V.6.1 Market Profile Part 2

Stocks & Commodities V. 6:1 (34-36): Market Profile Part 2 by Thomas P. Drinka, Ph.D. and Robert L. McNutt

Market Profile

Part 2 by Thomas P. Drinka, Ph.D. and Robert L. McNutt

The market is composed of time, price and volume. Each day, the market—in attempting to facilitate

trade—develops a price range delineated by the daily high and low and a Value Area where most of the prices congregate. Volume is generated by the interaction of time and price.

A "brief time/price relationship" is established when price does not remain in a particular range for a long time period. In this case, the market does not accept a particular price or price area and moves away from it.

An "extended time/price relationship" is established when price remains in a range for a long period of time during the trading day. In this case, the market accepts a particular price or price area and establishes value by trading within that area.

The fundamental approach to trading is predicated on the notion that—under the prevailing market conditions—the current price can diverge from market value. This divergence creates market opportunity. The key is knowing when current market price diverges from value and being able to judge whether price will move to value or value to price. The Chicago Board of Trade Market Profile identifies the Value Area within a day's range and allows a trader to take advantage of a divergence of price and value.

Usually, the Value Area is established as the market uses price probes which move, alternately, too high and too low in order to create Time/Price Opportunities or TPOs that seek the trading activity of market participants. These price probes have an impact on the quantity supplied and demanded: As price moves up, the quantity supplied is stimulated and the quantity demanded is dampened. As price moves down, the quantity supplied is dampened and the quantity demanded is stimulated. In this fashion, price consolidation is promoted and a Value Area is established within which most trades occur.

Figure 1 is the Market Profile of CBOT December 1987 corn futures for May 28, 1987. A 30-minute bar chart also is shown. The pioneer range—1924 to 1952—is highlighted by the single vertical line. With the exception of stock index futures, the pioneer range is the price range established by the first two half-hour time periods. (Due to the length of the trading session, the pioneer range of stock index futures may be established by the first five or six consecutive time periods.) The day's open and last tick are designated by triangles adjacent to 1942 and 1910. The third triangle—between 1924 and 1926—designates the middle of the day's price range.

By definition, approximately 70% of the day's trades occur in the Value Area. To determine the Value Area of May 28, the highest-volume price of 1926 is noted in Figure 2. The contract volume of the adjacent ticks above and below this price are compared. A higher volume is added to the volume of 1926. This procedure is continued with successive adjacent ticks, until a minimum of 70% of total daily volume is reached.

The Value Area in Figure 2 is represented by the double vertical line ranging from the low price of 1920

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FIGURE 1

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FIGURE 2


to the high of 1950. Similarly, the double vertical line ranging from 1920 to 1932 represents the Value Area of the previous trading day.

An evenly balanced TPO count suggests there is, indeed, no willingness to accept a di vergent price.

Customer trade indicatorCBOT stratifies market participants into four categories designated by the "customer trade indicator" (CTI). Two categories of traders generally participate in the market each day: CTI1 designates local floor traders and CTI2 designates commercial clearing members. Each of these market participants has a unique motivation, trading objective and trading style.

Local traders tend to trade with the market; that is, they tend to buy strength and sell weakness. They are day-time-frame traders who seek a "fair price"—that is, they operate to buy the bid price or to sell the asking price—and, thereby, provide the liquidity that services the market.

Commercial clearing members are other-time-frame traders who seek an "advantageous position"—that is, they operate to buy at the low end of the price range or to sell at the high end of the price range. Thus, their response to price-probes tends to provide support at low prices and resistance at high prices. Although they may not initially intend to conduct business in a specific trading session, they may assume a market position because of an attractive TPO.

There are two additional CTI codes. CTI3 designates clearing members who fill orders for other members and non-clearing commercial traders. CTI4 designates clearing members who fill orders for the public or any other type of customer.

At CBOT, the combined trades of CTI 1 and CTI2 (local and commercial market participants) generally account for 65% to 75% of daily trading volume. Because of their motivation, trading objectives and trading styles, these market participants have only a slight impact on price direction and change. The combined trades of CTI3 and CTI4, referred to as the "residual volume," account for the remaining 25% to 35% of daily trading. Since their objectives and trading styles are similar, their combined market impact can be substantial when their trading volume is high. As a rule at CBOT, the market has the potential to trend when the residual volume is on the high side of the 25%-35% volume range.

We use Commodity Quote-Graphics' System One to prepare CBOT Market Profiles. At the time of this writing, System One displays the CTI2 percentage of daily trading volume in the Value Area after the trading session. In Figure 2, the volume of trade in the Value Area was 41,985 contracts. CTI2 volume was 8.40% of that amount.

Time/Price Opportunity countIn the first article of this series, we noted that observing the behavior of market participants makes it possible to interpret market conditions; for example, to judge the profit potential of buying strength or selling weakness. One aspect of market condition involves the willingness of market participants to buy a higher price or sell a lower price. This willingness can be judged by the "TPO count"—the dispersion of volume above and below the highest-volume price in the Value Area.

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The highest-volume price is the price in the Value Area that trades in the most half-hour time periods. In Figure 2, CZ7 traded at 1926 during the "D," "F," "G," "H" and "I" time periods. (Note that if more than one price traded in the same number of half-hour time periods, the one nearest to the middle of the day's price range is the highest-volume price.)

There were 25 TPOs above 1926 and 17 below, and there is a high probability the market will trend whenever such an imbalance develops in the Value Area. Therefore, it is important to watch for any small incremental change in the Value Area, because this change can indicate the willingness of traders to buy or sell at a higher or lower price. An experienced pit trader has an intuitive feel for the willingness of market participants to accept higher or lower prices in the Value Area.

An evenly balanced TPO count suggests there is no willingness to accept a divergent price. An imbalanced TPO count in the Value Area below the highest volume price (as seen in Figure 2) indicates a propensity to accept a divergent price below this level if price were to probe there. That is, market participants have exhibited a greater willingness to sell than to buy and may be willing to sell at a lower price. An imbalanced TPO count in the Value Area above the highest-volume price suggests a willingness to accept a divergent price above the highest-volume price.

This analysis of volume dispersion is applicable only to consolidation areas, that is, only to normal profile days, and the analysis is difficult if the highest-volume price occurs at the extreme of a Value Area.

Thomas Drinka is an associate professor and Robert McNutt is a research assistant in the Department of Agriculture at Western Illinois University in Macomb, (309) 298-1179. Western Illinois University is the first university to teach the CBOT Market Profile and Liquidity Data Bank as part of its curriculum.

The authors wish to thank the Chicago Board of Trade and the Chicago Mercantile Exchange, which waived exchange fees associated with this price quotation service, the Market Logic School for reviewing this article, and Commodity Quote-Graphics for their review of this article and for the System One donated to the WIU Department of Agriculture.

"It's the final step in our tax simplification plan. The Government simply takes what it needs."

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ReferencesChicago Board of Trade, CBOT Market Profile, 1984.Market Logic Schools, Transcript of Educational Program II, Chicago, IL, May 9-12, 1987.Steidlmayer, J. Peter and Shera Buyer, Taking The Data Forward , Market Logic, Inc., Chicago, IL, 1986.Steidlmayer, J. Peter and Kevin Koy, Markets & Market Logic, The Porcupine Press, Chicago, IL, 1986.

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V.6.1 Market Profile Part 2