How to Use the Volume Profile Pt.2

So last time, we closed with talking about balance vs. imbalance, and how we always want to trade in the direction of the imbalance. Our "high volume nodes" are our indication that the market is in equilibrium, and suggests that price has been "accepted" at this area, and both sides feel that it is a fair price for the security. What we didn't talk about, however, are low volume nodes.

Low volume nodes are essentially price rejection areas. These are levels where the market has deemed as "unfair value," meaning buyers and sellers had disagreed about the validity of that price/level.

One characteristic of low volume nodes is that price tends to move through them relatively quickly. They provide support/resistance, like the surface of a balloon, but once the balloon pops, the market rushes through it with force.

The most common low volume nodes are at the high of the day, and the low of the day. Again, these are areas where the market deemed "unfit" in terms of value. Usually, if these LVN's fall within the VP, they are areas where there was a major imbalance to one side, and price moved with great volatility. You might also have a large LVN in the middle of the profile, on a double distribution trend day (with a B-shaped profile).

So I'm sure you're asking yourself, "how can I use this to my advantage?"

For one, LVN's provide great support and resistance. For instance, if you are trying to get long off of a pullback, you can "lean on" the LVN, using it for support and putting your stop part way into it, as that area is likely to be more difficult to break through. I commonly like to employ this strategy on a market that's run up quite a bit, entering on the pullback. This can be helpful, particularly as it's somewhat nerve wracking to buy something for $250 that you could have gotten for $210 yesterday. It's a double-edged sword, however, because (if you have an LVN above you) that area will provide strong resistance, although - when it breaks - it will do so with significant force.

There are some key points about profile structure that I wanted to mention as well. For one, the "fairest price" or the equilibrium price on the profile is called the Point-of-Control. This is the widest section of the VP, or the price that incurred the most trading. There is also a section of the VP called the Value Area - this is the section of the profile where the majority of trading took place (usually set at 68%), and includes two bands - a value area high, and value area low. I wanted to mention, however, that this is merely a mathematical equation, and does not always accurately portray what value is. For instance, if you have an elongated profile, that only has a HVN in one section, it will portray value as being a section of the VP that incurred very little trading... therefore, know that the 68% is an arbitrary figure, and you want to make your own determination as per where "value" is on the chart.

Since the POC (point of control) is considered the fairest price, we can utilize it to determine price, and it's relationship to value. When price diverges from value, we have an opportunity to take advantage of the temporary imbalance, whether we are reverting to the mean (fading the imbalance back into value), or trading in the direction of the imbalance, when the market moves into "price-discovery" mode. When price has gotten ahead of itself, so to speak, we can expect that price is going to return to it's mean-price, as the average tends to work like a magnet. In fact, HVN's in general work like magnets, and can be particularly helpful in selecting targets. Why does this happen? The market will always undergo temporary imbalances, which can be influenced by a multitude of factors. However, the law of averages suggests that, over time, the market will eventually move back into balance - whether the POC moves up to a particular level through price-discovery, or the imbalance is rejected, and counter-trend traders take advantage of the temporary imbalance and force price back into value.

Another key indicator used in the Volume Profile is VWAP - or the "Volume-Weighted Average-Price." VWAP is essentially a moving average that figures not just the average price over a series of bars, but price X volume over a series of bars. Like the POC, it is also used as a determinant of where the average lies, and you will often see trends pause temporarily to test VWAP, and then continue in their original direction (these are often some of the best entry points during a trending market).

Prior-Day analysis is one of the cornerstones of the Volume Profile. We can utilize the profile and it's characteristics to determine price's relationship to value, if the market is in balance or imbalance, and the migration of value over time. For instance, if the Value Area is from 3201-3223 on Tuesday, and 3221-3243 on Wednesday, "Value" is migrating higher, and it denotes bullishness. If the Value Area is from 3201-3223 on Tuesday, and 3205-3226 on Wednesday, then we can assume that sentiment hasn't really changed; the Value Area is largely overlapping, and the market is in relative balance (and the market is saying that it means more information before it can move with conviction). If the Value Area was from 3201-3226 on Tuesday, and the market opens substantially higher (gap-up), it could mean two different things (depending on context). Either A) the activity is initiative, sentiment has changed, and position-traders feel price is under-valued and drive the market higher, or B) price has gotten ahead of itself, and the temporary imbalance is an opportunity to sell higher than what it's worth.

When price starts getting away from Value, you have to ask yourself, "is price likely to revert back to Value, or is Value likely to move up to price? On trend days, for instance, price is actually leading Value. Strong initiation activity broke the market out of the prior day's Value Area, and once the trend starts to come to a close, and the market starts to consolidate, the POC will likely move up, indicating Value has changed. However, there are instances in which price gets away from Value, but the POC does not follow suit. When this happens, a mean-reversion strategy is more suitable. Stuff like this often precedes short squeezes or long liquidation, when the market gets ahead of itself and reverts to the mean.

In utilizing Auction Theory, we can observe what is happening - in terms of volume - and determine how good of a job the market is doing. In asking yourself, "what is the job of the market?" The market's job is simply to bring buyers and sellers together, and facilitate trade. That's it! However, when the market starts to become extended, and volume is drying up, it may need to auction lower in order to find new buyers. Price, in this instance, is an advertising function; when the market is moving higher, it is looking for sellers, and once prices get so high that they are no longer attractive to longs (and considerably more attractive to shorts) the auction will reverse, and we will auction lower in search for buyers (where the cycle will continue). It's much like any other auction. For instance, if you have a group of people bidding on a car, there will be lots of bids near the median price, but as it begins to more higher, you will get progressively fewer bids coming in; this is much like a tail on the Volume Profile; as the market auctions higher, there is less-and-less trade taking place, so the Volume Profile begins to thin, until the market finally reverses, auctioning down to find more buyers. Traders can utilize these tails in order to find optimal entry points, in employing a mean-reversion strategy.

This is just like any other marketplace. For instance, if you are in Real Estate, if you have the prices of your homes set to high, then volume is going to be diminished; people simply will not express any interest in your homes. In this instance, prices will need to drop, in order to engage potential buyers. The same goes for the sell-side. If you are a supplier for candy-canes, following a recent "boom" in candy-cane sales, there may be many new suppliers that have entered the marketplace, saturating the market to such a degree that prices have become TOO low, and you either decide to withhold selling until prices come back up, or exit the market entirely. The act of suppliers leaving the market will allow prices to rise again, bringing candy-canes back into their equilibrium price.

Just like trading, can you understand how the examples had to move from imbalance, back into balance? The markets had become imbalanced, with Real Estate having been driven too high, and candy-canes being driven too low; volume began to dry up, and prices reverted to their equilibrium price. The act is price getting ahead of itself is called "excess," and serves as an opportunity for the long timeframe buyers and sellers.

Position traders look for prices moving to ideal levels where they can enter a position that they intend to hold over time. The long term buyer is going to wait for price to reach a favorable level where he can buy at a discount, and hold the trade for a period of hours, days, or weeks. The long term seller will do the same, but he is looking to sell when price is at a premium. These are the players that create directional moves in the markets. It's commonplace for traders to believe that algorithms and market makers are hurting their trades, however, the market makers and algo's are typically holding for seconds, or taking profit at a single tick, therefore, they are NOT the traders that create directional moves - they simply care about getting a fair price, and getting out of the trade. The long term traders are people like you (even if you are trading in the day-timeframe), as well as commercial and institutional traders, such as Invesco, JP Morgan, and Fidelity. As a positional trader, it's imperative that you understand the relationship between price and value, so you can enter the market at an ideal time and amplify your results.

It's crucial that you understand that the long term traders are doing. If you are oblivious to the key levels on the daily and hourly charts, you are going to do what 93% of traders do, and lose money. Perma-Bears will often trade counter-trend either too soon, on insignificant signals, at weaker (non-higher timeframe) levels, and near the median price (churn-zone)! If you think about it, a position trader is unlikely to enter near the POC or VWAP, unless their actions are initiative (where something has changed in the market, and they feel price is over/undervalued) they are supporting an existing trend. Why is that? Position traders engage often wait for favorable prices, whether buying at a discount, or selling at a premium - thus they are more likely to enter during periods of excess (tails on the VP).

Profile shape is also important, in terms of judging direction. Let's say that you have a very elongated profile on top, as sellers have been in control virtually all day, and you have a very fat, profile near the bottom. If the market's job is to facilitate trade, and you have a fat profile on the bottom, then trade is not being facilitated well to the downside, so therefore, prices will likely have to move higher, before they move lower. You can think of a fat-bottom as being like the base of a lamp; a wide base will be more difficult to push over. In terms of the mechanics underlying this condition, it's likely that there are buyers entering at this level (and are willing to hold) therefore, the profile builds outward. This, however, is invalidated if you have a weak low, or "failed auction."

When you have a low that does not have any excess (such as a double-bottom), it's considered a failed auction, because the market did not auction to the point in which there was only one seller left. It's almost like you have two people bidding against one another for cattle - both people are willing to bid $3/lb, and then the auction just stops. Because there was more than one party that was still willing to buy at that level (or in the previous example, sell) the auction did not complete, and therefore has unfinished business, and is likely to test that level again.

Profile shape depends heavily on context, however. For instance, say you have a very large, and thin, elongated profile, in a market that has been trending up all morning. Despite how "extended" you think the market has become, it still has to go higher, as value has not been established yet; the upward trend is advertising for sellers, but because the profile hasn't built-out yet, there hasn't been enough selling coming into the market, in order to halt the buying.

In order to be successful in trading, you have to be able to buy below value, and sell above value. That's it! One of the issues with using indicators like the MACD, stochastic, and others is that they assume that "all prices are equal," but they aren't! Prices are relative, and through use of the VP, we can establish where price is in relation to value, and can get better prices for our dollar.

We will leave it here for now. Tune in for the next edition of Auction Theory and the VP!