I read somewhere recently -- and
can't remember where -- having to do with Market Profile, I believe -- that most
experienced traders will avoid trying to catch the tops and bottoms and focus on
"the middle", waiting for confirmations to enter and confirmations to exit.
However, since "the middle" is by definition where most of the trading is going
on and is largely non-directional, there is also a lot of whipsawing in the
middle, and that generates a lot of losing trades. One can sometimes avoid this
by widening the stops, but, since the market always teaches us to do what will
lose the most money, this will turn out to be an unproductive tactic.
The
safest and generally most profitable trades are found at the extremes.
Therefore, you wait for the extremes. Wyckoff used a combination of events to
tell him when a wave was reaching its natural crest or trough: the
selling/buying climaxes, the tests, higher lows/lower highs, and so on, all
confirmed by what the volume was doing and by the effect the volume had on price
(effort and result). As a result of this work and of his exploration of trading
ranges, he developed the concepts of support and resistance along with their
practical application. Auction Market Theory (AMT) takes these investigations
into support and resistance further, an “organic” definition of support and
resistance like Wyckoff’s, that is, determined by traders’ behavior, not by a
calculation originating from one’s head or from a website somewhere. Determine
whether you are trending or “balancing” (ranging, consolidating, seeking
equilibrium, etc), determine the limits of the range (support and resistance),
and you’re in business.
The notion of support and resistance has been and
is the missing piece for many market practitioners. One can try to hit what
appear at the time to be the important swings again and again and be stopped out
again and again, hoping all the while that once one hits the true turning point,
all the effort will turn out to have been worthwhile and the P&L will change
from red to black. But by waiting for the extremes, one avoids most or all of
those losing trades, and, even more important, avoids trading counter-trend.
These boxes -- which are simply a graphic variation of the Market Profile
distribution curve, whether skewed or not, or of the VAP (Volume At Price)
pattern -- are nothing more than a means of locating those extremes. What I've
found more useful about them is that they are encapsulated by time, i.e., the
price and volume ranges have a beginning and an end. This enables me to see at a
glance where the important S&R are, or at least are likely to be. Without
them, one ends up with line after line after line until the S/R plots become a
parody of themselves.
All of this can be very confusing to someone who’s
learned to view the market in a different way, perhaps less so to someone who’s
just starting since he has so much less to unlearn. But backing up to the basic
tenets of AMT, as well as to the concepts developed by (and in some cases
originated by) Wyckoff, one can perhaps find a solid footing and proceed from
there.
To begin with, in the market, price is often not the same as
“value”. In fact, one could say that since the process of “price discovery” is a
search for value, they match only by accident, and then perhaps for only an
instant. Blink and you missed it. Add to this the fact that for all intents and
purposes there is no such thing as “value” but rather the perception of value.
After all, what is the “value” of, say, Microsoft or GE or that little stock
your stylist told you about? This state of affairs may seem like a recipe for
chaos, but it is in fact the basis for making a market, that is, reconciling the
differences – sometimes extraordinarily wide differences – in perceptions of
value.
As Wyckoff put it, if a stock (or whatever) is thought to be below
“value” and a trader or group of traders see a large potential for profit ahead,
he/they will buy all they can at or near the current level, preferably on
“reactions” (or pullbacks or retracements), so they don’t overpay. If the stock
is above what they perceive to be value, they'll sell it (or short it),
supporting the price on those pullbacks and unloading the stock on rallies until
they are out (or as much out as they can be before the thing begins its downward
slide). “This”, he writes, “is why these supporting levels and the levels of
resistance (a phrase originated by me many years ago), are so important for you
to watch.” When price then begins to lose momentum and move in a generally
sideways direction, you’ve found “value” (if value hasn’t been found, then price
won’t stop advancing or declining until it has). Value, then, becomes that area
where most of the trades have been or are taking place, where most traders agree
on price. Price shifts from a state of trending to a state of balancing (or
consolidation or ranging), the only two states available to it.
The
trading opportunities come (a) when price is away from value and (b) when price
decides to shed its skin and move on to some other value level (that is, there’s
a change in demand). This is also where it gets tricky, partly because demand is
ever-changing, partly because you’ve got multiple levels of support and
resistance to deal with and partly because we trade in so many different
intervals, from monthly to one-tick. If we all used daily charts exclusively, it
would all be much simpler, though not necessarily easier. But that’s not the
case, so we must remember always that a trend in one interval – say hourly – may
be a consolidation in another, such as daily. The hourly may be balancing, but
there are trends galore in the 5m chart. Or the 5s chart. Or the tick chart.
Regardless of how one chooses to display these intervals – line, bar, dot,
candle, histogram, etc – there are multiple trends and consolidations going on
simultaneously in all possible intervals, even if they’re in the same timeframe,
even if that timeframe is only one day (to describe this ebb and flow, Wyckoff
used an ocean analogy: currents, waves, eddies, flows, tides).
To sum up
where we are so far, and keeping in mind that there is no
universally-agreed-upon auction market theory, the following elements are, to
me, basic, and are consistent with what I've learned from Wyckoff et al:
- An auction market's structure is continuously evolving, being revalued;
future price levels are not predictable
- An auction market is in one of two conditions: balancing or trending.
- Traders seek value; value is price over time; price is arrived at by
negotiation between buyers and sellers.
- Change in demand drives change in price.
- One can expect to find support where the most substantial buying has
occurred in the past and resistance where the most substantial selling has
occurred.
Now let’s translate all of this into a chart.
I'm
sure everyone has noticed that swing highs and lows and the previous days’ highs
and lows and other /\ and \/ formations can serve as turning points and appear
to act as resistance. However, this type of resistance stems from an inability
to find a trade and is accompanied by low volume*. Price then reverts to an area
where the trader finds it easier to close that trade. That's what provides that
ballooning look to the volume pattern “A” in the following chart. "Resistance"
in this sense, then, refers to resistance to a continuation of the move, whether
up or down.
*Volume may look “big” at the highs and lows, but the
price points are vertical, not horizontal (as they would be in a consolidation),
so the volume – or trading activity – at each price point is lessr than it would
be if the same price were hit repeatedly (again, as it would be in a
consolidation).Note that you may have more than one "zone of
concentration" (this is how jargon gets started), as in the first balloon.
Nearly all the volume is encompassed by the pink lines, but there is a heavier
concentration within the blue lines because of where price spends the greater
part of its time. The volume in the balloon “B”, however, is more evenly
distributed throughout the zone, partly because price spends so much time in it
and partly because it ranges fairly steadily within it. Instead of rushing to
the limits and bouncing back toward the center, they linger at those limits, the
sellers trying to push price lower, the buyers trying to push price higher. Thus
there is more volume at these edges than in balloon “A”, but buyers eventually
fail in their task as sellers do in theirs, and trading drifts back toward the
center, providing, again, a relatively even distribution of volume throughout
the range.
Balloon “C” is similar to “A” but much thinner due to the fact
that price has made only a single round trip to the bottom of the range. It
lingered a bit in the middle, simultaneously creating that protrusion in the
center of the volume pattern. But volume at each end is thinner than in “B”,
thinnest at the bottom due to the \/ shape, giving the volume – if one is
fanciful – something of a P shape.
If
price drops through one of these zones, those who bought within that zone are
going to be miffed. Some of these people are going to try to sell if and when
price re-approaches that zone. This is the basis of resistance. There's just too
much old trading activity to work through in order for price to progress unless
there is enough buying pressure to take care of all those people who want to
sell what they have, then push price even higher (in which case those who sold
may think they screwed up yet again and buy back what they just sold). However,
those who bought or sold at the outer reaches of these zones will also be
disappointed if they can't find buyers for whatever it is they just bought, not
because there's too much volume but because there isn't enough.
So how
does one trade all this? First, you will have to monitor several intervals at
the same time in order to (a) find out what interval you want to trade and (b)
where price is within whatever range or ranges is/are in that interval. For
example, if you’re most comfortable with a 5m interval, you’ll want to check a
smaller interval or two to see what price is up to down there, but you’ll also
want to look at larger intervals, such as the 15m or 60m or even the daily (I’m
using time intervals here in order to keep this from becoming even longer than
it will be, but the same approach applies whether you’re using range bars,
volume bars, tick bars, candles, lines, etc).
Second, locate the ranges.
Box them or circle them or color them or in some other way highlight them. If
you find a range that is wide enough for you to trade (that is, there are enough
points from top to bottom to make a trade worthwhile), get “into” the range via
a smaller interval in order to find a trend. Perhaps at some smaller interval,
price is at the bottom of that range. That gives you a good possibility for a
long (or it may be at the top of the range, giving you a good possibility for a
short).
At this point, you have three options: a reversal, a breakout, or
a retracement. If, for example, price bounces off or launches itself off the
bottom of the range (support), trade the reversal and go long. If instead it
falls through support, short the breakout (or breakdown, if you prefer). If you
don’t catch the breakout, or you prefer to wait in order to determine whether or
not the breakout was “real”, prepare yourself to short whatever retracement
there may be to what had been support and may now be resistance.
A more
boring alternative is that price is nowhere near the top or bottom of any range
that you can find but rather drifting up and down, aimlessly. No change is
occurring; therefore, there is no trade, or at least no compelling trade.
Finding the midpoint of the range may be useful since price sometimes ricochets
off the midpoint, or launches itself off the midpoint if it has settled there.
Such actions represent change since price may be looking for a different value
level. It may come to a screeching halt and reverse when it gets to one side or
the other of the range and return to the midpoint, or it may launch itself
through in breakout form and extend itself into the next range, if there is one,
or create a new range above or below the previous range (in determining which,
back off into larger intervals in order to determine whether or not price is in
a range in one of those larger intervals).
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Getting
Down to Cases
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