TraderFeed: Market Profile: A Best Practice in Trading

Monday, February 12, 2007

Market Profile: A Best Practice in Trading

My recent posts have emphasized the importance of tracking the large traders in the market you're trading. Such tracking will help you identify when we are making breakout moves and when we are trading within bracketed ranges.

Market Profile is a tool for organizing time and price data, graphically representing how volume builds at various prices over time. When we see most trades occurring within a relatively narrow range of prices, we know that the market is in balance. Price will probe the edges of this balance area--called the value area--as markets constantly update their estimates of value. If prices higher or lower than value cannot facilitate trade (i.e., if higher prices don't attract buyers or lower prices don't attract sellers), we will tend to trade back into the value area. If these probes to the edges of the value region do facilitate expanded trade, we will break free of the value area in a trending move. That trend will continue until sufficient sellers or buyers perceive value in the new prices and take the other side of the trade, beginning the process of forming a new region of balance.

My specific best practice is to be aware of value areas at one level larger than the timeframe you are trading. Very often, a breakout at a shorter time frame occurs within the context of a longer-term market bracket. Knowing where value is located on the longer timeframe helps you identify price targets for the shorter-term move.

An excellent resource for understanding the dynamics of Market Profile at multiple timeframes is the new book Markets in Profile: Profiting from the Auction Process by James Dalton, Robert Dalton, and Eric Jones. It is not a lengthy book, but it is packed with trading principles and clear examples of how the Market Profile is relevant at various timeframes: from the daytrader to the longer-term investor. Dalton and colleagues explain how markets transition from brackets to trends and, more importantly, they help traders understand why. One of my favorite features is the graphics that help you see balance areas on bar charts. It enables you to see the market in profile even if you're not looking at a Market Profile.

If you are just getting started in the area of Market Profile, the authors' earlier book, Mind Over Markets, is a classic and a great introduction to understanding market auctions. You can also find excellent reading resources on Market Profile on the WINdoTRADEr website. WINdoTRADEr is a charting application that enables traders to see Market Profiles at different time frames simultaneously; the firm also offers hands-on training in the use of Market Profile and the software. It's a brilliantly designed piece of software (which, by the way, has benefited from input from Jim Dalton).

What makes Market Profile a best practice in my book is that it provides new and experienced traders with a way of thinking about market action and framing their trade ideas. If I were running a training program for traders, Market Profile would be a mandatory part of the curriculum. It's important to know, not just *what* to do, but *why* to do it.