Volume Profile Part 1

Introduction

Traders,

I want to spend a few minutes talking about the Volume (Market) Profile. I warn
you beforehand there is going to be some ink dedicated to my personal opinion
about indicators and the structure of market itself. I think this is important to lay
the groundwork of why a technique like profiling may be a better analytical tool
compared to other similar tools available today. I will get a little philosophical.
If this is not your thing, you can save your self 3 minutes and skip to Section C.

Why do we need any analysis at all?

Market is an unstructured environment. There are very few, if any rules. Any
thing can happen at any time in markets.

Market participants, for as long as the markets have been around, have tried to
box the market into quantifiable or subjective rules. Some times it works. Most
times it does not. In this quest, traders try an endless variety of tools AND
indicators. Charts, oscillators, various methodologies like Elliot Waves are BUT
an extension of our quest to be able to predict the market.

A lot of times these tools do not work. A fundamental reason for these tools to
not work is that they are inherently built using past data whereas the markets are
always forward looking.

At end of the day, what we need is a framework we can use to leverage whatever
information market provides us , use context , use any other factor to our
advantage in order to extract an edge. While no methodology works 100 % of
times, we want to be in a position where we are able to be right more often than
wrong. We want to win bigger when we are right and lose smaller when wrong.

I do not use any technical analysis in my own trading except one tool which I
often refer to, mostly for daily and weekly time frame analysis. This is Volume
Profile . This will be a multi-part newsletter with 3 aspects:

1. Understanding the basics of volume profiling

2. Operationalizing & implementing the Volume Profile
3. Optimizing the volume profile

I intend to cover the introduction this week and address the other 2 in coming
few weeks. If you have never used volume profile before , you may want to set
one up in a sandbox or demo environment and just play with it for a few weeks.
I included some instructions on setting one up for Think or Swim Platform
(Section F) as I assume most readers have access to it. All charts are courtesy of
Think or Swim and/or Ninja Trader. For those readers who are familiar with
Volume profile already, this installment may not be a great value add but I hope
they get some benefit from the forthcoming newsletters.

Without further ado, let us dive into it.

A: Background:
Most of the early work to my best understanding in market profile which was a
predecessor of volume profile was done by Peter Steidlmayer back in the
1970’s. If you have not already, I highly recommend reading his
book “Steidlmayer on Markets: Trading with Market Profile” which describes
Market profile very succinctly. While some of the technical concepts he
described may not be very relevant today due to the technology shift and how
the markets have evolved, the underlying structure of what he describes stay true
today almost 50 years later.
Figure A: Solid reference

B: Structure of Markets:
Markets globally in 2021 at their core are a price-advertisement.

Almost all market phenomenon we hear and read and tweet about, spectacular
crashes, breathtaking all time highs, FOMO is at it’s heart simply a price
event. Market is never wrong, though price may be fair or unfair.

The reason public markets exist and function so well is because they provide a
framework through which various entities like the corporates, the governments,
the municipalities can issue their stocks, bonds, debts etc. and let the market
decide a “fair” price for them.
In essence they are willing to take a risk in return for “favorable pricing” from
Mr. Market. If the market likes and accepts their offering, it is willing to pay
higher and higher prices for their issues. If the market rejects their issuance,
higher prices are rejected and lower prices are accepted. This is a very simple
example however this is the basic way market operates 24 hours, 5 days a week.

In a perfect world, traders and investors will be able to see this phenomena in
slow motion 4K, make their bets and earn millions of dollars in profit and set

sail into the sunset 🌅… However, due to an increasingly entropic world, millions
of players and their varied intentions, the markets have made this pricing process
extremely difficult to read and make any sense off. For any one new to the

markets, they will be forgiven 100 % for thinking the market is schizophrenic 😜
with its never ending mood changes, jumping up and down several hundred
price points within a day!

Fortunately, the market leaves subtle clues in form of price action, which a
shrewd and experienced operator can decipher , given enough motivation and
screen-time.

If you have made it this far, you already have the motivation 🙃 Read on for some
pointers on screen-time.

C: Organizing the market:

So, is there any hope for making sense of it all? I think there is. And based on
my own trading from past 15 years, I have seen several examples where even the
most volatile of markets can make sense when you organize their actions in a
meaningful way.

What is this way that I speak of ?

This is where the concept of Market Profile enters the picture.

To be able to understand what the market may do next, you need to be able to
understand how good (or bad) of a job it has done so far to advertise it’s price to
its prospects. Market (or volume) profile is a graphic representation of this
activity.

In all my writings, I use non-standard way of describing things and this will be
no different: In its simplest form, the market profile is a graphical
representation of which price is every one positioned or traded at, for a given
time period. How much volume was transacted at each tick? How much time the
market spent at each price point? Profiles answer this question.

Look at this chart below. This is a beautiful representation of balance and

symmetry. One look at it and I know instinctively there is a LOT going on at the
middle of x-axis and very little interest at it’s extreme edges. This illustration is
a crystal clear representation of what market or volume profiles represent in
markets.

Let us say the y-axis represents the volume (or time). The x-axis is the price, let
us assume the left most x is 1 and the right most x is 10, with the middle being a
5. If this was the profile for one whole day, without a second thought I know the
market loves that $ 5 price. If there ever was a “fair price” for this asset, this $5
is!

At this point, I think it makes sense to ask if you are still with me or
completely lost?

If you have not thought in these terms before, it may make sense to re-read up
until here. Give it a few minutes to absorb. If you are still able to understand this

then keep reading 👍👍

Figure B: Balance

Now this is but a very rudimentary example. However the good thing about
thinking in these terms is the outcomes or possibilities of market organizing it
self like this are handful. These situations or “day types” as I call them will be
covered in a different post. However, it suffices to say that for any given time
frame, the market will either “accept” the advertised prices or “reject” them.

What does it mean?

1. Acceptance: in simplest terms, using a profile, you will see a bulge at

certain prices. This means for howsoever momentarily , that zone or that
price is being deemed fair by market. These bulges are also known as
“High Volume Nodes (HVN)”
2. Rejection: you will see almost no bulging at these levels. This means the
prices are unfair. This may be represented as Single Prints on a TPO chart
or “Low volume Nodes (LVN)” on a volume profile chart.
3. Now unfair doesn’t automatically mean “bad”. Price rejections almost
always are great way to identify good support and resistance levels. Price
rejection almost always means a lack of inventory at that price.
4. In our case, if you are my reader for some time, consider this newsletter
from Wednesday: Daily Plan. How very little time was spent at this price
(4541-4545). There was almost no bulge here at this price. This means
there is really very little inventory to be sold at these levels. If I had a
cheat sheet, it will be:
 o Lack of bulge at the lows = Demand
o Lack of bulge at the highs = Supply

Of-course there are finer variations to this. You have to know if these rejections
happened in previous acceptance zones, or if these rejections occur in previous
rejection zones. For example, a lack of bulge above a well established bulge may
indicate a market coming out of a consolidation zone and should not be
considered rejection but rather a market moving higher. The good thing is we
can start using these bulges and skinny-LVN to start forming some hypothesis of
our own. The bad part is there are sub-variations in these as well , however with
any thing else , more screen time will lead to a better understanding of nuances.

I hope you are still with me and getting at least some value out of these. These
take a lot of time for me to draft and if it helped you learn something new, make
sure you hit the share button to allow me to reach more traders, like your self.

So to summarize this section, first step to become an order-flow practitioner and

trader, is to :

1) Start thinking in terms of price acceptance and price rejection.

2) Visually know that Profiles offer an easy way to see where accepted and
rejected pries are for the given session

3) Form your own hypothesis using the HVN, LVN, single prints to formalize
where these “pain points” or references live within your session of choice

4) Actively look for formation of these new structures or nodes throughout the
session and see prices interact with them

If you could take one thing away from this post, it should be for an infinite
and unstructured environment like the market, only references matter. Good
references will profit you. Bad references will let others profit off you.
D) The 70 % rule:
I don’t know or understand what is the reason behind 70% value area rule,
however, I am sure statistically it is is important and captures few of human
emotions in some way or shape.

So, now you are beginning to think it terms of how market organizes itself. You
have added a volume profile indicator on your workstation. You are starting to
observe the session as it progresses. You want to now know if there are other
things that may impact market action. Yes, so value area on most days (but not
all of them) acts as a natural containment or support/resistance level.

What is value area? Well here is a definition : Value Area , but suffice to know,
within the TOTAL Bell Curve of the session, this zone contains 70% of all
volume or activity.

The upper and lower bounds of this zone are natural support and resistance lines.
If they don’t work for a given session, they may offer some kind of opportunity
the following session. They are “high probability” levels to offer some thing. In
my experience they are 60-70 percent effective in terms of offering some pause
to the price on following day or even within the same session.

E) Putting it all together:

I intentionally want to keep the implementation part separate from this
introduction part. This is to create a space between learning it and knowing it .
For those who have never worked with a profile or another statistical approach
before, they should probably just slap it on their workstation and just watch for a
few weeks to a month or two. For more experienced traders, they can start
thinking in terms of value .
While there are several strategies that can be potentially developed off this
information, a few of my favorites are:

 Value moving up or down

 Expansion of Value Area
 VPOC shift
 Rejection at the VAL and VAH followed by new Value formation.

Explaining these by itself require an additional installment or two.

Now are there markets which are more suited to this type of analysis than
others?

I think this works in most cases, however it works better in markets with on
balance a 1-2% average true range a day. Just from an opportunity flow
perspective, I will avoid markets which move less than half a percent on
balance. I know many swear by 30 year bond ZB_F and ten year ZN_F etc. but
those put me to sleep and in my opinion not the best markets to trade with

profile. Let me know if you agree or disagree 👎

I think this is quite a bit to chew through for most new to the profiling concepts.
So I will stop here.