How to Use the Volume Profile
Updated: Oct 15, 2020
Developing a market bias is not easy - particularly if you are new to trading. As a beginning trader, there were innumerate times that I felt "lost" in the charts, like I was stumbling around in a dark room, trying to find a light switch. The first big break that I came to was through my use of the Volume Profile, however.
So what are the markets, anyway? At it's essence - it is an auction. Just like any other auction, whether it's for cattle, artwork, automotives, or whatever, the markets are just a place that brings buyers and sellers together - and like any other auction, it is subject to the laws of supply and demand.
You may remember from your high-school economics classes a bit about supply and demand. A key takeaway was always, "as demand rises, so does price," and, "as supply rises, price decreases." This can be seen in virtually any market. Take peanut butter for instance. Consider that an article came out suggesting that peanuts were hit by a severe blight, and were expected to become extinct within the next year; demand for peanut butter would increase dramatically, which would mean (in order to offset the massive influx of new buyers entering the peanut butter market) that sellers would have to raise prices. By the same token, if a market looks like it's going to crash (as equities did in the Coronavirus drop), those that are long-equities are going to flood the market with sell-orders; all of this selling means price will fall, as no-sound buyer would pay higher prices for a product that the market is being inundated with.
The markets are in a constant state of flux, with the force of supply and demand affecting it at every juncture. The market will move from a state of equilibrium (or balance) into imbalance (meaning there is an imbalance in supply & demand, and the market will drive until it finds a new state of equilibrium). The great thing about economics however is that the markets balance themselves, and an imbalance will always move back into balance (although not always right away).
Now, on the Volume Profile, what does balance look like? Well, it looks like a high volume node. On a candlestick chart, the epitome of balance would be a trading range - when the market bounces between a support and resistance area multiple times. These are temporary-balance areas, where both buyers and sellers can agree that it is a fair price for the product. Just think about all of the Fast Food meals that encompass the $5 price point - TONS! This is a "high volume" price point, and were you to look at a chart that showed all of the Fast Food meals sold at various prices, you would see a massive number of meals sold right around $5 (which would look like a very "fat" area on the Volume Profile).
So how does this help you, as a trader?
Well, think about it this way - if both buyers and sellers agree that it is a "fair" price for the product, you're going to get a lot of people entering there, and because of this, the market will lack directional conviction, and it's likely to chop around a lot (think of them like "whirlpools" or the "center of gravity"). It's almost like saying, "I think Carl's Jr. is going to raise their prices, so I am going to buy all of the meals they offer for $5, before they get a chance to run up the price!" Well (buddy), because it's been established that many people are willing to pay $5, and that many sellers (meaning many Fast Food places) are willing to SELL for $5, you are basically trying to buy-out something at it's "fairest" price... the price that thousands of others agree is neither "low," nor "high." If you are going to do this, you need to be damned-sure that demand is going to vastly outstrip supply in the near future - otherwise, you are going to be scratching the trade at best!
"So Cory, you are saying NOT to enter in areas of high volume, right? Well, where should we be entering?"
Well, we've already established that the market doesn't really move when it's in balance, right? So what does move the market? Imbalance. This is when supply is outstripping demand, or vice versa. If you were to be watching a cumulative delta indicator (an indicator that displays the difference between market-buy's and market-sell's), you would see that one side is temporarily out-running the other. Also, an important point - in trading, there are never "more buyers than sellers" - this is a common misconception; there are only "more aggressive" buyers than sellers, and vice versa. We will get to this in another post, but for now, just understand that there is always 1 seller to 1 buyer, but it's the aggressive orders that actually move the market.
But back to my point - imbalances are what move the market, and it's our ability to identify, and capitalize upon these imbalances that will make us successful as traders. Imagine you have a trading range; the market is bouncing back and forth between a support and resistance, and price isn't really going anywhere. This is because the market is in equilibrium, and both sides are equally interested in trading that level. However, at some point, something will change, and one side will aggressively overtake the other, breaking from the temporary balance area - otherwise known as a "breakout." Now, there are thousands of different ways to identify "how" this is going to happen, but what I want is for you to understand WHY. When you get a break from balance like that, the market is rejecting the previous level; aggressive buyers or sellers determined that it was no longer a fair price, and came in with heavy volume, driving prices higher or lower. To bring it back to our Fast Food analogy, it's as if someone DID come to Carl's Jr., and buy out all of the $5 meals, simply because they thought there would be a beef-shortage, or something to that effect.
The market will remain in equilibrium until something changes. Once it breaks out of balance, we generally want to trade in that direction (the direction of the imbalance). The reason being, is because the market had determined that the area of balance (we will call this the "value area") was no longer a fair price, and promptly rejected it. Because of this, "value" or "worth" has yet to be determined (value is not established until the market finds a new area of balance). Until then, because range is infinite, and the market is trying to "discover" new prices, we always want to trade in the direction of the imbalance.
This is the end of part one - please stay tuned for part two!