So today I’m going to talk to you about the way I trade the market.
As a discretionary trader, I do not use any trading system or signals-based strategy. Instead I have developed (and continue to improve on) a methodology based on a conceptual framework, a decision-support tool called Market Profile.
The idea of Market Profile was conceived by Peter Steidlmayer of Chicago Board of Trade. He identified recurring behavior patterns in the trading pit and recognized these principles, neither arbitrary or random, as the basis of market activity. The concept of “non-random” is of fundamental importance, because as a day trader you need to believe the market is not random at all, but actually follows logical behavior based on a purpose. In order to explain this idea, let me define the Auction Framework.
The Auction Framework
The purpose of the marketplace is to facilitate trade: it simply means that as the price moves up, it brings in more buying or, as the price moves down, it brings in more selling. In other words, the market auctions up until there are no more buyers. Then it reverses and moves down until there are no more sellers. All market activity occurs within this broad framework – with the market moving up to cut off buyers, and down to cut off sellers. In other words, the market begins to move directionally and advertises for an opposite response to cut off the directional move.
The concept of “advertising” is very important to understand the natural dynamic of the marketplace and to introduce the concept of value. Buyers and Sellers both look for value, and in order to do that, they keep on exploring opportunities up and down.
The negotiating process
More specifically, we can say that a directional move establishes parameters that contain the auction’s price range; an unfair low at the low end and an unfair high at the high end. We’ll call these excesses.
Once the market defines a range, it negotiates within that range to establish value. Nowadays, the way we define value is based on volume traded, i.e. the number of contracts traded in a specific period of time.
The most important question a trader needs to ask himself is: is this price accepted or rejected? The Market Profile conceptual framework is based on this question. For me it doesn’t matter at all if a level is broken or not without the info I receive from volume and without asking myself “is this price accepted or rejected?”. That makes a huge difference to the majority of traders I personally know. That’s why I never trade breakout.
Balance or Imbalance
There are basically two categories of market: balance and imbalance.
If the market is balanced, an equal amount of buying and selling are present in an area called Value Area. The market rotates up and down because it has found a fair price zone around which it can distribute. Buyers and Sellers are agreed what is the fair value of the market. A consensus is in place!
If the market is imbalanced, either buying or selling activity is predominant. The market is moving higher or lower, in order to find an opposite response: the fair price zone is not clear at all to the market participants. In the chart here you notice the typical shifting of value in the direction of the trend.
Let’s focus our attention on Balanced Market, which represents 80% of the market activity. If you have any doubts on that think about the opposite: it would mean that the market doesn’t work at all because it fails to fulfill its purpose of facilitating trades.
With this insight, Steidlmayer was able to divide all market activity into two categories: STF (Short Time Frame) and LTF (Long Time Frame). STF Traders are active for day time frame activity while LTF Traders are institutionally more oriented to overnight position.
The STF trader’s behaviour characteristic is his desire for a fair price. The best he can do is a fair price because he has to trade today. Since a fair price is acceptable to both buyers and sellers, STF buyers and sellers do trade with each other at the same price, and at the same time.
The LTF trader’s behavior characteristic is his desire for an unfair price. He can wait because he doesn’t have to trade today. Since LTF buyers’ and sellers’ objectives are different, they do not trade with each other at the same price or at the same time. For example, an LTF buyer with a 20-day time frame may trade with an LTF seller with a 5-day time frame. And these traders are still a small part of the total LTF group.
So the market develops a fair price area in the session mostly for STF buyers and sellers: the high volume in fact shows acceptance.
Conversely, the market spends very little time at the advantageous price above and below value. These prices are low volume, rejected excess area. Prices above the value area are advantageous for LTF sellers; prices below are for LTF buyers. Only traders with a longer-term time frame, those who do not have to close the position today, can take a chance on making their trade in an area where the market doesn’t spend much time. If you have to trade today, you can’t count on being able to enter your trade in a low volume; basically the unfair area. The high volume area where the market spends most of its time provides the liquidity you need.
BUT YOU HAVE TO BE AWARE OF LOW VOLUME AREA IN ORDER TO PLACE YOUR TRADE
This last concept is extremely important in my methodology, because I do not trade on LVN (Low Volume Nodes) because it’s too risky for an STF trader (remember there’s no liquidity there). But I expect rejection effectively takes place in the daily time frame and after I place my order. I expect LTF action on predefined LTF levels, but I trade only after evident signs that STF traders follow LTF activity. As a day trader, I need liquidity to trade.
I’m going to monitor the activity level of LTF traders as they respond to prices above, below or within value in order to anticipate whether the market will move up, down or sideways.
Our focus is always on what the LTF traders are doing because, in pursuing their interest, they are responsible for the way the day’s range develops and for the length of time of LTF lasts. Think about it! Why is a low volume node predominantly tested during the trading day? My answer: STF traders look for LTF action in order to re-enter into value area and keep on trading where liquidity is available.
The dynamic of the marketplace is based on interaction between STF Traders and LTF Traders in a sort of continuous dialogue where volume represents the language.
Every morning I share on my twitter page my Pre Market Analysis for the day where I identify levels to watch for LTF presence and the vision for the day: it represents the framework where I expect to do business when the market opens.