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How to Use the Volume Profile Pt.3

Updated: Oct 18, 2020

One thing that I forgot to mention in the previous sessions was what the initial balance is. The initial balance (or IB) is typically the first hour of trading (this is an arbitrary duration, however, and I recommend you utilize whatever IB-timeframe you feel is best suited). Why do we take note of the IB, however? This likely evolved when pit-trading was at it's prime. When the market opened up, the "locals" or floor traders (essentially scalpers, placing orders for brokers, on which they will piggyback their own orders for a few ticks at a time), will look for a level in which two-sided trading can take place. Generally, the wider the IB, the more stable the market is that day (think of it like the base of a lamp - the wider the base, the harder it is to knock it over). Although pit trading is somewhat passé by today's standards, we still have market makers and algorithms that attempt to provide liquidity to the market, seeking to "get between" every trade, and find trading ranges particularly favorable conditions.

Any trading that takes place beyond the initial balance is called range extension. Range extension occurs when one (or both) sides of the IB are broken, and and position traders have entered the market. The market makers are not responsible for substantial, directional moves. Again - they are merely scalping, taking a few ticks (or even a single tick) at a time - it's the position traders that are responsible for the major moves. Any time that you have range extension, you can assume that something has changed, and position traders have entered the market. For instance, if we get range extension, I will typically attempt to trade in that direction. If, however, the range extension comes to a halt, and we cannot transact much further than the IB-High or IB-Low, I will often fade that move, as any market that peeks just above/below a key level and fails, will often test the other extreme.

Equally important as the initial balance, is the type of open the market is employing. Each level denotes a different level of conviction, and you can utilize the opening type in order to gauge directional strength.

The strongest level of conviction is exuded by the open-drive (or OD). An OD will often look like a race-horse bolting out of the gate - the market will open, and immediately take off in a single direction, often creating an extreme that will hold for the entire day. Again, this denotes strong conviction, and you typically want to trade an OD by simply getting in as early as possible. If you wait too long, you may miss a significant portion of the move, and given the level of conviction, it's likely that - even if you enter with somewhat poor positioning, the market will quickly auction back up to your level where you'll be back in the green.

The second strongest level of conviction is employed by the open-test-drive (or OTD for short). The OTD is where the market will test either higher or lower, be abruptly rejected, and then auction the other direction with force. I will commonly see the OTD after days where the market has gotten very extended. After a big drop, responsive traders will often enter the market, hoping to buy at a discount; if position traders still feel price is at a premium, however, they will overwhelm the buyers with sell orders, trapping them out and invoking a stop run. OTD's happen very fast, and for that reason, it's important that you get good at identifying them, so you can capitalize on them when they happen. One technique you might employ is by entering with a half-position right when the rejection occurs; once the market breaks lower, and comes back up to re-test the breakout level, you enter the second half of your position, after confirmation that the level will hold.

The third strongest (or median) level of conviction is the open-rejection-reverse (or ORR). This is similar to the OTD, but the market usually has to auction quite a bit further before the reversal occurs. An OTD will usually test, and then reverse with minutes or seconds (it happens very fast), whereas the ORR might auction for thirty minutes to an hour or two, before the reversal kicks in with strength.

The open-auction (or OA) is the lowest level of conviction, coming in at number four. An open auction will typically open, and then trade back and forth - trading through the opening price several times. An OA denotes very poor conviction; the market is in balance, and is usually waiting for more information before a strong, directional move will take place. An OA will often turn into a double-distribution day (more on this later), or non-trend day (a low-volume day known for abhorrent structure and little to no conviction whatsoever).

We talked a bit about profile shapes in the previous session, but I wanted to expand more upon that idea. There are some very common shapes that one should look for, in terms of analyzing the Volume Profile. Importantly, the more you understand the VP, the better you will get at projecting what the completed profile might look like (and therefore, an easier time in conjuring your directional bias).

One of the most common shapes a VP might employ is the uppercase B-shape. This is indicative of a double-distribution trend day. The double-distribution day often has a narrow initial balance (the first hour into the trading session), and typically opens with an open-auction. The narrower the IB, however, the easier it is to trade through it. Once it does break out, the market will trend in one direction for some time, until it eventually auctions high enough to find value, builds out the profile, and often kicking the POC higher or lower.

Another common shape is the uppercase-P shape. This will commonly incur when you have substantial short covering, or a short-squeeze (otherwise known as a "short-covering rally"). This will often occur when you have a market that consolidates, and then breaks to the downside. Unlike a trend day, however, Value is NOT pulled down to price; a precursor to this might be when the POC remains at the top of the profile, but price is continually auctioning lower - another key indication you may have a reversal in tow). At some point, the market will reverse, and everyone that got short is quickly squeezed out, being forced to cover and driving the market back up into the prior area of Value. You might commonly see this during news releases, where an economic or political event will cause the market to drop with breakneck-speed, until a point where it quickly v-bottom's, and rises almost as fast as the initial drop.

The same concept applies to the lowercase-b shape, conveyed by the long-liquidation rally. Like the short-covering rally, the long-liquidation rally will have a period of consolidation, followed by a break to the upside, but again - because Value/the POC remains lower, prices will revert to the mean, trapping all of the longs and forcing them to liquidate their positions. This will force the market back into the lower area of Value (hence the lowercase-b shape).

A "D" shape often reflects a Gaussian, or balanced profile. These are typically neutral days, or non-trend days, where the market will auction back and forth all day long. Balanced days are "outside-in" days, meaning you want to fade the extremes back into value.

Another major concept we want to consider is whether VALUE is likely to move to PRICE, or whether PRICE is likely to move back to VALUE. Long-liquidation and short-covering rallies are perfect examples of the latter; in this instance, price had essentially gotten ahead of itself, and because it wasn't able to establish Value at new levels, it rapidly reverts to the mean, rejecting new levels and trading back toward the POC. The former is best illustrated by trend days. On trend days, price is leading value - it auctions higher or lower with strength, until it begins to consolidate, establishing Value and moving the POC. You always want to be thinking about this, when price starts to move away from Value.

Since we didn't get to talk very much about prior day analysis, I wanted to go ahead and cover it, since there's so much value (see what I did there?) to be gained from doing so.

When the market opens up in the prior day's Value Area, it's essentially saying that opinions haven't really changed, and the market is waiting for more information before it can move with conviction. Days that open inside the prior day's Value Area are likely to chop. On these days, you will often get D-shaped profiles, and the only real opportunities are fading the extremes (unless the market can break out of balance, in which case you have a good chance of developing a double-distribution trend day).

When the market opens up outside of value, but inside the prior day's range, the market is slightly out of balance, but not incredibly so. Convictions are higher than the latter, as are the opportunities (but the greater the opportunity, the greater the risk). On these days, the Value Areas of the two days will commonly overlap, and you can estimate the day's range by taking the prior day's range, +/- 10%. For instance, if the previous day's range was 50 points, and you open up in-range but ouside-Value, you can estimate the current day's range to be somewhere between 45-55 points (you can also use this same technique for days in which you open up IN Value, by the way). This is to be taken with a grain of salt, however, and depends a great deal on context.

The greatest risks/opportunities occur when you have a market that opens up outside the prior day's range, otherwise known as a "gap." When the market gap's up or down, you have position traders taking initiative activity (initiative activity is any buying within/above the prior day's Value Area, or any selling within/below the prior day's Value Area), creating an "invisible spike," and driving the market wildly out of balance. Prior to common belief, gaps typically do NOT like to be filled. A spike indicates strong, position trader activity, and because a gap is essentially an "invisible spike" we can assume that it was created by position traders, and these parties are likely to defend their positions, should they be tested again. For this reason, we typically want to trade in the direction of the gap (unless the market has traded so far from Value that it has gotten ahead of itself, and responsive traders enter the market). The gap will provide support/resistance to initial tests, but subsequent tests increase the likelihood that it will falter, often "closing the gap." Once the gap is closed, the base of the Gap then provides S/R (which is why many gaps will fill, and then continue on in the original direction). Lastly, the prior day's Value Area provides S/R; should the prior day's Value Area be penetrated, according to Jim Dalton, any market that trades back inside the prior day's Value Area has an 80% chance of trading through it - especially if it is a narrow one. This is known as the "Value Area Rule."

If you want more info on how to develop your bias, and employ auction theory rules, please refer to my post, "FREE GIFT FOR NEW READERS!" where I have a great flow chart for employing concepts like these.

That's it for this session! Stay tuned for more auction theory in the near future!

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