In “Negative development As A Setup”, I attached the chart in Figure 1.
FIGURE 1 S&P Zones in a Sideways Market
I have been asked to explain how I use them and how they are calculated. So here it is.
Zones 1,2, and 3 in Figure 1 represent 1st, 2nd and 3rd standard deviations of the boundaries of congestion, using Market Profile TPOs. For a full description of the process, go: http://www.cbot.com/cbot/pub/page/0,3181,1184,00.html where you can download the CBOT Market Profile Manual.
For those that would prefer a quick and dirty calculation: Take the range of the boundaries of congestion and divide it by 8. The sell zone (Primary Sell Zone) is “High -1/8 Range”; the buy zone (Primary Buy Zone) is “Low + 1/8 Range”. These zones represent the 3rd standard deviations.
The 1st standard deviation is represented by the 33% and 67% retracement levels of the boundaries of congestion. The 50% retracement corresponds to the Profile’s Point of Control.
Note that the retracement levels are approximations only of the statistical zones. But they are close enough approximations to use.
So that’s the way I calculate the zones – the full method as well as the ‘shortcut’.
Let’s turn to the way I use the zones.
I use the Primary Buy and Primary Sell Zones as areas where I initiate and liquidate positions. I also use the zones to tell me if:
- The sideways market are likely to be coming to an end; and
- I use them to manage a trade.
Let’s take point (1).
The Primary Sell and Primary Buy Zones are rejection areas. If a sideways market is to continue, we should not see buying conviction bars in the Primary Sell Zone (High -1/8 R) and selling conviction bars in the Primary Buy Zones. If we see two consecutive conviction buying closes in the Primary Sell Zone, we have a clue that the Primary Sell Zone will give way. You reverse the process for the Primary Buy Zone.
An example of point (2):
Let’s assume the market comes off the Primary Buy Zone (Low + 1/8R). The market then has two consecutive closes above opposing 1st standard deviation (in Figure 1, Zone 1 High, 1513.60). If the market now closes below the Zone 1 Low (Figure 1, 1427.60) without first entering the Primary Sell Zone, we can expect the boundary of congestion low to give way.
This is the great thing about the Market Profile: it’s full of these little gems that help a trader manage his trades.