In this post I’m going to demonstrate how and when I use Market Profile in my price analysis. It is far from from a comprehensive look so if you’re interested in learning much more about market profile I suggest looking at the works of Jim Dalton at Jim Dalton Trading and/or Peter Reznicek at Shadow Trader. Both are excellent however I will say that, with adding any new analysis to your toolbox, if you dive into the deep end, it can lead to the dreaded paralysis by analysis if you’re not careful. In this post I’ll keep it very simple!
Below is the market profile chart for Apple (AAPL) showing the July 19 reversal. If you’re not at all familiar with market profile do a google search or ask your favorite AI buddy to explain it to you more in-depth. All you need to know for this analysis is that the trading day’s profile is broken up into thirteen 30-minute periods; 1 thru 0 (0 represents 10) in purple and 1 thru 3 in blue. The first 30-minute period is know as the opening range. On the left side of each profile is the volume that traded while price was at that particular price level. I often speak of acceptance in my price analysis and this is where that term comes from. Acceptance means a price trades at a level for a long enough period of time and accumulates enough volume to consider it to have been accepted by both buyers and sellers. The point of control (POC) for the day is marked in purple and that is where the most acceptance has taken place. That’s what is referred to as fair value. Enough of the explanation! Looking at the market profile chart below should clear up any confusion between acceptance and excess.
Below is the standard daily candlestick chart of AAPL. The July 19 area of excess that was easy to see on the market profile chart is just as easy to see on the candlestick chart. So what added value do I get from looking at the market profile chart?
In order to best explain the value offered by a market profile chart, below is a chart of the S&P 500 index ETF (SPY) featuring the July 7 reversal. On the candlestick chart it was a clear bearish reversal with a long upper wick, very similar to the AAPL candlestick chart. Now compare the SPY market profile from July 7with the AAPL market profile chart from July 19. 🤔 Totally different, right? Price spent quite a bit of time trading in the upper third of the range gaining acceptance and only late in the day did price spike down. There was no clear rejection followed by a strong reversal so sellers didn’t appear to be as motivated on the SPY chart as they were on the AAPL chart. In the days following the SPY bearish reversal of July 7 price did in fact rally again meaning that the bearish reversal of July 7 wasn’t actually a bearish reversal at all. More likely it was either related to option dealer positioning or it was a good, old fashioned, fake-out where large buyers push price lower to trigger sell stops which they step in to buy at a discount before taking price higher again. Wait, can they do that? Isn’t that illegal or at least unethical? 😄 Welcome to the world of big boy and big girl trading where almost anything goes!
Back to the AAPL candlestick chart below. I always say IF a candle is truly a bearish reversal candle THEN price should find strong resistance in the 50%-61.8% Fib retracement zone of that reversal candle. It can happen in the distant future but, most often, it happens in the next candle. Candle #1 was the potential reversal candle and #2 was the next day. Good location for a short following a bearish reversal is the Fib resistance zone with a hard stop above the high of the reversal candle and a soft stop on price acceptance above the 61.8% Fib level. Price clearly exceeded the 61.8% Fib level, but did it find acceptance?
Below is the AAPL market profile chart with the Fib resistance zone overlaid onto it. You tell me, did price accept the spike above the 61.8% retracement level or not? Was price converted to value or did it do a ‘look above and fail‘? In retrospect, a short at either the 50% or 61.8% Fib retracement looks like pretty good trade location, doesn’t it?
Let’s put a wrap on this post by looking at the AAPL chart as of the July 21 close. We saw that the Fib resistance zone worked well on the reversal candle but does it also work on a strong continuation candle? A strong bearish continuation candle is one that has a red body and is at least above average in size. #2 was a decent continuation candle so I put the Fib retracement resistance zone on it and prepare to short it at either the 50% or the 61.8% retracement level. What would have been my drawdown if I initiated a short trade at the 61.8% Fib retracement? That would be just $.02! That’s TWO CENTS!
Well that can’t be right, price doesn’t just turn magically at, or very near, important Fib levels. That is true, I mean that part about it being magic (or coincidence). There’s no magic or coincidence involved! What is happening is algorithmic traders (algos) are programmed to trade at certain levels that can be programmed in advance. That offers the assurance that there will be resting orders to buy or sell at the Fib levels. What you don’t know in advance is what size those orders represent in relation to the size on the other side of the trade. Algos can get run over just like you and me and when they reverse that trade to stop out it can add fuel to the fire! That fact however doesn’t stop me from often trading those levels using defined risk, low probability (cheap) trades, as well as hard and soft price stops as mentioned above. By the way, here’s a couple of links to posts about low probability trades: https://vegaoptions.com/?p=1744 and https://vegaoptions.com/?p=2342
Hope this helped at least a few of you. Leave your comments or questions down below!