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What does "Market Profile" say about the present market environment? Does it provide something that other methodologies do not, and if so, what?
First let's discuss the present environment and what is different about it from other panics, what may be similar and if there is an objective way to analyze what is happening and to potentially benefit from it.
Auction market principles have as primary tenets that freely traded markets determine value through the actions of those involved in the market place – the buyers and sellers themselves determine what is fair value and what is not fair value. When a market has determined what value is, and what it is not, it will trade in a range in a relatively orderly fashion between the unfair high price and the unfair low price until the perception of value changes. When the perception of value changes the market will trend and will be dominated by either the buyer in an uptrend or the seller in a downtrend. Eventually there will evolve a closer agreement as to value and a range will establish that begins the process again. It is the inability of a market to determine value that "causes" it to trend.
So, exactly what is at play here? It is an auction market at work. The "rules" of auction market principles have not been suspended, and are clearly working normally. While the fundamental cause of the present market crisis is different than any since at least the late 1920's well into the 1930's, the Market Development and Market Structure principles of how an auction market develops are working now just as they did on the 1920's and 1930's.
We appear to be in a period of tremendous political and social change and the eventual outcome of that process of change is anyone's guess, but as long as there is something resembling a freely traded auction market the tenets of how an auction market functions are not going to be suspended.
My job as a trader is not to worry about things I cannot control and to focus on things that I can and to go about my business. There is nothing that has happened that suggests the model on which I base my trading is not working or has dramatically changed. As a matter of fact, recent trading is an incredibly affirming example of how robust auction market principles are.
How many times have you heard over the past several months that this or that market cannot determine what value is, or is not? Whether it is the value of a portfolio of CDOs or some other exotic product of financial alchemy, or the S&P 500 being "valued", that market is going to continue to search and probe and volatility and range will be historically outsized until the market is satisfied with what may be value. BUT, in all markets in which there is transparency and open trade the same principles – and opportunities, will be present as they were last year, the year before, etc. As a corollary, until some of the "toxic" assets are fully exposed to a market where value can be determined they will have an effect on the larger markets involved.
Below are charts of the Dow in the 1920's and 1930's as well as other periods in our history of tremendous change, uncertainty and market volatility. Is it different this time? You be the judge.
The charts below are quarterly profiles with each "rotation" signifying one week in time.
DJIA July 1928 – July 1930
This period includes the run up into the final high subsequent to the 1929 October stock market crash.
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DJIA July 1929 – Sept 1931
This period includes the October stock market crash in 1929 and subsequent several quarters.
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DJIA October 1931 – October 1933
This is the view at the ultimate lows of the stock market that occurred coincident with the nadir of the Great Depression. Incidentally, if you look closely at the price scale of the Dow at the low on the graph it reads "396". That is 39.60 as in thirty-nine and change. It represented over a 90% drop from the high of 1929.
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DJIA January 1933 – January 1935
This period was the beginning of the period of recovery coming out of the depression.
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DJIA October 1939 – January 1941
This period included the bombing of Pearl Harbor and the beginning of US involvement in WWII.
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DJIA October 1973 – January 1976
This period includes the severe economic recession of the 1970's and the low in the stock market of that period.
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DJIA January 1987 – April 1989
This period includes the run up in to the summer highs in 1987, the subsequent crash in October and the following several quarters into April of 1989.
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Summary
Just a cursory visual review of the quarterly profile graphs reveal it is crystal clear that auction market principles were at work in the markets of the late 1920's through the markets of the Great Depression, during the early stages of the United States involvement in WWII, in the severe economic contraction in the 1970's and before, during and after the 1987 market crash.
Understanding Market Development and Market Structure through the lens of auction market principles provides a roadmap that is robust across all markets and in all degrees of time. This is a time of tremendous opportunity for anyone that understands these concepts.
Fundamentally, socially and politically it is certainly different than any "crisis" since the Great Depression and its kickoff by the stock market crash in 1929. It is NOT different this time from the perspective of auction market development.
The huge benefit to those basing their trading on the model of auction market principles is its robustness in all market conditions and all timeframes. This is a methodology unique in its incredibly robust principles, and those principles, if thoroughly understood and placed in the context of an appropriate trade plan involving viable strategies and tactics can offer a trader or investor the opportunity to profit greatly from the present market conditions.
Back to the Present:
Let's look at the quarterly profiles of the four primary trading indices (cash contracts) and see if we can find anything useful.
S&P
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Dow
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Naz
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Russell 2000
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Here is the objective information we can discern from the quarterly profile units of the four indices:
- The trend is down. We can clearly see value migrating lower.
- The Russell and Nasdaq broke to the downside out of substantial intermediate term Balance Areas.
- It is a little early in this particular time frame to draw firm conclusions about which of the four steps of development is dominate at the moment.
- It is obvious from a Market Development and Market Structure perspective there is nothing unique about this period – this is important.
Profile Analysis – S&P Daily
High Volume Nodes represent the area of greatest Value in a given profile unit. The migration of value is a consistent way of quickly determining the trend of any market. Value has been migrating lower in the US (and worldwide) indices since the fall of 2007. The initial signal a long-term low may be in place is when the most recent volume node on the daily profile chart is exceeded.
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Profile Analysis – Dow Daily
The Dow and the S&P are very highly correlated and almost always form even minor highs and lows practically simultaneously.
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Profile Analysis – Nasdaq 100 Daily
The Naz is showing a lot of relative strength and has closed in a very important Key Reference Area, the High Volume Node of the November-February composite profile. High Volume Nodes tend to slow strong trends so the next week or so will be interesting to watch in the Naz. Even if an important low is in place, the Naz has reached an area in which it is likely to trade in a range for several days and/or experience some retracement of the recent rally. If it does not, it is a very bullish signal.
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Profile Analysis – Russell 2000 Daily
I have always used the Russ 2000 as the "tell" for the larger market of stocks. It is broader, deeper and more difficult to manipulate that the other indices.
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Because auction market principles provide such a robust perspective on market behavior any time frame can be analyzed in the manner described above. We will discuss this in future articles here in Trader Kingdom.
Glossary
Balance, Balance Area (BA): Synonymous with Horizontal Development (see below). Horizontal Development is one of the two primary phases of Market Development
Buying Tail: Two or more Single Prints at the low extreme of a day's range. A Key Reference Area
Fair Value: A general consensus between buyer and seller as to fairness of Value. It is an area that is not too high for the buyer and not too low for the seller. The majority of transactions and volume typically occur in the Fair Value area of a given profile unit.
High Volume Node (HVN): The smallest area of a profile unit containing the most amount of volume. There can be multiple HVNs in any given profile unit. It is a Key Reference Area.
Horizontal Development: One of the two primary phases of Market Development and the one in which the market spends the most time trading, in all degrees of time. It is synonymous with Balance and consolidation.
Initial Balance Period: Generally considered to be the first two half-hour periods of a day trading day, assuming a market is a market-place dominated market and not a market dominated market. The US stock indices are an example of a market place dominated market. Trading in the US stock indices is dominated by the US exchanges day sessions hours. FX trading is an example of a market driven market. It is truly a 24-hour market not defined by the limitations of market place time constrictions.
Key Reference Area(s) (KRA): A KRA can be a single element that comprises all profile units – high and low extremes, POC or HVN, VA and VA extremes, or it can be a coincidence of one or more of those elements in a relatively tight zone. The coincidence of KRAs in a zone typically represent the best place to initiate trades
Market Development: The basis of what we refer to as "Market Development" is Auction Market Value Theory© (AMVT). Market Profile® is the graphical representation of AMVT. The gist of Auction Market Theory is that all free markets exist for the purpose of facilitating trade and that market participants - buyer and sellers, identify value, or lack thereof, by their actions. An auction is a price discovery process between buyers and sellers. Bids and offers are made between buyers and sellers until they reach an agreement on price. Prices that are too low will not have many sellers (offers) and prices that are two high will not have many buyers (bids). If prices are too low or high they are generally "unfair" to the buyer or seller and will not do a good job of facilitating trade. Price will gravitate to the area in which there is the greatest agreement on price. Market Profile graphically displays this process. The area of greatest value is that area where trade most easily occurs between buyers and sellers. This is usually where the greatest volume will be and where a market spends the most time trading. Where and how much buyers and sellers trade defines the present state of market development.
The equation that represents the above is: Time over Price = Value
The primary tenet of Auction Market Theory is one of value; markets constantly rotate between two cycles, or phases of Market Development, either Horizontal Development or Vertical development, or Balance and Imbalance. A market in Horizontal Development is one in which there is general agreement among buyers and sellers as to fair value. A market in Vertical Development is a market in search of value. The Market Profile graphic visually displays both forms of this development. Everything about Market Development is quite logical. The various threads that weave together to form the larger concept of Market Development are logical, consistent and simply "make sense".
Market Profile®: The graphical display of Market Development based on Auction Market Theory
Market Structure: Market Structure are the pieces of the market development puzzle. Market Structure includes each individual day's profile, the components of that profile that include the Value Area and Point of Control, the potential Day Type that is being formed, etc.
Selling Tail: Two or more single prints at the high extreme of a day's range. A Key Reference Area
Single Prints: An area in a profile containing only one TPO. A Key Reference Area.
Value: Agreement on buyer and seller to conduct business at a price resulting in a transaction.
Value Area (VA): The smallest area of a profile unit containing 70% of the volume.
Value Area High (VAH): The upper extreme of the Value Area
Value Area Low (VAL): The lower extreme of the Value Area
Vertical Development: One of the two primary phases of Market Development and the one in which the market spends the least amount of time trading, but is responsible for the greatest magnitude of net price change. It is synonymous with Imbalance and trend.
Rotation: The primary "personality" of the market. All freely traded markets "rotate" in the price discovery process of identifying Value. Markets are dominated by the behavior and characteristics of rotation in all degrees of time.
Unfair Value ("unfair" prices): An area where prices are considered too high by the buyer and too low by the seller. These are low volume areas and are quickly rejected. Price spends the least amount of time trading in an "unfair" area.
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