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I'd like to comment on market profiles, price distributions and their
utility in practical trading situations.
The Market Profile was invented by Pete Steidlmayer (a very
successful trader on the CBOT) in the early 1980's. Steidlmayer told
me once that when he first got started trading (in the late 60's) he
learned to evaluate the market's condition in terms of these
profiles. So the idea goes back (at least for him) to the 60's.
The basic idea is that most of the activity during a trading day
takes place in what Steidlmayer called the day's "value area". The
center point of the value are can be thought of as the "fair price"
which the market has "discovered" for the day.
One very important point to remember here is that some days do NOT
have value areas. There is no "fair price" or central tendency for
the day. The days which lack a value area are typically wide range
days on which the market shows a strong, day-long trend in one
direction. Occasionally days without a value area are wide-range days
on which the market pulls a "U-turn" in the middle of the session and
then develops a strong trend in the opposite direction for the rest
of the day.
Once one has learned to identify days which have a value area,
Steidlymayer's main axiom is that the trend of the market is just the
trend (if any) exhibited by successive value areas. My observation is
that in most trends the market will show occasional days with value
areas moving opposite to the underlying value area trend, but rarely
will this happen on two successive days.
The value trend is important. Steidlymayer liked to observe that all
the good traders he knew traded value, not price. In other words,
traders who thought in terms of value areas were happy to fade
reactions against the trend which carried back to or below some
prviously established value area. They were the opposite of trend
followers. One would often observe these value traders fading
breakouts in appropriate situations rather than going with them.
Of course it is helpful if one can learn to anticipate the end of a
value trend in one direction and the emergence of a new one in the
opposite direction.
One approach to this is to look at the market's value areas in longer
time frames, e.g. weekly or monthly. I personally have found this
quite helpful and simple to do.
Another idea that works in all time frames is to look for what
Steidlmayer called price "excesses" or "rejections". He always said
that the single most effective trading idea is to trade in the
direction of the most recent excess.
Price rejections or excesses typically take one of three forms.
The most common and visible is what I call the false breakout
excess. This happens when the market breaks past a previously
defined high or low, but not by too much and then runs rapidly in the
direction opposite to the breakout.
The second form of rejection is the V or U top or bottom - the market
has a fast move in one direction, then another equally fast or faster
move in the opposite direction (in the case of the U reversal these
two moves are separated by a period of dull or narrow ranges).
The last form of rejection doesn't occur at the extreme, but takes
the form of an obvious acceleration in the trend away from a recently
established extreme.
I typically use unusually wide range bars to recognize these three
types of rejections. Most, thought not all, trends begin with a
rejection.
Carl
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