What is Market Profile? How to Read and Use It Correctly?
What is the Market Profile? Market Profile is a technical analysis tool that combines price and volume information to create a unique price chart. The chart shows the volume of trading that occurs at all the price levels of a financial security trades during the day. It was created by J. Peter Steidlmayer, an independent floor trader of commodity futures at the Chicago Board of Trade (CBOT) and a former CBOT Board of Directors member.
While Market Profile data can be useful for trading across any timeframe, it was originally developed for intraday trading. Steidlmayer’s original Market Profile charts were 30-minute charts. The visual representation on a Market Profile chart serves as a tool. It helps day traders or intraday swing traders identify support and resistance levels and select market entry and exit price levels.
Commodity trading was originally the sole province of Market Profile charts. However, as more and more traders saw the usefulness of Market Profile data and using a Market Profile chart, Profile trading began to spring up in other financial markets. For example, the stock market, the bond market, and forex trading.
As with many technical analysis tools originally developed for commodity trading, Market Profile charts quickly favored forex traders. In addition, with the increasing popularity of day trading in the 1990s, many stock traders began to complain if their brokerage firm didn’t provide access to Market Profile data.
What the Market Profile Shows
Pinning down a precise definition of exactly what the Market Profile is has proved a bit challenging. The book “Mind Over Markets” by Jones and Probus Dalton defined it as follows: “The market’s price activity recorded in relation to time in a statistical bell curve.”
The Market Profile bell curve is a histogram that’s created by plotting volume on a horizontal axis. Each Market Profile point represents a certain amount of trading volume by indicating the amount of time the market traded at that price. The blocks of time are typically designated with either letters or colors and are known as a “time price opportunity” (TPO).
The Advantage of Market Profile
The key advantage Market Profile data offers over traditional technical analysis or candlestick charts is its representation of market-generated information – especially the way how it incorporates volume data with price data. Rather than just presenting a total trading volume number, it shows how much trading occurred at each price level.
Essentially, the Market Profile shows “value areas” – price levels where the highest trading volume occurs. The higher volume reveals the price level(s) that the largest number of traders currently perceive to be the fair market value of a security in the ongoing two-way auction process between buyers and sellers.
The price level that has the highest volume of trading is referred to as the “point of control” (POC) – so called because it’s considered the price that held control of the day’s trading. Lower volume at other price levels indicates collective trader rejection of those price levels as “fair value.”
Continued trading naturally moves price back toward Steidlmayer’s Market Profile “value area.” The value usually contains about 70% of the day’s trading action and is within one standard deviation from the POC.
The underlying principle of the Market Profile is this idea of volume-indicated “fair value.” Thus, prices above or below the high-volume fair value price are considered “unfair” prices (i.e., not accurate reflections of the traded security’s true intrinsic value).
The Market Profile in Action
In the Market Profile chart of one day’s price action, shown below, note the following:
- The point of control is the price level designated with the longest list of letters – representing the fact that the market traded at that price level for more time periods than it traded at any other price.
- The “value area” – bounded by the value area high and value area low – contains the price range within one standard deviation from the POC.
- Both the high and low extremes of the trading range are interpreted as “unfair” price levels, indicated by the fact that the market traded at each extreme for only one time period, creating only a single time price opportunity.
The following image shows Market Profile charts of several days’ trading. Over this longer timeframe, the use of Market Profile charts shows a clear, strong uptrend, as the market establishes a new fair value level at successively higher prices:
Finally, the Market Profile charts of several days’ price action shown below reflect a trendless or ranging market, as the fair value price level rises one day, only to fall back the next day.
You can also use your charting and trading software to show the point of control starting at a specific date. Now the system cumulates the trading volume over the whole period instead of showing the daily point of control. Below is an example of Apple based on a daily chart with its point of control automatically plotted at $146.55.
How Profile Traders Trade the Market Profile Fair Price
The basic trading strategy employed by most traders using the Market Profile is a simple strategy. It is much like the two-step basic approach of value investing (no surprise, since Steidlmayer was an admitted fan of Ben Graham’s theories and teachings on value investing):
1. Identify Fair Value
Identify the stock price that most accurately reflects a company’s genuine intrinsic value – the point of control on Market Profile charts.
2. Buy Low, Sell High
Having identified the “fair value” price, look to buy at a lower price and/or sell at a price higher than the fair value price. Market Profile charts also clearly delineate support and resistance. Those areas where high volume trading has occurred that has stopped price from falling lower or advancing higher.
Traders can look to establish new market positions at these levels. They are buying at a support level or selling short at resistance levels – placing initial stop-loss orders a little beyond the support/resistance price level.
Initial Balance, Trends, and Non-Trends in the Financial Markets
Steidlmayer noted that a traded security typically makes a significant price move up or down from the previous day’s close in the first hour of trading. By the end of the hour, the market has usually encountered a level of support (if the opening move is to the downside) or resistance (opening action drives price higher) that stops the market from advancing further in its initial direction.
At that point, the price begins to settle somewhere in the opening hour’s trading range. That is, there is significantly more trading volume at some price level in the trading range. This first point of control established by opening market activity is Steidlmayer’s “initial balance.”
Where this first market price balance point forms is often a clue to the rest of the day’s trading action. For example, assume a stock closed the previous day at $45.
It opens the next day at the same price, quickly moves higher. There is relatively little trading at $46, $47, and $48 – then the initial balance forms around $49-$50, where the bulk of the first hour’s trading occurs. Several implications can be drawn from this initial price action:
- There is, at least initially, significant buying pressure in the market – thus, traders may expect that an uptrend day is more likely than a downtrend day
- However, as the price was stopped from advancing above the $49-$50 price level, that appears as an area of price resistance – it may continue to hold the price down, but if price later breaks above $50, then that is a sign of an extending uptrend, in which the $49-$50 level will now be seen as a level of support
Now, consider an alternative scenario where the first hour of trading sees price quickly advance to $50, but then quickly fall back to around $45, and trade between $44 and $46 for most of the hour. The implication here is that the attempt to push the price higher has failed. Therefore, the most likely future results for the rest of the trading day are either:
- A non-trend day where price just ranges back and forth, further confirming the $44-$46 price level as fair value – a price attractive to large numbers of both buyers and sellers, or
- A downtrend day if price subsequently falls below $44 and finds fair value at a lower price.
Hopefully, this article has helped you understand the theory and basic concepts behind Market Profile charts and Profile trading. Market Profiles can be used as a standalone trading system or employed to supplement an existing trading system. However, mastering the use of Market Profile takes quite some time and study.
Suppose you’re thinking of making the Market Profile an integral part of your trading strategy. In that case, it’s worth picking up a book on the subject that can provide you with much more in-depth information. One to definitely consider is “Steidlmayer on Markets: Trading with Market Profile,” by J. Peter Steidlmayer and Steven B. Hawkins.
See Also: Trading Edge: 7 Steps to Success