleration or rejection of the day’s trend. So, when in the ‘K’ period the market started to rally, I had solid reasons for believing my analysis was wrong. Because the potential for a reversal occured at previous support, I covered not only the shorts I had instituted that day, but also the ones entered on February 28.
  3. I received posts here and privately telling me that they disagree with me – that the Day Type for March 4 was a trend day down.

Now here’s the point. The posts were 100% right – I did get it wrong. But we knew that only after the event! Similarly, if I had been looking for rejection off the 1310 low, I’d only have known I was right after the event. This is the crucial error newbies make. They assess their performance after the event has completed. If we view our performances in that light, we never learn.

It’s really more important to ask:

  • Given my experience and knowledge, was there anything that occurred prior to the ‘J’ period low that would have told me that the market was ready to rally?
  • Assuming I don’t have prescient powers, can I learn anything from the event that will allow me to correctly identify a Neutral Day earlier than I did?

In this way, we add to our store of knowledge, knowledge that allows us to continually update our scenarios as fresh information comes in. To do this effectively we need to avoid selective perception of information.

I experienced a great example of this yesterday.

On March 4, we ended up with a Neutral Day closing in the upper extreme. This suggested more upside until at least the end of the Initial Balance. On March 5, the market has an open-gap that is not closed after the first 60-minutes of trading. In addition:

  • We have a Reverse-Open up (suggests a Neutral Day)
  • We opened above the previous day’s Value Area and
  • The Initial Balance had a range of 17 points. (The Normal Range is about 22 points).
  • We are in a congestion range between the 1400 high and 1310 low.
  • The market had failed to breakdown on a test 1310 generating what I call a 313O buy signal.

Based on the range of the Initial Balance, and the context (within the sideways boundary), I opted for a Normal Variation Day as the most likely event. The second most probable event was a trend day up (market opened above value, confirming the Neutral Day). I thought this less likely because there is CPI on Friday and the buying delta volume for March 4 suggested short covering than fresh buying.

I dismissed a strong possibility of a Neutral Day because of where the market was trading. Neutral Days tend to occur as test days at end of trends or on the boundaries of congestion; they seldom occur in the middle of congestion ranges.

Figure 1 shows the Profile to the ‘F’ period.

03-06-2008-fig-1-f.jpg

FIGURE 1 March 5

In the ‘F’ period the market made a new high on light volume and then returned to congestion – this suggested a high was in. At this point, I revised the probability of a Neutral Day from low to moderate. The ‘F’ period extended the range to a mere 17 points. This was below the normal of 20. Given the price action of the March 4, I thought we’d do at least 20 to 25. So we were either going to have a below Normal Range Day (I rated this as the highest probability) or a Neutral Day.

When in the ‘H’ period we covered the ‘A’ extreme on volume, the probability of a Neutral Day became the best-case scenario. I range extension had three possible targets:

  • The normal range 1345 – 20/25 = 1325 to 1320
  • The close of the 4th 1327
  • The top of value 1322 – 1321
  • The inflection point at 1319

If I were day trading, I’d have passed with the ‘go with’ break of the low at 1328. My stop would have been above the midpoint (1327) and the best would be a 10-point gain. On the other hand, if I waited for the end of the range extension, I’d have a 3 – 4 point stop and since the target would have been the POC, the reward:risk would have been at least 1.3:1: much better odds and possible more. For example, if the market bounced off 1327, I’d enter say 1330 risking 1324.75 (6 points) for a target to 1338 (8 points); if it bounced off 1319, I’d enter 1322 risking 1316.75 (6 points) for a target 1338 (20 points).

Figure 2 shows the options.

03-06-2008-fig-1-poc.jpg

FIGURE 2 Risk Reward

For those curious Figure 3 shows the completed profile for the day.

03-06-2008-fig-3-eod-pro.jpg

FIGURE 3 EOD Profile

  • Notice that my initial assessment of the market was wrong. But as the day developed and new information came in, I reassessed the probabilities. At the end, if I were trading, I’d probably have made around 10 to 12 points. Notice too the superiority of the Profile to other tools when it comes to entering the market. The Profile gives us a greater probability of success by using volume as trading occurs rather than waiting for the end of a period.

If you are a day trader, assessing reality correctly in the light of new information is a key to success. What the market looks like at the end of the day, doesn’t matter after a day’s trading: by then you have closed shop!

Tomorrow I am going to the other end of the spectrum and introduce the Ray Wave.

The Initial Balance: Two or Three 30-Minute Periods?

Before I delve into today’s topic, I’d like to tell you of a great bonus to my readers. From time-to-time, I’ll post the Camtasia file of my trading diary in order to illustrate a point. The idea of using Camtasia as part of my journal came from Dr. Brett Steenbarger (http://traderfeed.blogspot.com/). Thanks Dr. Brett, this is one of the best ideas that have come across my desk.

How do I use this idea? I record my thoughts on Camtasia as I trade and then review the day and create a written summary. That way, my record of the trade is not influenced by the vagaries of memory.

You can view my Cam file for March 04 2008 at http://www.tradingsuccess.com/stcuser/market-profile/03-03-2008/mp.html. One point: when the market moved in the K period, I must have forgotten to press F9 because I don’t have a recording of the last 90 minutes.

As you will hear in the Cam file, I was concerned at the lack of thrust down on the breach of 1310 and the failure to develop a trend day range. When in the K period, the market started to rally, I decided firstly to exit the shorts executed 1319. And when it was clear that the market would close above 1310, I closed out all shorts at 1323.25

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Most books on the Market Profile state that the Initial Balance is the first two 30-minute periods. The authors calculate these periods from the start of the session. I take the view that this practice does not achieve the outcome for which the Initial Balance was designed.

To understand why this is so, we need to go back to the original ideas of Peter Steidlmayer.

When he first wrote about the Profile, all markets opened at a half hour either at the ’30’ or at ’00’, Peter took the view that the range of the first 60 minutes was set by the day timeframe trader i.e. those that initiated and closed out trades on the same day. The range after the first 60 minutes was set by the other timeframe trader (anyone not a day trader). He then based the Day Type, Open type, etc around this distinction.

The Initial Balance for the ES was always one surrounded by controversy. Initially it was set at the K period – recognizing the schizophrenic nature of the ES. Often the market changes its nature in the ‘K’ period. Dalton published research in his newsletter that showed the superiority of using the first 90 minutes of ES trading as the Initial Balance; the K period was a period to watch for reversal of the intra-day trend or an acceleration of the intra-day trend.

Prior to this research being published, the financial markets started opening minutes before 7:30 (CT); for example Bonds opened at 7:20 am (CT). The question that arose was whether the 60 minutes should be measured from 7:20 or would it be better to treat the 7:20 to 7:30 as a 30-minute period. Most publications opted for 7:20.

I took a different tack. I asked myself if the other timeframe trader came in because 60 minutes had expired or because of the time e.g. in the Bonds, did he come in because it was now 8:20 (because it was 60 minutes from the open) or did he come in after 8:30 (because it was 8:30 – whatever the reason). Using Peter’s ideas that Range Extension and Extremes are created by the other timeframe trader and that by measuring these parameters we could derive an idea of future direction, we tested the two time periods for robustness.

We found that treating a time period i.e. 8:30 am (CT) as the time the other timeframe trader commenced his activities was a more robust indicator of a market’s direction.

So for this reason, I use the first three 30-minutes for the ES and where the market does not open at the ’30’ or ’00’. Using the correct Initial Balance is not a matter of academic interest. You will have very different results e.g. whether or not you have a 3i Day depending on what standard you use. In turn, the differences have a material impact on your bottom line.

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BTW: a 3i Day is a Free Exposure trade i.e. a trade where the worst result is usually a scratch trade if you act in the Initial Balance of the day following the 3i day.

Another free exposure trade is the Neutral day closing in the Upper or Lower quartile of the range. For example, the March 4 day ended up being a Neutral Day closing in the upper quartile. This gives us a free exposure to the long side in the 1st 90 minutes of trading today.

The Initial Balance and Day Type

I received a number of e-mails and I noticed that the members of of one of my links expressed the same problem. But before I get into the blog, I’d like to ask a favour. Please direct questions on a blog to the blog. I’ll no longer answer private e-mails unless you have raised issues outside the post.

“Nice Blog on MP
I read the article & it seems the main idea he is saying is that one can have a fair predication of whether day will be two timeframe or onetimeframe based on
1. open type
2. open relative to yesterdays range/value area
Till here I understand but after that his use of IB , ATR & normal range is not clear”.

This was taken off one of the users to the Traderslaboratory: http://www.traderslaboratory.com/forums/f6/normal-range-in-the-market-profile-3536.html and is great summary of the e-mails.

I suspect that the authors of the e-mails have not read or perhaps not studied Daltons’ Mind Over Markets. If you want to be a student of the Profile, I believe you need to KNOW the contents of this book. Even the sections that have been superseded by the Steidlmayer Distribution (Modern Market Profile) are worth knowing for the insight they provide into the structure of the markets.

This is not the place for a full treatise of the Day Types. But I’ll use the Normal Day as an example of what is possible.

At the opening of any day, we need to define the likelihood of the day being rotational or 1-timeframe.

  1. The first tool I use to do this is the Steidlmayer Distribution. Is it in IPM (Initial Price Movement) mode i.e. directional mode? Is that likely to continue or change (I use statistics to determine this).
  2. The next tool is the relationship between today’s open and yesterday’s Value Area. For example, if the market opens within the previous day’s Value Area, then we are likely to see a rotational day.
  3. The third tool, the type of open. For example a Drive-Open (or as Dalton calls it Open-Drive, see Dalton page 63). A Drive-Open is usually a sign of a rotational day.
  4. The final tool is the relationship between the Initial Balance, Normal Range and Type of Day. You MUST know that in a Normal Day, the Initial Balance is 80% to 100% of the Normal Range. So, if the ES has an Average Range of 25 points and today, we have an Initial Balance of 24 points, the likelihood is we’ll have a Normal Day.

Tomorrow I’ll tell why I use three 30-minute periods instead of two.

Success Depends on Knowing Your Outcome

The Asian Traders Investment Convention (ATIC) held in Singapore over the weekend drove home to me how important it is to our success that we clearly identify the outcome we want and the reasons for the outcome.

In Singapore, I hold one seminar a year. The aim of the seminar was always to provide an educational service that would allow newbies an avenue to take that first step to trading success.

My experience with the mentor program suggested that providing a free service was not the way to go. Not a single ‘sponsored’ (i.e. free course) student has ever graduated – perhaps one day. So, when I first ran seminars in Singapore, I charged the going rate and taught the areas I had the best knowledge: The Barros Swing, the Market Profile and the Ray Wave. Cost per head ranged from S$2,800 to S$3,500. But because overheads and cost of acquisition were so high, I normally lost a little money on the events.

The loss didn’t worry me; but what did cause concern was the fact that I did not achieve my outcome: the seminar made little difference to most of the attendees. So, they not only wasted my time, they wasted their time and their tuition fees.

So I went back to the drawing board and designed a 2-day course that focused on a quantitative journal keeping approach to identify the impulse trades; a simple position sizing approach and a plan based on Cutler’s use of the RSI – I did make a tweak here and there. Back-testing shows the plan will make a profit of around 10% to 12% with low drawdowns.

The outcome I want from the seminar is to teach the attendees to execute consistently their plan with proper position sizing. Once they attain this, they can expand their knowledge and improve their plan.

Since previously I had lost around S$5k per event, I planned my budget around that and came up with a fee of S$400.00 per attendee. If no one attended, my maximum loss was S$4000.00. All in all, a win-win situation: in my worst-case scenario, I’d lose less and the attendees had an inexpensive leg-in to success.

The trial seminar last year went well – around 63% of the trial class is making a small but consistent return. They are now ready to move on and expand their knowledge of the markets.

This year we launched the seminar at ATIC and I succeeded in niggling everyone around me:

  1. Understandably, I niggled my friends and fellow educators who were promoting their own S$3K seminars.
  2. I also niggled my wife and Ana Wang who work tirelessly on my behalf – they feel that the I am ‘selling’ my services too cheaply.
  3. But surprisingly, I niggled some ATIC attendees who were overheard to remark: ‘so cheap, must be no good!” And “Why does he think he is so good?”

The point is: unless you have a firm idea of the outcome you want, it would be difficult to maintain a sense of purpose. In this case to provide the attendees with a solid platform for future success preferably, at no financial cost to me. Whatever others may think of the idea, this is the vision I have.

What does this have to do with trading?

You need to know why you trade – this is part of the Vision and Goal aspects of the trading plan. And when setting the Vision, it’s not enough to quantify the dollars you want out of trading. Another Dr. George Lianos quip: ‘money is never just about money; sex is never just about sex”. What he meant was we need to look beyond the obvious: what does the dollar return mean to you?

Security, love, appreciation? And so the list continues.

By identifying the emotional premise for trading, we are on our way to identify what Denise Shull calls ‘the echoes of perception’ – the unconscious motivations formed in our youth that govern our lives today. By forming a well-formed outcome, we achieve two things:

  1. A standard by which to measure our behaviour and
  2. By understanding the underlying reasons for our outcomes, we ensure that they align with our values and in the process discover, and thus manage, our unconscious motivations. By uncovering them, we find that consistent execution of our plan becomes more a habit than a chore.

Market Profile Conclusion

Tonight I am concluding the Market Profile series.

This is a little late because I wanted to show a real-time analysis of the ES. 

Figure 1 sets 5-d (weekly) trend context. We are in a possible sideway market marked by A-B-C?. The A-B-C is taking place in the 18-d Primary Buy Zone, 1396 to 1370, basis cash (now an area of resistance).

 02-29-2008-5-d.jpg

FIGURE 1 5-d

Figure 2 shows the current Market Profile. At the end of the Initial Balance (‘C’ period), we know:

  1. The market gapped open below Value.
  2. It failed to cover at least 50% of the gap by the first 90 mins.

Both (1) and (2) suggest a trend day. To fit the trend picture, we needed to see smaller than normal Initial Balance. Instead we have a test opening and an Initial Balance of 80% of  the Normal Day’s range. This suggests a rotational day. In these condtions, the best fit Day Type is a Normal Day featuring a late in the day range extension to complete the Normal Range (about 20 to 25 points).

With the high being 1355, the low of the day can be expected around 1335 to 1330. Figure 2 also shows the possible entry zone at the point of inflection at 1351 to 1352,

 02-29-2008-es-day-type.jpg

FIGURE 2 Day Type

Figure 3 shows the Composite Profile since the low on Jan 23 2008. The last line of support is 1325 to 1330; so for today, we have some confluence of support 1325 to 1335. If I were day trading, and short from 1351, I’d seek to exit at 1331.75.

 02-29-2008-es-composite.jpg

FIGURE 3 Composite Profile from 1270 Low

Remember I’ll use the inflexion point (see Figure 1) at 1351 to 1352 for entry. Now for the stop: Figure 4 helps me identify its location.

 02-29-2008-es-composite-2.jpg

FIGURE 4 Composite Profile from Feb 28

There are two possible resistance areas:

  1. The 50% gap of the open: 1360 and
  2. The 50% of the IPM that started at the ‘L’ Period Feb 28. This comes in at 1358.

I’d place my stops for tonight at 1362.75 for the sales at 1351 to 1352. With an profit exit at around 1332, entry at 1351 and my stop at 1362.75, I have an acceptable reward:risk of around 2:1.

Hope you found the series interesting!

Normal Range in the Market Profile

Today I’ll be covering the idea of Normal Range. Derrick raised this on February 27 and it is a topic not understood by many. Indeed, many authors on the Profile take the view that: ‘Day Type cannot predict in advance and is only of marginal use in real time” (Tom Alexander’s ‘Practical Trading Applications of Market Profile’).

It is my view that this one is one of the best of Pete Steidlmayer’s contributions to trading. Understanding, no later than the completion of the Initial Balance, whether a day profile is likely to be rotational or 1-timeframe, has a major impact on the strategy I shall employ for the day. I covered this in the “Power of the Market Profile”. Keys to being able to doing this are:

  1. The type of opening,
  2. It’s location relative to the previous day’s Value Area,
  3. The Normal Range of the Initial Balance

(1) and (2) are covered in Mind Over Markets (Chapter 4, section 1). Let’s turn to the “Normal Range”.

Peter classified the Day type into 6 types: two were 1-timeframe and 4 were rotational. The 4 rotational days depended on the idea of the ‘day’s normal range’ for classification. Now here’s the problem – we don’t know what the day’s range will be until after the end of the day. So of what use is it?

Most newbies to Market Profile trading fell at this point and concluded that Day Type was not useful to trading.

I saw Peter work with this idea and knew he made successful trades with it. It finally dawned on me that part of Peter’s unconscious knowledge was an idea of how large a Normal Day’s range was. Armed with that, I classified two types of statistics:

  • The ATR and normal range of an instrument; and
  • The average Initial Balances and average 30-minute ranges for the last two hours of trading

Armed with this information and knowing the Day types allows me to ‘guess’ if a day is likely to be rotational or 1-timeframe and provides another means of estimating the day’s range.

Let me give you an example.

 02-28-2008-sp-day-4.jpg

FIGURE 1 Market Profile 

I have divided yesterday’s Profile into 3 stages. The first section covers the “A” to ‘D” period.

The market gapped down and opened below the previous day’s value area. At the open we knew:

  1. If the market remained below value, then a 1-timeframe day was probable.
  2. If it returned to value, the probabilities favoured a rotational day.
  3. If the market failed to accept above 50% of the gap in the 1st hour, we could expect a trend day on breach of the 1st hour’s range.
  4. If the market accepted above the 50% or closed the gap, we could expect a rotational day.

At the end of the “C” period, we added to our information:

  • Based on the above, the probability was for a rotational day.
  • We had a test opening and a probable Normal Variation Day. The Initial Balance was about half of the ATR range.
  • The test opening favoured a range extension to the upside and the Normal Variation Day suggested a double of the Initial Balance projecting a high of 1388.5 (roughly a double top with Feb 26).

So without looking at context by the end of the ‘D’ period, I had a possible price for the top and I knew that I’d be a buyer below Value or at least the lower end of value: 1374 to 1372.5 Context provided 1393 to 1388 as a target for the high for the day.

Whether you are a day trader or position trader seeking to optimise your entry, the Market Profile in general and the Type of Day (including type of open), provides immense value.

The Power of the Market Profile

Today I want to show you the power of the Market Profile. It adds a dimension to my trading that would not otherwise be available. This is especially so when the market is in congestion and/or in a transitional phase.

In Figure 1 we have a candlestick daily chart of the cash S&P.

The chart provides a lot of information.

  • The 18d is in a confirmed downtrend. In the jargon of the Nature of Trends, we have an Upthrust Change in Trend pattern, with confirmed time and price filters (WPC, LCC and acceptance below the Maximum Extension).
  • The market formed a possible sideways market with “2 Extreme Rejection Pattern”: A rejection of the 1270 low was followed by a rejection of the 1369 high. The market then formed a value area.

02-26-2008-blog-2.jpg

FIGURE 1 S&P Daily

Since the Profile works off futures data, let’s turn to the ESH8

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FIGURE 2 ESH8 Daily

The ES formed the Value Area and on completion gave a ‘failed mid-point break’ buy signal to then move above the top of value. What ought to have occurred was a move to the 1269 to 1270 Primary Buy Zone rather than a break above 1368 (based on the retracement areas).

On last night’s price action, we could say that:

  • There is MIDAS resistance (FIGURE 1).
  • But apart from that, the market looks strong. Last night’s range was not much below the previous two days (24 to 29) and the candlestick showed bullish conviction.

What does the profile tell us? Figure 3 is a composite profile since the 1269 low.

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FIGURE 3 Composite Market Profile

  1. Once the market crossed above 1363.50 (Market Profile top of Value – Blue Vertical Line to right of composite), we could expect the market to move to the Primary Sell Zone ‘1395 to 1390’. Given that we had negative development by moving above value rather than below value, we should see a break above 1395. HOWEVER, if the market is in the grips of the bear, we should see the upside breakout above 1395 hold below the Maximum Extension (1418 basis March 08).
  2. This break above value was a sign of strength that was in conflict with a bearish view of the market. We need to assess this in any analysis.

Last night I was long from 1350.75 and looking for a break above 1395 to exit. The market got to 1388 and backed off.

Let’s turn to yesterday’s day profile to see what that tells us.

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FIGURE 4 Market Profile 30-minutes

A few points to notice:

  1. We see that in the third 30-minute bar (‘C’), the market started an IPM and formed a bull pattern. If we join ‘A’ and ‘B’ to ‘C’, yesterday was a double distribution trend day. Trend days ought to finish in the top 25% of their range. Instead the market closed below the Point of Control.
  2. In addition, notice that there was no volume between 1386.5 and 1388.5.
  3. Added to this we have MIDAS resistance coming through and you have a possible top. All these are signs of weakness.

Given those factors, I exited longs and I am looking tonight to see if:

  • Selling comes in and if it does,
  • The quality of that selling. I define good, quality selling by looking at the average selling Delta volume and its standard deviation. Market Delta does colour code the buy/sell Delta volume but I prefer to keep my own statistics. I also keep the total volume per 30 minutes so I can form an idea if the buying/selling volume is taking place within the context of healthy/normal/unhealthy total volume.

It’s impossible to show the ideas in a blog; but I find that by having a context and knowing:

  • The type of opening,
  • It’s location relative to the previous day’s Value Area
  • The Normal Range of the Initial Balance

I can determine most times if we’ll have a rotational or a one-timeframe day.

Based on this analysis, I formulate the entry strategy.

  • In a rotational strategy, I look to sell above the Value Area and buy below it; I look to sell new highs and buy new lows. This means I let the market come to me – patience is the key.
  • In a one-time frame market, I sell new lows, buy new highs. Here, impatience is the key – I act swiftly on any volume break.

That’s it folks.  I hope I was able to at least arouse your curiosity in the Market Profile.