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What is Market Profile?

Each day the market defines a Market Profile (MP), a Value Area (VA) and a Point of Control (POC), all of which are invaluable to trading the following day. Similar market-derived data over longer time frames is also of great value to day traders and other time frame (OTF) traders. Before I expand on this subject, let's back up and define the various terms we will use.
The sole function of any market is to facilitate trade. Over time a profile of the nature of the trading develops and levels of perceived value become established. By the end of the trading session, a structural profile for the period has been established. This is referred to as Market Profile (MP).

Definitions You Should Know

Market Profile (MP): The MP organizes price on a vertical axis and time on the horizontal axis. A price/time relationship is established. A convenient way to evaluate demand at any given price and time is to use tick values, which are immediately available. Subsequently a bell curve of price - volume distribution over time is created.
The basic time period used in MP analysis is the thirty minute time frame. The half hourly tick volume is organized by alphabetic code starting at 8:00 A.M. Letters of the alphabet are assigned for prices that occur in each half hour. The period 8:00 to 8:30 is A; B is 8:30 to 9:00; C is 9:00 to 9:30, and so on. .

Value Area (VA): The "Value Area" (VA) is one standard deviation (70%) of a normal bell curve of the time/price distribution in a given period, commonly each day, i.e. the volume of trade as well the cost of trade is included in the computation of the VA numbers.
Value Area High (VAH): The upper price limit of the Value Area.
Value Area Low (VAL): The lower price limit of the Value Area.
Point of Control (POC): Is the price at which most trade is conducted during the period under study. It is that line of TPOs that makes the very apex of the bell curve of distribution. It is the statistical mean of the price, time, and volume relationship.

Responsive Selling?

If perceptions do not change as prices move away from the upper VA level, prices quickly run out of buyers and start attracting sellers who return prices towards and into the value area. This is also true at the other end. As prices move away from the lower VA level, prices quickly run out of sellers and start attracting more buyers who will bring prices back to the value area. This phenomenon is referred to as responsive selling or buying, respectively.
On occasion, the migration of prices above or below the VA extremes, rather than attracting responsive buyers or sellers, attracts the big money who (for whatever reason) now considers the VA extremes as unfair. The big money responds by initiating buying at this previous extreme. Once this happens, the upside breakout is likely to gather momentum as short sellers quickly cover their losing trades. Prices are likely to trend strongly for the rest of the session, or at least until the big money considers a new upper limit of value has been reached. This is also true at the lower VA level (VAL). Normally when prices reach this area, they cause traders to respond by buying. But occasionally the big money will have reevaluated value at this VAL and consider it overvalued and initiate selling. This will attract further selling and a downtrend is likely to continue into the close, or until fair value is perceived to have been reached.
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The Value of the Value Area

The VA of the day is of great value to traders the following day. The opening of the Chicago regular trading hours (RTH) relative to the previous day’s VA can be above, below, or within the VA. Opening price, if outside the VA, may or may not pull back into the VA. All these possibilities have significant implications for the ensuing day's trade. Markets frequently rotate through value and only occasionally trend. So VA extremes offer opportunities to enter fading the extreme or trading the breakout. Knowing which to trade has obvious implications for your financial survival.

The POC's Daily Implication

Similarly the POC of the previous day has great implications for day traders. Being the level of the greatest perception of value, and the price at which the greatest volume of trade took place, it is likely to offer significant support on downside pull backs in an uptrend, or resistance on an up-side correction in a downtrend. The POC will then offer opportunities to fade the pull back. However, failure of these normal expectations as prices test the POC would amount to a break out of sorts, and fading the POC could be a costly mistake.

VA and POC Insight

Similarly, VA and POC studies of longer time periods offer great structural insight to the market for day traders and other time frame (OTF) traders who are usually the big money looking to initiate, or hedge positions for the long haul. But as James Dalton says in his book, 'Markets in Profile,' "Even OTF traders are day traders when they put on a trade."
Use of the VA overlay charts over a 5-, 10- and 20-day period can be a great aid in identifying potentially low-risk trade placement and setting reasonable targets for price movement. These are of use to day traders and swing traders.

Larry Levin