ASX Charting Course

Chapter 54

Market Profile Logic

The purpose of the market is to bring buyers and sellers together, to facilitate trade. Price exploration allows the market to go up and down and attempts to involve all participants in the process.

The market is advertising to sellers when prices go up. When the number of sellers overwhelms the number of buyers, prices stop going up. Conversely when prices go lower, the market is advertising to buyers. If the market doesn’t get the necessary buyers to stop prices going lower, they will probably go lower.

The process of price exploration is similar to any other auction process. At the beginning of any auction there will probably be only a few bidders. As prices rise there will be more and more with roughly the bulk of the bidders being at or around true value, as they perceive it. As price moves above value the number of bidders will drop until only one bidder is left at the top and wins the auction.

A trading session is a series of auctions up and down. Sometimes it’s just one big, one way auction, up or down. The result is called market structure. Market structure is the profile. The profile tells us many things, but first it gives us value.

As an example let’s take a normal looking bar chart of monthly sales for some commodity.

The left hand Y scale is price and the time X scale is monthly. Value is the price where the commodity has traded most frequently, in this case at $2 and $3 each with five tpo’s. We could say value extends up to $5, but the probe to $8 was a one off and clearly above value. We can say the market rejected the $8 price.

Commercials versus Locals

We can break the markets main participants into two groups, locals and other time frame traders or commercials. It would be nice to know what the commercials are doing, wouldn’t it? If we knew which side of the market the commercials were coming from it would certainly give us an advantage. After all, at the end of the day, it’s probably the commercials that are responsible for any change in value. They really do move the market.

Commercial traders are big traders. They are typically large institutions like banks, brokers, hedgers, grain houses, mining companies, etc. Their nature is to trade in large clips, but not often, resulting in low volume overall. They look for a large profit or mark up and therefore lean toward the longer time frame. They are fortunate in that they can pick and chose when and at what price they get involved in the market. They don’t have to trade on a daily basis. They have the capacity to carry large open positions and often do.

Locals or scalpers, on other hand, are the meat in the grinder. They are the short term traders, the speculators. They’re the ones who facilitate trade, the price explorers, the ones the commercials can, get set too in a hurry. They trade large volume, in smaller clips, but more often, so their overall volume is high. They only trade for a couple of ticks and the profit per trade is therefore low. Their time frame is short term, often extremely short term. They almost always square up at the end of the day. They don’t have an open position when the market closes, but they do trade everyday.

“All the news is in the price.”

Value is projected into the market by commercial traders, the other time frame traders. The commercials are privy to the industry relevant information and they make their move in the market before they tell the press. If there is no outside news to move price then they react to industry costs and recent market conditions.

Responsive activity versus Initiating Activity

If things are cheap, most people are naturally inclined to be buyers. Commercial traders, other time frame traders, are exactly the same. If prices are high, above value, commercial traders are more inclined to be active sellers. This is normal activity. This is responsive activity, higher prices attract sellers and lower prices attract buyers.

Locals on the other hand don’t really care where they trade. They trade everywhere, at every price, in any direction they perceive might give them an advantage. Their concept of value is often extremely short term.

There are times that commercials buy above value or sell below value. This is initiating activity. It occurs when the other time frame trader perceives an imminent shift in value to higher or lower prices. They are happy to pay above recent value, expecting a new value area to be established at higher prices.

Of course there’s the inevitable battle between responsive sellers and initiating buyers, each time the market approaches or breaks the extreme parameters of a trading bracket value area. Most of the time the responsive players win out, but some of the time they get steamrollered.

Initiating activity is immediate activity, it looks impulsive. It’s usually assisted by stop activity. In every day terms, initiating activity is when you pay to go to the preview of a movie before the cinemas get it.

Responsive activity on the other hand is less immediate, it looks more calculated. Waiting for the movie to come out on video is an example of responsive activity. It’s cheaper, better value and safe.