If you day trade futures, understanding how market profile works can be valuable knowledge. Even for swing traders, understanding how to read market profile can help you gain a competitive edge.

What is market profile?

A market profile is a convenient relationship between price and volume. A market profile is constructed by looking at all the prices that a security traded at over a given time period and relating them to how many units were traded at each price.

Let’s look at a simple market profile over the period of one day. It sounds harder than it really is:

The market profile above shows that 500 contracts were traded today when the price was 899. Similarly, 1000 and 750 contracts were traded at prices 900 and 901, respectively.

Analyzing market profile can be useful in that we can identify how buyers and sellers respond to various price levels. For example, in the profile shown above, we can see that there were a lot of contracts traded at 900. That might be a signal that buyers and sellers were in agreement at that price. This is also known as an efficient price zone.

We can also think of this in terms of acceptance or denial. When a high volume of contracts are traded in a given price range, we might say that the market is “accepting” that price. In contrast, a market will often make moves on low volume, only to quickly reverse when it reaches a certain price. In that case, we would say the market “rejected” that price.

It is usually helpful to visualize a market profile by looking at a price by volume graph:

A visual representation of a market profile and the resulting value area

From this graph we can see the distribution of volume by price. It shows what appears to be a bell curve. In this case, the market rejected extreme values  to both the upside and downside, as evidenced by the low volume levels. The market was accepting of mid-range prices, as shown by the high volume at those prices, which brings me to the concept of value area.

Value Area from Market Profile

Most market profiles include an area where pricing is very efficient. When I say efficient, I mean that a lot of contracts were exchanged in that range of prices, resulting in many small, non-directional movements in price. In general, you want to avoid trading these small, non-directional movements.

This range of efficient pricing is called the Value Area. Value area is defined as the range in which 68% of the day’s volume occurred. The uppermost region of value area is known as value area high. Likewise, the bottom boundary of value are is value area low.

In the market profile shown above, value area is indicated by the red box.

As I said before, the environment within value area is poor for day trading, in and of itself. However, over the years I have learned some clever techniques for trading value areas. I’m not an extremely active day trader. I’m more of a swing trader, but when I do take a day trade, it almost always almost involves value area in one way or another. Let me explain….

Setups Involving Value Area High and Low

Value area high and low are very special in that they act as excellent levels of support and resistance. Even though price action within value area is choppy and non-directional, a breakout above value area high or a breakdown below value area low usually results in explosive, actionable movements.

In that same vein, tests of these levels are more likely to result in rejections than not, especially when it is the first test. That can also be used to your advantage when trying to game the market.

Breakout/Breakdown Trade

This is one of my favorite market profile setups to trade. First of all, I always trade using the previous day’s value area.

When I see a breakout above value area high or a breakdown below value area low, I wait 20-30 minutes to ensure that the market is accepting the new price range. After 20-30 minutes I look to enter the trade on a pullback. Ideally, I will be able to enter right at value area high/low. I then set my price target equal to the nearest pivot point or other source of support/resistance.

Here is an example from last Wednesday that worked out perfectly. Prior to the cash market open, the S&P futures broke above value area high on positive news (notice the aggressive move out of value area). The market traded sideways, accepting the breakout, for a good deal of time – far more than the 20 to 30 minutes needed to confirm the breakout.

When the market opened, I was looking to buy into the first retest of value area high. Value area high also happened to line up almost perfectly with the pivot point for the day, which made for an extra strong support level.

Sure enough, at 10:30 AM, I got my pullback. I bought into the pullback right at value area high, with my stop 3 points below. My target price was S1, which was about 7 points away. Prices got there within an hour and a half and I took profits without thinking twice.

A textbook value area setup

The key with this setup is to be extremely patient. Perfect setups like this one come around 3-4 times a week and when they do they are easy to trade. The trick is not getting too aggressive at the wrong times.

Reentry into Value – the 80% Rule

My other favorite market profile setup involves trading a breakout or breakdown that involves reentering value area. This works especially well when the range between value area high and low is wide.

Often times the market will open up above or below value area. It’s not uncommon for the market to reverse its trend and break back into value. If this occurs, and prices confirm the movement by spending at least 20 minutes in value area, prices will proceed to the other extreme of value about 80% of the time.

For example, if the market opens above value area and breaks down beneath value area high, I start my stopwatch. If it spends at least 20 minutes in value area, I would look to get short. I usually try to enter within 0-3 points of value area high or low. That minimizes my risk should I be wrong – I can just put my stop 1 point above the edge of value area.

How to Calculate Value Area High and Low

I’m working on creating a Pimp My Trade Value Area Calculator, but in the meantime, you can learn to do it yourself.

1. Go to http://www.cmegroup.com/tools-information/build-a-report.html?report=priceByVolume
2. Select the futures contract you want to calculate values for
3. Select the front month contract, check “Globex” and choose yesterday’s date
4. Hit create report
5. Select all four columns with your mouse and make sure all the data is selected by going down to the bottom
6. Copy the data to your clipboard and paste it into a text file. Save this file as (your filename).txt
7. Close the text file and open Microsoft Excel or another similar spreadsheet program
8. Go File–>Open
9. Change the “Files of Type” setting in the open file dialog box from “All Microsoft Excel Files” to “Text Files”. Open your text file.
10. Excel should prompt you about how to open the file. Check “Fixed Width” and hit finish. This will import your data into MS Excel.
11. You only need the Trade Price and Total % columns. You can delete the rest.
12. Find the maximum of the Total % column. Go to that cell and highlight that row so you can find it easily. This price is called the “Point of Control,” and represents the midpoint of your market profile distribution.
13. Find an empty cell and type the following formula: =SUM(”The point of control Total % cell”)
14. Double click on your “Sum cell”. You should see a blue box surrounding the point of control cell. Expand that blue box by equal increments above and below the point of control until the value of your “Sum” cell equals 68% or near that number. The most extreme values will be your value area high and low.

Value Area for Longer Time Periods

Value area and market profile are applicable for longer time periods as well. I don’t have a great methodology for calculating value area high and low, however, I know how to approximate it.

I usually use stockcharts.com. One of the studies they offer is called “Volume By Price.” If you dial the chart into the time period you want to use and activate that study, you should see a market profile chart overlaid on your candlestick chart.

Here’s an example

I then try to identify where 68% of the volume lies and find a round number corresponding to the high and low of value area.

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