141 West Jackson: A Journey Through Trading Discoveries

141 West Jackson A Journey through Trading Discoveries

r

J. Peter Steidlmayer

Steidlmayer Software, Inc. Chicago, Illinois, 1996

Copyright © 19961. Peter Steidlmayer All Rights Reserved. Reproduction or translation of any part of this work beyond that permitted by Section 107 or 108 of the United States Copyright Act without the permission of the copyright owner is unlawful.

This

publication is designed to provide accurate and authoritative infor­ mation in regard to the subject matter covered. It is sold with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional service. If legal advice or other expert assistance is required, the services of a competent profes­

From a Declaration of Principles jointly adopted by a Committee of the American Bar Association and a Committee of Publishers. sional person should be sought.

Printed by: Litho Art Printing· 60 I SE Clay St .

•

Portland, Oregon

97214 Market Profile® is a registered trademark of the Chicago Board of Trade.

Library of Congress Catalog Card Number 96-72352 First Edition Printed in the United States of America

To Kirby-whose sense of order was complete and wonderfully infectious.

Preface

It has been an interesting journey. Over the past fifteen years, I have seen Market Profile evolve from an objective output which required a fair amount of subjective input, to what we have today, a Market Profile digital database that helps to objectify the market. Over that same time horizon, markets have become more international, interconnected, and complex. The challenge to the individual trader has become more daunting. The influence of external markets and today's capital flows would tax the market understanding of the most successful intuitive trader of the past. To deal with the ava­ lanche of the information age and remain objective and there­ fore in control as a trader requires new tools. When reading this book, approach it as you would any mental exercise. Look to gain knowledge, and consider how you could apply the concepts presented to your trading. Don't see it as a how-to book that contains the Holy Grail. The way Mr. Steidlmayer offers his insights, thoughts, and observations as public domain is surely selfless and exemplary. He is a visionary who has conveyed a lifetime of thoughts and ideas on markets into one all-encompassing manuscript, 141 West Jackson. Steven B . Hawkins SBH Capital Management December, 1996

Acknowledgments

In this book there are many uses of both the singular and plu­ ral in describing developments. Sometimes it's I, sometimes we or us, depending on the way I just naturally felt about what took place at that particular moment. I've been fortunate to have a lot of help throughout this project, including especially the full sup­ port of all those associated with me as well as those who be­ lieved in me. It would be proper to acknowledge each person who was involved individually, but the contributions came from the whole Market Profile community, and that includes almost everyone I've dealt with. I would like to single out the person most responsible for the existence of Market Profile: the former Chairman of the CBOT, Les Rosenthal. Leadership, unlike stew­ ardship, calls for having a sense of direction, and more impor­ tantly a clear perception of how to let things proceed. To all of you who participated, I'd like to express my thanks for a very fun journey, and for your efforts in helping to make what I feel is a lasting contribution to the industry. It is always difficult to find a clear way of expressing radi­ cally new ideas. And expressing myself is not my strong point in any case. I'd like to particularly thank my editors, Cynthia Brown and Robin Mesch, for their truly brilliant transformation, or per­ haps I should say transmutation, of my rough manuscript into its present polished form.

1111

Background

When I graduated from college and first started trading, my father asked me why I would want to get into a business where almost everyone loses. My answer was that there wouldn't be much competition. Despite my bravado, I knew I would need to overcome formi­ dable obstacles on the path to my goal. Most importantly, I real­ ized I was working against a background where the accepted prac­ tices were not making other people successful. Because of my experience in school, I was confident that I could learn how to learn. I also knew it was important to keep the learning process separate from making money. To me, what others regarded as success, whether it was immediate financial gains, or the good opinion of others, was not real success, because it might not have a real foundation. The foundation for being successful was in the learning; the real definition of success was improvement in my ability to function, improvement in my performance as compared to the background of what I was before. I felt that most people didn't take the time to learn and didn't make a commitment to keep learning once they began to make some money. The path I was going to take was one where I would question everything I did. One factor in my decision to become a trader was my experi­ ence outside the Chicago Board of Trade (CBOT) in trying to get into other businesses. I had what I thought were a lot of good ideas, but I had a hard time convincing people in power to go along with them. In other words, I got the old "Well son, when

x

you have a lot of experience come back and see me," attitude. I was terribly frustrated. I could see that it would be a long time before I got the opportunity to use my capabilities in the business world. I began looking at the CBOT markets as a place where my ideas could hatch. I wanted to become an outright trader, rather than a broker, a spreader, or a scalper, because I felt that was the highest echelon one could achieve: it had a limitless potential. If I couldn't succeed as a trader, I was willing to leave the industry and try something else. The path I eventually developed for myself was rather unor­ thodox at the time, and, because of my preference for market controls over financial controls (ideas I ' ll explain later) and my insistence on the need for the industry to change, it is still very controversial. However, in view of the lack of success of the cur­ rent methodologies, logic would say that change is necessary. Over the years, as I worked to become a successful trader, I kept returning to my father's question, wondering why so many aspiring traders fail. I have come to believe that consistently suc­ cessful trading requires a grasp of the underlying processes that drive the market, at least on an intuitive level. Successful trading has to emerge from an understanding of the background of the market. My goal has been to make that understanding explicit, and to make the processes objectively measurable. The tool I've evolved and used in this endeavor is the database and market analysis system called Market Profile. This book is the result.

Contents

Chapter One What This Book is About

.......................................................

1

Chapter Two Getting Started

........................................................................

7

Chapter Three Market Discipline, Background, and Efficiency

................

21

Chapter Four Looking for the Purpose of the Market

..............................

33

Chapter Five Efficiency and its Role in Market Organization

................

39

Chapter Six How the Market Defines Itself

.

...

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55

Chapter Seven Capturing Market Data ....................................................... 61

Chapter Eight The Importance of Two-Dimensional Expression

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65

Chapter Nine The Bell Curve

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.......................

..............................................

Xl

75

xii

Chapter Ten Updating Our Understanding of Market Profile

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79

Chapter Eleven Looking to the Future--Data Arrangement

103

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Chapter Twelve Price...The Market Messenger

125

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Chapter Thirteen Where Do We Go From Here? Index

127

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133

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CHAPTER ONE

What This Book is About

Studies of the commodities markets consistently show that 85% of all traders lose. I've begun trading stocks in the last couple of years, and interestingly, if you measure the results of stock mutual funds versus a standard index, the success ratio is simi­ lar: approximately 85% of all stock funds failed to beat the S&P last year. The "trading" activity in a stock fund is stock picking. It is quite revealing that while most commodity traders are tech­ nically oriented, and most stock pickers rely largely on funda­ mentals, their trading results are quite similar. Why do such diverse approaches lead to equally sub-par per­ formances? What is the common denominator? The answer that I initially gave myself, and which I still believe is correct, has to do with understanding, particularly in terms of market back­ ground. The programs of both types of traders seem to eclipse background; in the case of the technical trader with financial con­ trols, and in the case of the fundamentally based trader with a belief in projections. A trader must try to understand a market in the present, rather than attempting to predict the future. I think that what follows in this book will go a long way towards solving this problem. The crux of why people are losing is that they are using the wrong database, one that actually inhibits the necessary insights from

2

CHAPTER ONE

PRICE

58-15 58- 1 4 58-13 58- 1 2 58-11 58- 1 0 58-9 58-8 58-7 58-6 58-5 58-4 58-3 58-2 58-1 58 57-31 57-30 57-29 57-28 57-27 57-26 57-25 57-24 57-23 57-22 57-21 57-20 57- 1 9 57-18

1,2

TOTAL

CTI

50 387 594 1530 2632 3288 5239 3696 3232 278 1 21n 2019 2635 3626 5543 6434 3849 5136 3952 3674 2206 2582 2078 1 317 1040 919 639 977 473 87

17 247 38 1 916 1630 2092 3348 2166 1804 1910 1391 1350 1 7 14 2454 3462 3989 2360 3 1 93 2627 2441 1317 1681 1 288 699 622 586 404 582 258 76

Table 1-1.

CTI

1,2%

34 63.8 64. 1 59.9 6l.9 63.6 63.9 58.6 55.8 68.7 64 66.9 65. 1 67.7 62.5 62 61.3 62.2 66.5 66.4 59.7 65. 1 62 67.2 59.8 63.8 63.2 59.6 54.5 87.4

Bond trade volume by categories, Oct.

4%

CTI4

CTI

33 140 213 614 1002 1 196 1 89 1 1530 1428 871 781 669 921 lIn 2081 2445 1489 1943 1 325 1233 889 901 790 618 418 333 235 395 215 II

66 36.2 35.9 40. 1 38.1 36.4 36.1 4l.4 44.2 3 1 .3 36 33.1 34.9 32.3 37.5 38 38.7 37.8 33.5 33.6 40.3 34.9 38 32.8 40.2 36.2 36.8 40.4 45.5 12.6

6 1981

developing, and thus blocks them from learning about the markets. Internal market statistics reveal that successful traders, who are mostly concentrated among the professionals, are using a different strategy than unsuccessful ones. Table 1- 1 gives volume

WHAT THIS BOOK IS ABOUT 3

Top 1 /3 Middle 1 /3 Bottom 1/3 Table 1-2.

CTIl, 2

CTI4

59.4 (62.9) 64.5 (62.9) 64.2 (62.9)

40.6 (37.1) 35.5 (37.1) 35.8 (37.1)

Trade percentages summarized by categories

statistics for trading in bonds on October 6, 198 1 . It was issued by the Chicago Board of Trade in an attempt to help the trading public by providing information on the various types of market participants. At that time the volume data was broken down into segments of CTI codes (Commodity Trader Identification codes, such as commercial trader, local, local off floor, and other); CTII and CTI2 are the local and professional trader categories, while CTI4 represents all others (CTI3 was not used). The total percentage of trades for the local and professional traders is 62.9%, with the remainder going to the others. If both categories of traders were trading the same way, then the percentage columns would read 62.9% and 37. 1 % all the way down the table. Clearly, this is not the case. To get a better idea of what's going on, let's average the percent of trades for each category in the top, middle, and bottom third of the table. The result is summarized in Table 1-2. Note that in the top third of the range the CTI4 traders are several percentage points above their 37. 1 % average, while in the middle and bottom third they are several percentage points below it. The implication is that the market is extracting a pre­ mium from this type of trader for the potential opportunities pre­ sented. The CTIl and CTI2 traders have the reverse effect; they are not paying the premium because they are trading the efficient part of the market that the trades are going to emanate from. The

4

CHAPTER ONE

implication is to move your trades to this part of the range as well. The lesson here is that successful traders have an under­ standing of the market that produces a different strategy than that used by unsuccessful traders. A great deal has been learned about markets since 1 982, when the original version of the Market Profile data management and analysis system was first formalized. The initial effort was based on the notion that the bell curve, a fundamental organizing prin­ ciple in statistical analysis, would have some important relation­ ship to market behavior. While not perfect, the first version was successful enough to inspire an ongoing quest to understand more. Progress was incremental and relatively slow, as learning came from observation and experience, contributed to by many people in an open process of exploration, discussion, and discovery. Many of the key formats used in organizing the data were fortunate discoveries that proved to have important ramifications far beyond what we intended when we first developed them. When we went back to try to understand why the formats worked so well, we were led to the operating principles of the market. The original formats, which were based on an intuitive understand­ ing of trading, had in them the seeds of the formal knowledge we were seeking. It took 1 5 years of working with Market Profile to develop all the insights. Towards the end, progress was greatly accelerated by using a computer to do the processing, allowing us to work out and verify our ideas on many more markets than we could have dealt with otherwise. In fact, bringing the com­ puter into the world of trading has accelerated the flow of infor­ mation and hence the evolution of the markets and of trading methods in general. With new types of data arrangement, the com­ puter allows quicker forward movement. Change enables the suc­ cess of people just entering the markets, as a new technique al­ ways offers opportunity to the new person. Our most important innovation was the data entry system it­ self. Its key advantages were that it allowed us to get away from using chronological time as a basis for organizing our data, and

WHAT THIS BOOK IS ABOUT

5

forced a two-dimensional data representation, giving us a verti­ cal base for data processing. This system got the effort of data organization off on the right foot and gave us a solid basis for going forward. Over time, the data entry system evolved from daily profiles into profiles organized around market events, and finally to a database of smallest meaningful data units. The system accom­ plished the graphic capture and display of the market in a two­ dimensional setting that reflects the underlying market processes. This is a clear prerequisite for obtaining objective measurements that define the state of the market, and thus the opportunities that may be present. Markets measured means markets defined. De­ fining your opportunities in terms of market measurements is as close as you need to be. The culmination of our studies was the discovery that the market is a dynamic, self-organizing system that is based on effi­ ciency. The market is always trying to make order out of disor­ der. It has a well-defined underlying process that can be under­ stood and recognized, and that process has a natural progression that can be seen and measured. It has reference points, which, when identified, represent important information, and it produces a final output or resultant, which accomplishes the market's pur­ pose. The process is cyclic: it reaches closure and then starts over again. Finding the market's purpose was our most significant break­ through, and it is the central theme of this book. Our explanation of the market's fundamental process reconciles the notion of mar­ ket efficiency with the ability of skillful traders to make money. (In an efficient market, price moves immediately to reflect value. Thus, the cost of information outweighs the profit potential from having it.) The idea of efficiency has a long association with markets, mostly conceived as a barrier to successful trading, and it has been a revelation for us to note its importance as a dynamic resource for traders. The various stages of the development of Market Profile through the years reflect our increasing understanding, as well as

6

CHAPTER ONE

actual changes in the markets. Throughout the process, we fol­ lowed a consistent theme. As our understanding developed, we began to notice a correspondence between the disciplines im­ posed on traders by the market and the notions we derived by studying the bell curve and its expression in Market Profile. At first these were subconscious revelations that led us to choose good data representations; later, as theory and practice began to merge, we were able to objectify our intuitive understanding. Along the way to our final results, we had several important contributory insights, which we'll discuss as we follow the path of Market Profile. For example, the material on liquidity and its relationship to randomness has very practical applications in trad­ ing. The strategies of big traders are always interesting and note­ worthy, and provide us a viewpoint that should in principle be adopted by all traders. We' ll look at the concept of background, which substitutes for financial controls for large traders, and how it should be used by small traders. As we consider the notions of horizontal and vertical market phases, we' ll introduce the terms dominance (the force that drives the vertical phase) and lull (the pause that usually follows a ver­ tical move, and is hard to handle). These terms will allow us to formalize and discuss important phenomena that people usually take for granted as a background, without consciously studying and measuring them. In particular, we' ll investigate the essen­ tially two-dimensional nature of the market. The purpose of this book is to enhance your market under­ standing. Your future success is your responsibility; there is no automatic, "foolproof' formula. As you develop yourself as a trader, take particular note of the lessons of principle-those that have come from the market itself, and those coming from your own experiences. These will provide the basis of integrating market data into your own trading program.

CHAPTER Two

Getting Started

In the course of this book we' re going to examine the under­ lying ideas behind Market Profile, as it was when we first for­ malized it, as we developed it, and in its present form as we bring it to a final phase of understanding. Unlike most books about trading or the markets, we are not going to prescribe a specific trading plan, nor will we give "how to" details. This book is like a cookbook that explains the principles of cooking, rather than giving specific recipes. One always needs a deeper understand­ ing than recipes or formulas can give to achieve anything real. It's my hope that this book will provide the reader with a strong background and understanding of markets, and stimulate the de­ sire to take advantage of the opportunity thus presented to pursue the issue of markets further. I have been trading for over 35 years. From the beginning of my trading career, I have organized data around the bell curve, loosely at first, and more formally from the early 1 980's on. I feel that I've finally come to a full and complete understanding of the merits and subtleties of this approach. Data organization is fundamental to my theory of the market, and it can also serve as a knowledge base for you, whether you plan to trade as a ca­ reer or just want to understand trading as part of your financial education.

7

8

CHAPTER Two

Like most of you, when I started trading I had questions relat­ ing to my ability to understand what I was going to do. How would I know whether to buy or sell? How would I recognize an opportunity, and how long would it remain an opportunity? There were three stages in my development as a trader. The first was an exploratory, or educational, phase. I became interested in trad­ ing while at V.c. Berkeley, after reading an article about it in Fortune. I began to focus on trading as a career after a course on investments. The text in that course, Graham and Dodd's Secu­ rity Analysis, explored fundamental analysis. The methods de­ scribed in the book appeared logical and made a lot of sense to me. The book emphasized that mistakes or good decisions could be isolated and understood against a background of principles. This was my first exposure to financial controls, the use of ob­ jective parameters like profits per share, cash flow, etc. to control investment decisions. Significantly, these controls were internal, in that they emanated from the company itself. I also became aware that there was a profound difference be­ tween speculation and investing, and that because so little was understood about markets and speculation, almost all commod­ ity traders ended up losing. I read extensively in "How-To" books, books about great stock traders, and whatever else I could find that related to the markets, trying to find the best way to get started. I asked myself what I was going to bring to the table. What was it that was going to put me into the successful group? There wasn't much material available on winning commodities traders, and, with my lack of experience, I wasn't in a position to readily ac­ cept or reject the available knowledge and teachings that were basic to the trading industry. I decided to try to use as my guidelines the business principles of other industries, ones where most participants were generally successful, and see if they couldn't be applied to trading. I real­ ize now that I was fortunate that information about winning trad­ ers was so sparse, since I might have tried to emulate them and would not have had the ability, at that stage of my development,

GEITING STARTED 9

to do so. Even at the time I felt that by studying business prin­ ciples that worked I would be able to carry on within myself at whatever level of ability I had, rather than asking myself to be greater than I was. Another source of potential wisdom was the many "sayings" about trading that were passed along by experienced traders. A "saying" is a truism coming from the practical experience of those who have dealt with the market. For example, "The market takes no prisoners," means that there is no middle ground between be­ ing right and being wrong. Such sayings were never explained, and were usually quite general and unspecific, but they repre­ sented insights that had helped people trade well over a period time. Both the business principles and the sayings turned out to be fruitful areas and worth exploring further. They contrasted di­ rectly with the "take it on faith" attitude and lack of real under­ standing I found in most books on trading. In many of these books, everything seemed to revolve around financial manage­ ment-that you could always pre-determine where to get out, but could not determine anything else. You took whatever came first: if your goal was hit, you had a profit; if your stop was hit, you had a loss. Further, with no particular knowledge or skills, one was supposed to be able to deftly mange a winning trade to its maximum potential. It seemed to me that this type of program did indeed make commodity trading a gamble, just as most con­ servative investment books said it was. Most commodity indus­ try approaches seemed to fly in the face of commonsense busi­ ness practices that were applied every day in other industries. You would not dream of running a business you understood with the practices these books recommended. Most of the academic works I encountered dealt with eco­ nomics or investments, not with trading, but I nevertheless found a lot of principles to think about. My basic conclusion was that understanding had to be the key to success, and that understand­ ing was a present tense process. Predictions, especially those

10

CHAPTER Two

that can be characterized as more or less baseless assumptions, cannot be used as a continual foundation for a business. In trad­ ing, people think that they can use money management to com­ pensate for any assumptions they make. This is an illusion. You solve the problem by understanding the background, projecting forward from a sound base, and seeing a contrast to the present, not by looking at the excitement of the moment. Predictions are dreams, and dreams are hard to evaluate. Reading gave me a certain amount of preparation, but I real­ ized that the only way to really find out anything about trading was to give it a try. Some experience would help clarify matters and perhaps give me a path to follow. I was not very successful at first, but I managed never to lose more than I had. In retro­ spect, this is about adequate as far as financial controls are con­ cerned, as I always managed to stay about where I started. Most of the disappointments came when things were going well and then turned against me. After a couple of years, I started to get the feeling that I could in fact succeed, and decided to go to Chi­ cago. This began the second stage of my development as a trader, what I call the early experience phase. When I started in Chicago, I knew that I had to have a reason to make a trade other than some baseless prediction, and a mar­ ket-derived reason to exit outside of a simple profit or loss. As a CBOT member, and a floor trader, I was able to learn by watch­ ing markets and traders at work. Being able to study and contrast successful and unsuccessful traders was very instructive. There was definitely a base of successful knowledge on the floor, and an invaluable opportunity to watch great traders in action. (This, by the way, is a problem for the young exchanges today, and for screen-based exchanges, where there's no opportunity for begin­ ning traders to learn by example.) Along with watching traders, I learned to look for market behaviors: the activity level, tone, and so on, of markets that were moving up, down, or sideways. I could tell the basic opportunity level by how many traders were in the pit. I would ask myself why there were 1 00 people trading

GETIING STARTED

11

com, compared to 300 in the bean pit, and how that affected the way the market was acting. This gave me a chance to understand the different types of market activity. In my first week of being a CBOT member, I had two real insights that tested my resolve. Many of the successful traders at the exchange were scalpers or scalper-spreaders, trying to buy the bid or sell the offer. The way they illustrated their technique to young traders was to mark a price on one side of a trading card with a pencil, showing a hypothetical buy at, say, $ 1 .23 1/8. Then they would flip the card to the other side, where there would be three potential exit prices: $ 1 .23 1/4 (a profit), $ 1 23 1/8 (scratch), or $ 1 .23 (a loss), whichever came first. They were most helpful to me and other young members. Their advice was never to be smarter than the market. The market was always right, i.e., take your loss if price went against you. I understood the principle that trader discipline was impor­ tant, but I felt that this type of trading again reduced the market to a gamble in terms of whatever event came first, and I ques­ tioned its merits. I did not understand the reasoning as it related to taking the loss in the prescribed manner. How could a finan­ cial loss by itself make you right or wrong? I did not think that anyone could be so good as to never have an equity loss at some time during a trade, so I decided not to use that as a determinant. My first need was to find a way other than stops to exit a bad trade. I reasoned that the market had only three ways to move: up, down, or sideways. I figured that if I thought the market was going to go up, and it didn't, it should at least move sideways. This gave me a 66% chance of not losing, a big improvement over the 50/50 chance associated with using a financial stop. If I thought the market was moving opposite the way I was set, I would get out immediately, but if the market was moving side­ ways I would tend to stay in, even if it was going against me to some extent. In addition, I was not at all skilled at or desirous of competing for the scalping type of trades in the pits, and viewed giving up the edge for the right to the idea as a sound practice for

12

CHAPTER Two

me. In other words, if I thought grains were going up, I would pay the seller's price, go for the idea, and either sink or swim on the results. My second insight came after a lunch with two respected trad­ ers who had more of a non-scalp mentality, and whose trading style was more in line with what I was doing. Both were very interested in helping young traders from a personal as well as a market perspective. At the end of the lunch, markets were dis­ cussed. My views and trade positions were opposite theirs in terms of the next probable moves in the markets. This was quite upset­ ting to me because when I put my trades on I really felt that I was right. That night I decided just to cover the positions in the morn­ ing and chalk it up to experience-I clearly had a lot more to learn. The next morning when I got to the trading floor I decided to wait for an hour or so and give the market a chance to go my way instead of immediately covering on the opening. The mar­ ket moved sharply my way, and later that day both members came over separately to ask what I thought now! This experience en­ couraged me to keep the general principle of what I was doing in place, and confirmed my notion that the best idea for me would always be my own: a principle I think holds true for all traders. This attitude was reinforced a couple of years later. I was short com over the April Stocks and All Positions report. I was fairly bearish on the market, and it was close to the typical seasonal end of the price movement for old crop com. Thinking that there would be no surprises, I did not stay for the release of the report, but instead went to a Cubs game that afternoon. Some other trad­ ers came out to the game later and told me the report was ex­ tremely bullish. I felt that this was big trouble for me, and that the market was likely to go limit up the next day. I was just hop­ ing it would not start there. I went down to the floor early the next morning and ran into a couple of large com brokers. I asked them what they thought of the report, and they said the market would likely be unchanged, or at most only a little bit higher. I was immediately relieved, and

GETTING STARTED

13

my anxiety started to dissipate. But, after a little more thought, I realized that what they had said could not be right. I felt that they and their customers were all short, and that they were trying to talk the market down. The more I thought about it, the more I knew that my feeling was right. The market opened reasonably well versus my worst expectations, but well above the general opening call given by the pit brokers, and I covered aggressively right on the open. I was hoping that they had decided to wait and see, and that they would be covering later in the day if they needed to. The market closed very strong that day. To develop myself further as I gained experience trading, I started a program of working with what I now call market disci­ pline. I studied all my trades each day against the backdrop of what took place in the market-what I did, why I did it, why was I right or wrong. I began to look at the market in two phases: a background phase, and a foreground phase. Market discipline consisted of studying the relationship between background and foreground: the internal contrast of the market within itself Market discipline has many connotations. Practically speak­ ing, it's the school of hard knocks. It means that the market will punish those who try to fight it. In this sense, it's a discipline that the market can and does impose on its participants. You learn by doing, by asking questions of yourself, by not repeating your mistakes, by taking responsibility for your actions and not com­ plaining about what-ifs, what went wrong, etc. You are in a con­ tinual learning mode. The problem with using financial controls is that background is never given any consideration-it is always taken care of by the financial control. This prevents people who use financial controls from learning. Market discipline is not a well-wrapped pretty package; learning from one's experience is never a neat and tidy process, but it is essential. In a more elevated and reflective sense, market discipline is the market's efficiency. After all, according to academic theory, efficiency is the reason one is supposed not to be able to make money trading. As a trader you are trading an inefficiency or a

14

CHAPTER Two

potential inefficiency that the market is trying to rectify: in con­ crete terms, a vertical move or potential vertical move. Usually a trader has paid a premium in terms of trade location for the infor­ mation that an inefficiency exists. The important thing to note is that an episode of inefficiency has a life and is not static. It is this "life" that gives the trader an opportunity to succeed. The reason inefficiency can develop is due to market uncertainty, which al­ lows it to expand or contract on itself. In retrospect, it should have been obvious to me and others that no static theory could account for an uncertain process. Inefficiency is the ultimate con­ trast of the market within itself, because that is when the fore­ ground is most different from the background. Both background and foreground must be expressed in terms of efficiency, in order to evaluate opportunity. (For example,inefficiencies are gener­ ally absorbed into an efficient background, if they are not power­ ful enough to change the background.) It makes sense, then, that to succeed, one must understand efficiency, or market discipline, work with it, and make it central to one's trading approach. As we shall see, efficiency is a dynamic phenomenon that is totally internal to the market. This brings me to the third stage of my development as a trader, a stage I have been in for a very long time now. It is one of continual exposure to and absorption of market discipline, ac­ companied by a constant desire to improve myself. Market dis­ cipline is not a road map, it's a compass. You find the direction and keep going, in a process of discovery. There are two major advantages that I have had over others in trying to pursue education as it relates to markets. The first was being on the floor and getting exposure to a lot of good traders. I met new young traders who approached the markets in a fresh way; in growth situations, the new are always closer to the beat, so to speak. I also met many fine traders who were satisfied trying to stay the same, and over time I realized that was not the way to go, as those who continued to update seemed to do better. Evolution theory tells us that the most specialized organism is

GETTING STARTED

15

the most successful in a constant environment, but can't survive through a change. The trader who keeps learning might not be the most successful in any given situation, but can keep going and adapting as conditions change. But in either case, the knowl­ edge of markets as expressed by these various individuals was in a subjective code. Hardly a trader could explain the what or the why, but the knowledge itself was definitely there. Most floor traders learn their skills through their experience of the practical side of trading, where participants are brought together in the discovery process, whether it's the open outcry methodology, specialist, screen based, or something else. Oddly, nothing has ever been directly written about this. Most people who are learning to trade fantasize about being just like so and so, the great trader. If you have the opportunity to discuss trading with a successful trader, try to elicit the principle behind what is being done. Remember, if someone is good over a period of time, there is something being done right. I was trading in the bean pit once on an extremely volatile day, and I had bought some beans at 786. The market moved up to around 792. Then, it paused and backed up to the 790 1 12 level. All this was taking place quickly, over a period of just a few minutes. In the pit there were probably 40 to 50 participat­ ing scalpers and traders in addition to all the brokers. Most of them were very actively bidding, offering, and competing for any order that carne into the pit. When the price reached the 790 area, I decided that I'd like to hit the next bid that carne into the mar­ ket, and I didn't mind hitting a local who was bidding the bid price or slightly under. As I watched for my chance, to my amaze­ ment not one local had both hands up and they all were only bidding verbally, which meant that they were only required to take one contract. I sensed that my of knowledge of this situation was not isolated, as the behavior of the whole group indicated that they had read the market the same way, and they were all waiting to hit the next bid. I dumped the market a cent and a half lower; it bounced back about a 1 12 cent and then broke 1 0 cents.

16

CHAPTER Two

The thing that surprised me was that we all came from different approaches, and we all traded differently, but we all knew that the situation was not favorable for an active bid. In looking back on this experience over the years, I learned to make the same trade over and over again. The important clue that we all picked up on in the pit was that there was a very quick move from 92 back to 90. This indicated a large degree of ineffi­ ciency in the market, which became an outer boundary from which the market was going to move vertically. In later years, when­ ever the market was in a position where it was ending a vertical movement that I wanted to trade against, I always waited for a quick vertical move in the direction I was looking to go in before I would make the trade. This example illustrates that the market does in fact commu­ nicate with those attuned to some sort of market discipline. Trad­ ing based on events like quick moves, totally dead markets, and so on represents implicit knowledge that has never gotten out. Most people approaching markets want rigid definitions, when in fact it's best to have a general principle defined in relative terms. The intuitive feeling of those attuned to market discipline is filled with relativity. What is the underlying order in the seemingly chaotic open outcry system that allows it to work so well? What information is produced, when and how does it become available to partici­ pants or to those wanting to participate, and how do they use it? This would, if understood, be the basis from which to go for­ ward, because it provides an organic understanding. It is an in­ tuitive part of successful trading that has never been articulated. Importantly, one could note that with prediction and financial controls dominating traders' thought processes, there was prob­ ably no demand for it. The second advantage I had in coming to grips with the order of the market was the visual output of Market Profile. I could begin to trace the outline of market discipline in the data units of the aggregated profiles. I was also able to separate my trading

GEITING STARTED

17

results from my efforts to attain a higher plane of knowledge. Over a very long time, I was able to correlate more and more of my practical trading experience with the visual order created by the profile, thereby getting what I would now describe as a con­ vergence of the two. Each small piece of understanding contrib­ uted greatly to unlocking the next problem, until now I feel that I've gone as far as I can, that I've reached my goal of objectify­ ing the market. This goal is different from most people's; it's not a trade parameter we ' re running through a database and backtesting with financial controls to see if it produces a profit or loss. Instead, we have built a framework from which questions can be asked and the whole spectrum of opportunities can be identified and routed to the proper trading programs. For example, a friend called me last week and pointed out a trade setup. It was good, but the trade took a lot of skill in execu­ tion in terms of finding it, getting it on, and managing it. In look­ ing at the background in which the trade opportunity had devel­ oped, there were many opportunities earlier in the week in which the same trade could have been made under less demanding cir­ cumstances. Most experienced traders will tell you that the set­ ups for good or losing trades look identical when looked at in the context of short-term market activity. It's the longer-term back­ ground that can distinguish between them and allow a market­ oriented approach to replace reliance on good financial manage­ ment. Most associate not having financial controls with total reck­ lessness and lack of discipline. An objectified data base, which provides information related to the background, gives much bet­ ter control than any financial control. Upgraded opportunities are the result. While I feel that I've reached my goal of objective market understanding, I do not think that all my ways of implementing my insights are by any means ideal. But the basic fundamental principles are there and will not change. It is these principles that will propel the industry forward as better ways to implement are continually found. I see basic industry growth coming from

18

CHAPTER Two

expansion into other arenas. I think that commodity trading will expand into the area of investments, and that stock investment will expand into stock trading. Logic and reasoning in the present tense, something we' re all capable of, will begin to replace the fantasy and fiction of predicting the future. The result will be a business that operates on the basis of internal controls, the key ingredient for a successful business in the long term. I have always looked to the future and tried to place myself somewhere in it. And I think your interest in this book signifies that you do the same. What does the future hold? I am certain that it is going to be something very different. I really do not have the ability to stray too far from my base, so I'm going to just look at the areas that I'm currently involved in. Coming from a ranching/farming background, I have always been resource ori­ ented. Trading has been natural extension of that interest. From a historic view of economics, we' ve had an abnormal situation in recent years where political and economic policy has been run to favor the financial markets-and they have certainly benefited. In addition, there have been other fundamental changes in the economies of the world that are supporting increasing market use. I feel that there is going to be a more obligatory participa­ tion in the future; markets are going to be needed as never be­ fore. And these circumstances will arrive sooner rather than later. We' re all concerned about our future as we move toward a global society. The increasing speed of computer productivity is running at a far greater pace than human productivity. If com­ puters and our skills move along at the same rate, we' ll be needed as people. Thus, the emphasis by the government on education. But the trend over the last four to five years is disturbing. Tech­ nology is leaping ahead at a tremendous rate. For example, medi­ cal technology has gone to a level that we really can't even af­ ford. We haven't kept pace, and have been left behind as a soci­ ety. If we take a look at computer productivity and the growth of processing power, we're finding that the gap is beginning to widen. Is there a path that we can get on now that assures that we have a

GETTING STARTED

19

future? This is a question that all of us should be asking our­ selves. I've come to the conclusion that trading offers a tremen­ dous opportunity far beyond anything else in today's environ­ ment, in that it gives a person the self reliance that seems to be called for in the new environment. It's a skill that if learned and mastered will take you a long way. Another reason trading is important is because of the increas­ ing importance of resource production and distribution. As edu­ cation and capital spread throughout the world, we're going to find that consumption becomes more decentralized, increasing the economic base of markets, and this will produce a lot of mar­ ket growth. I think we' ll come to a day in the U.S . , if we do not grow at a faster pace, when other economic areas will bid re­ sources away from us. This will be a drastic change. I ' m going to stay as close to my base of expertise as possible, because ac­ tivity is going to be high, and there are going to be lots of oppor­ tunities for people who understand markets and trading to ex­ ploit. I'll close this chapter with a "saying" whose truth we've all experienced: if you really need a break, or something favorable to happen, it won't. Being in a position of indifference in rela­ tion to luck is far better, because then you'll probably get it. Prepa­ ration and skill are the foundation for a solid program for your­ self. A personal "business plan" in which you prepare to take care of yourself will never let you down.

20

CHAPTER Two

CHAPTER THREE

Market Discipline, Background, and Efficiency

The three topics listed in the chapter title, market discipline, background, and efficiency, are the most important and least un­ derstood concepts in the trading community. We' ve all had some exposure to the idea of efficiency, but we' ve been conditioned to think of it as the Achilles' heel of our trading, when in fact a proper understanding of it is the key to unlocking the mystery of the markets. Background has always been present by default; we' re going to talk about how it changes and how monitoring background is one of the most important factors in trading deci­ sions. Market discipline was introduced in the previous chapter; here we' ll expand on the idea and show its close relationship to the other two. The major point of this chapter, and indeed of this book, is the central role that efficiency plays in the market. The market is a self-organizing system that brings flare-ups of inefficiency back to efficiency. From a practical standpoint, efficiency is the mar­ ket discipline that ultimately determines either a profit or loss on your trade. The benefit from working with market discipline is that you get closer to the market, to the point where you're really in tune with it. Market discipline provides a basis of market study that leads you in the right direction and allows you to learn from your mistakes. The idea of market discipline is probably vaguely fa21

22

CHAPTER THREE

miliar to you from our discussion so far; it will be central to help­ ing you understand the purpose of the market. The goal of this chapter is to explain in detail what market discipline is and how to use it. I've been working for many years to understand the workings of the market. The benefit to me was twofold: better trading, even though I did not have a complete understanding for a long time, and the fact that I can now begin to objectify my data base. You will see that understanding did not just present itself, but took considerable time, effort, and a willingness to rely on my own judgments, which were many times wrong. To get the most ben­ efit from these ideas, you will also have to take time and effort, and be willing to develop yourself through learning from your mistakes. I was very fortunate to begin to recognize the internal con­ trols of the market, or market discipline, from the outset. Be­ cause market discipline is internal to the market, versus other controls which are external, it offers an immediacy in response time-it is always there first. If one deals with market discipline successfully, it pushes back the need to depend on external disci­ plines or controls. Being internal to the market, market discipline is imposed upon everyone who interacts with the market whether they like it or not; in fact, whether they know it or not. There are two other types of controls being focused upon by people in the industry, but they are external controls, and not really necessary if market discipline is understood. The most important of these external controls is what I call trader discipline: a focus on emotional control as it relates to nega­ tive ( or positive) events in the market. It is a tough discipline, as people tend to trade themselves versus the market. That, in my opinion, is the wrong focus. Every trader needs this type of dis­ cipline, but I've found through the years that it was best for me to be very active, and that the activity tended to push me through any areas relating to emotional control. Shortly after my second

MARKET DISCIPLINE, BACKGROUND, AND EFFICIENCY

23

year of trading, I realized what some of my many character flaws were, and I decided to rectify them, so I could improve my trad­ ing results. After six months of hard work I had made absolutely no progress (and not much more money, either). I then decided to accept my faults and neutralize them by working with situations where they did not come into play. By featuring the things I could do well, and accepting my shortcomings, I had exponential gains. I call this industrial indifference: feature what you do best and be aggressive. The other discipline is the financial one that has engulfed the industry: the emphasis on money management. The very fact that it is endorsed by all segments of the industry (including le­ gal, regulatory, management, and the printed literature) means that it should not be a trader focus. It should be present to a natural degree, and one definitely needs to be aware of it, but anything beyond that is inappropriate. Financial discipline tends to creep forward, engulfing more of what you do, and in general interferes with the clear logical thinking needed to trade. It makes managing your trades an all-foreground program, as financial controls take the place of background. Every opportunity is treated the same way, when in fact no two are alike. Overemphasis on financial controls is a sign of a lack of understanding and self­ confidence, and leads to a false sense of security. The same is true in any area of business. As an example, a young and growing business has a banking relationship at the outset wherein the bank believes in the company and its manage­ ment. The relationship often does not fit all the bank's risk poli­ cies (which are their financial controls) as set out by the loan committee. As time goes on, and the business gets on its feet, the bank becomes stricter about its rules. Making a new business satisfy all the requirements shows little or no interest or confi­ dence by the bank, and forces the management of the business to focus on satisfying the bank near-term instead of on growing the business and its industry.

24

CHAPTER THREE

As individuals, we all are different, and will not necessarily fit a particular style of trading. Market disciplines are the most natural and immediate form of control available. It does not make sense to focus on trader or financial controls, which are artificial and external. I realize that some need more financial controls, just as some need to overcome themselves. I just want to point out that these types of problems are out there in all industries and are external to the businesses themselves. Working with market disciplines, or market control, does not imply that we now have control over the markets ; they are uncer­ tain. It means that we can gain control in a business sense. We have an understanding of what we are trying to do, and we have an understanding of what the market is doing. We can get objec­ tive answers to our questions. For example, a car maker might ask, what is the condition of the car market today, and what is our market share in the compact market? How is our new model moving compared to last year ' s model and to our chief competitor's? Has our new advertising the past month shown any benefit? A trader would ask, where is the soybean market now? Has there been any change in its condition in the past week? If so, what? What type of opportunity is it? What is the best way to trade it? How can we tell if we are right or wrong? These types of questions need to be answered in order to be successful, and this book will provide the basis for doing so. Successful traders have always done this subjectively, so it is not an impos­ sible goal. Objectivity, which can only come from a complete understanding of what we're doing and what we're working with, will allow more traders to achieve the same goal. We as traders need to understand not just the workings of the market (which is what I mainly focused on at the beginning), but what it does, what it does it for, and how it does it; what it means to call the market a self-organizing system, and what the orga­ nizing principles are. We need this foundation in order to gain a complete understanding of market discipline.

MARKET DISCIPLINE, BACKGROUND, AND EFFICIENCY

25

Understanding the market's purpose is the key to unlocking all this. This basic insight eluded me for a long time. My ap­ proach has always been from the ground up, trying to merge prac­ tical results into theory, rather than starting with a theory and trying to fit my observations into it. I think the fact that I made a persistent effort was more important than any one particular idea. It was my varied experiences in using the developing profile sys­ tem that revealed the most. I could always seem to find new ap­ proaches to keep the discovery process going. The constant changes taking place in the market really brought focus to the situation. It forced me to continually do things differently, and finding the same answers over again in different ways brought a degree of confidence that I was on the right path. Let's take a look at some specifics. From my beginnings as a trader, I have always tried to work with a consistent and recur­ ring aspect of market activity. This ties the trade opportunity to the market and to my knowledge base, and the trade potential is therefore much easier to manage on its way to maturity. For instance, when I first got to Chicago, the markets were very ac­ tive and the pits were generally full. I had a really hard time read­ ing the market activity when the pits were not full. Being more of a position trader, I began to notice that most of my profits would dwindle or disappear after the pit emptied out. I saw that the pit emptied because the good traders could sense a lessening of directional activity through the order flow, and that it filled again when there was a new opportunity. The market would al­ ways go the opposite way as the pit filled back up. After a short time I realized that I should exit my trades when the pit started to empty out in order to hold on to my profit. As with the last trading situation I described, I have taken advantage of this same situation over and over again during my 35 years of trading. Obviously, my ability now after years of ex­ perience to recognize the market conditions that precede the trade is the key to finding it again. The essential ingredient is the market's background, which is one of high efficiency. With this

26

CHAPTER THREE

background, any inefficiency that causes the market to move in either direction is eventually absorbed into the background of efficiency. Also, with this background, the market tends to move in the opposite direction from the one it had been moving in when reaching efficiency. Efficient markets are trading markets, where the inefficiencies run out of gas before they can change the back­ ground, causing the market to move in the opposite direction when a vertical move ends. Another experience taught me to recognize another type of background. When I started out, I traded all the commodities that were offered by the exchange, rather than just one. I noticed one day when I was standing in the corn pit that there was a loud roar coming from the soybean pit, and that runners were scurrying to the brokers. The floor was totally focused on the attempt to move the market higher. The price at the time was about 2.52 a bushel. About 45 minutes later, I noticed that the price wasn't any higher than it had been when all the activity started. It seemed to me that all the king's horses and all the king's men could not make the market go higher. I also thought it would be difficult for it to mount another charge of equal magnitude, and that I ought to go over there and sell the market. And, in fact, the sale worked out well. Once again, this is a trade that I've made over and over again. The issue here is that the market was at an efficient price. Gener­ ally speaking, when the market is in a state of efficiency, it is going to move vertically out of it at some point due to some real or perceived change. When the market has made a good attempt to move vertically in one direction, and fails, going for the oppo­ site direction is one of the easier trades to make, because prices will either move in that direction or at worst stay the same. In today's markets, I have noted that this condition often comes about when the market is focusing on a government report. There are two possible market conditions prior to the report. In one situation, everybody is generally getting flat, and the market has reached some state of efficiency. If the report comes out and it's

MARKET DISCIPLINE, BACKGROUND, AND EFFICIENCY

27

deemed to be bullish, and the market barely opens higher and then starts breaking, then it's the same situation as the bean trade all over again. If the day before an important report that everyone's looking forward to is an active directional day, it can make the report redundant, because in this case the market has not reached effi­ ciency prior to the report. When a report is issued in an efficient market, the market will go one of two ways: if there's no rally on a bullish report, it gives the other direction all the momentum. If the market is inefficient and moving directionally prior to a re­ port, generally the condition will prevail regardless of the report. This is again illustrative of the importance of understanding the background. There's something in common among the trades mentioned here and the bean trade example in the first chapter. They all illustrate what I mean by opportunities that come internally from the market. The ideas for the trades did not come from anything that I had read, nor did they come from any particular study, nor from technical analysis, nor from fundamental analysis, nor from the person standing next to me, nor from a news letter, nor from a news flash, nor from a squawk box that detailed what commer­ cial was buying or selling. They were real trading situations that developed from within the market, and they were recognizable as characteristic of some type of opportunity. Right now I am only trying to make the point that there is a great difference be­ tween internal and external approaches to trading. This in itself is not startling news, as most traders like to have good floor sup­ port from their brokers. But mere closeness to the floor does not have any value in and of itself. The closeness must come from your own program, and that calls for your program to be aligned closely with the workings of the market. Over the years, I have tried to take these kinds of practical observations and translate them into theory. But in my case prac­ tical success did not translate immediately or automatically to a correct theory. In academic circles, accepted market theory had

28

CHAPTER THREE

cast the market as being statically efficient, and hence implied that traders could not succeed in that environment. (The idea be­ ing that a trader succeeds by taking advantage of a situation where price has moved away from value. If price immediately changes to reflect value, there's no opportunity.) I had seen a great deal of success in the markets and this focused me in the opposite direction, away from the idea of efficient markets. I started to look elsewhere for the answers, but progress was slow. I felt it was necessary to understand the purpose of the market, and that did not seem to be expressed anywhere by anyone. I spent a good deal of time trying to find it, as you will see later on. I mentioned earlier that one potential source of wisdom I con­ sidered were the many "sayings" about the markets and trading. These sayings tended to be very practical in application, yet al­ ways seemed to defy logical explanation when I attempted to pin down just how they worked. Looking at the market within the context of accepted market theory and of practical sayings, it would be fair to say that the general workings of the markets were unknown and unexplored. Supporting this claim is the fact that even the practical everyday traders used external disciplines to control their trading-a situation that is still very much the case today. My insights arose in large part out of working with the Mar­ ket Profile notation as it evolved over time. Many readers will be familiar with at least the basics of Market Profile; for those who are not, let's take a quick look at it. In its raw form, data about a market is just an unstructured stream of numbers, recording the various times and price points at which buying and selling takes place: the sort of information recorded on a ticker tape. In an effort to gain a visual overview of price activity, traders came up with the bar chart, in which a ver­ tical bar records the range of prices for some fixed time interval. Many traders use daily bar charts; for our purposes, that time interval is too coarse. A popular intraday time interval, which became the foundation for Market Profile, is 30 minutes.

MARKET DISCIPLINE, B ACKGROUND, AND EFFICIENCY

Figure III-I.

Exploded profile chart for Dec. LIFFE Bund, Nov.

29

6, 1996

The problem with a bar chart is that it captures only one dimension of market activity: the vertical. Because the horizontal interval is fixed, there is no variance allowed in the display. The profile chart is, as we shall see, much more two-dimensional, in that it allows for horizontal variance. The easiest way to understand a profile chart is to start with each 30 minute time period shown as a separate column, similar to a bar in a bar chart. In Figure III-I , the price data for the Dec. LIFFE Bund for November 6, 1 996 is displayed in this fashion. (The asterisks are inserted by the Market Profile software, and need not concern us here.) In Market Profile, each half hour of the day is assigned its own letter. The LIFFE Bund begins trad­ ing during "1" period, so "1" is the leftmost column for Novem­ ber 6. The next half hour is called "m", and so on through the alphabet; the half-hour following "z" is "A". Now we're ready to create a daily profile chart. (The result is shown in Figure 111-2.) The starting point is "1" period; its range is from 1 00.3 1 to 1 00.40, and "l"s are placed in the correspond-

30

CHAPTER THREE

Figure 111-2.

Daily profile chart for Dec. LIFFE Bund, Nov.

6, 1 996

ing rows (price levels), forming a column just like the column of "l"s in Figure III-I . The next period is "m", which ranges from 1 00.35 to 1 00.47. Its range overlaps that of "1" period between 1 00.35 and 1 00.4 1 . When the "m"s are added to the daily profile, the ones between 1 00.35 and 1 00.4 1 go to the right of the "l"s, making the developing profile two letters wide at that point. The "m"s between 1 00.42 and 1 00.47 are the first letters in their price range, so they go in the leftmost column, where we placed the original "l"s. If you look at just the "l"s and "m"s in the Nov. 6 profile in Figure 111-2, you can see this pattern in place. Now we go through the rest of the half-hour periods in the same way, assigning each letter to its proper row (price level), and to the first empty location, starting with the original "1" col­ umn. The effect is as if we collapsed the half-hour columns of Figure 111- 1 by squashing them over to the left as far as possible, with the "1" column as a starting point. Notice the difference in the information conveyed by Figure 111- 1 and Figure 1II-2. In Figure 1II-2, the width of the profile

MARKET DISCIPLINE, BACKGROUND, AND EFFICIENCY

3 Figure 111-3.

2

1

2

31

3

The Bell Curve

gives a clear indication of the horizontal movement of the mar­ ket. If the market spends its time in a small range, the result will be a short, wide profile, in which the horizontal aspect predomi­ nates. A fast-moving, directional market will create a long, nar­ row profile in which the vertical clearly predominates. (For ex­ ample, periods "z" through "E" in the last profile in Figure III-2.) This brings out the vertical dimensionality of the market, in con­ trast to "1" through "y" periods on that day. One feature of this chart deserves some comment. When we first began working with profiles, we started a new profile each day. This had some justification, since the global, 24 hour market of today was in its infancy, and each day on the floor had a dis­ tinctive beginning, middle, and end phase. As we move through this book, developing our ideas, we' ll also show the correspond­ ing evolution of the profile notation. The other aspect of profiles that should be brought out at this point is their tendency to fall into a pattern resembling a bell­ shaped curve. The bell curve, which is at the heart of much of

32

CHAPTER THREE

statistical theory, arises in situations where we' re studying a quan­ tity whose value is influenced by a number of contributing fac­ tors over a large population. For example, if we were to measure the height of all the men in the country, and make a bar chart of the result, the chart would form a bell-shaped curve, since height is influenced by a host of genetic and environmental factors. Of­ ten the situation in the market is the same, as many small influ­ ences on each of a multitude of traders act to form each person's opinion of a good place to buy or sell. Figure 111-3 shows a typical bell curve, with some of its more important features highlighted. If we think of this curve as a bar chart of heights (where each bar is only one pixel wide), then the center value, the highest point on the curve, represents the single most common height. This value is called the mode. For a bal­ anced curve such as this one, it is also the mean, or average, height. If we go to the left and right of the mean, far enough to enclose approximately 67% of the data, this distance is called the first standard deviation. It's shown as a dark area in the center of the bell curve in our diagram, and marked with the number " 1 ." If we go out further from the mean, far enough to enclose ap­ proximately 95 % of the data, we get the second standard devia­ tion; adding the third standard deviation encompasses approxi­ mately 99% of the data. In statistics, the size of the standard de­ viation is used as a measure of variability; we've found it useful in a similar vein when applied to profiles. Look back at the profile for Nov. 6 shown in Figure 111-2. If you tum the book on its side, so that the left column of the profile becomes the bottom, the resemblance to a bell curve is clear. This profile is particularly close to the classic shape, with its mode almost exactly in the middle and the volume distributed evenly above and below the center in the characterstic shape. We'll ex­ plore the implications of this resemblance, and what it means when the market departs from it, as we develop our theory of the market.

CHAPTER FOUR

Looking for the Purpose of the Market

As I began to work with profiles and develop my theory, my first pronouncement was that the purpose of the market was to facilitate trade, i.e., to try to do the most business possible. Read­ ing the market from my background as a trader, I was not yet aware that trading activity within a constricted range is a sign of efficiency, or that the fast action on the extremes of vertical moves reveals a high degree of inefficiency. What I did notice in a prac­ tical sense was that the market would not go where it could not trade. When it tended to hold and accept an area, that area proved not to be an extreme. If the market was moving directionally, then I would assess the amount of activity as being increasing or decreasing; if it was increasing, I'd stay in or go with it, if de­ creasing, I would get out or go against it. The important point is that I was using information coming from the market. But, although the theory of trade facilitation was useful in practice, it was a long way from capturing the pur­ pose of the market. Looking back, this theory was more descrip­ tive than analytical in nature, but it did succeed in giving a good reading on continuation of directional change. As time went on, I refined the concept of vertical movement as it relates to trade facilitation to declare that the purpose of the market was to distribute. This was the channeling of trade facili­ tation (capital flow) into a medium of expression (markets). Ac-

34

CHAPTER FOUR

tually, this was farther from the true purpose of the market than my original theory, in that distribution (a one-dimensional verti­ cal move that stands out from the background) is an expression of the degree of inefficiency. What was revealing was that distri­ bution was part of a sequence of events: prior to a vertical distri­ bution the market had to have a base of horizontalness in order for the distribution to be seen. In other words, an underlying order of events was there which could be recognized and so po­ tentially lead to some form of control. Moving from trade facilitation to distribution as the underly­ ing purpose of the market advanced our understanding by pin­ pointing the area where the distribution started. I noticed that the background prior to the start of a distribution was always more horizontal, and this led to the key insight of a two-phased mar­ ket. Also, in the early days a vertical move usually started in the fat, or horizontal, part of the day profile. In short, the distribu­ tion theory advanced the necessary understanding of vertical movement for practical use, but it did not truly identify the pur­ pose of the market. Throughout my early career, I wrestled with the issue of whether or not the market was efficient. From a practical stand­ point, I did not think it was efficient, or if it was, it was only efficient for short periods of time; it was not statically efficient. Further, in my trading, I was not interested in the phase when the market was more horizontal, and thus potentially efficient. I started to take notice, however, when evidence showed that a lack of activity, which created a horizontal profile, usually preceded a good vertical move. What really brought this phenomenon into focus was the num­ ber of misplayed opportunities that started with a horizontal mar­ ket. It has always been a good trading practice to go with some­ thing until it's no longer there, and not to trade for what isn't there. I mostly adhered to this practice, and, as a result, I would sometimes be fooled by what I called a false expectations gap. Nothing at all would be going on, so expectations vis-a-vis the

LOOKING FOR THE PURPOSE OF THE MARKET

35

day would be extremely low. This condition would usually have persisted for a week or so, to the point where I was concerned about my ability to find any well-paying opportunity. Most of the things I did would just sort of die on the vine. At this point, more often than not, I would start off the day trading what I thought was a good opportunity. The market would immediately go my way, and I would quickly get out, having been conditioned to do so by the quiet market. It would never fail that the market made my small expectations look foolish. At this point, I was totally unaware that efficiency was the set-up for change. From a practical viewpoint, market efficiency was not in the vertical price action, which is what I was looking for, but in the horizontal, offering very little opportunity for trad­ ing profit. I tended to avoid horizontal price action as dull, a market with nothing going on, and tried not to trade under those condi­ tions. As time went on, the fact that the market had what ap­ peared to be two phases, dead and then vertical, began to register in a theoretical way. I began to reassess my earlier rejection of the generally accepted theory of efficiency, as it seemed that I had recognized efficiency in my practical trading. It was defi­ nitely a market condition, but not a constant one. The market was not statically efficient, so its other phase had to be non-effi­ ciency. The market appeared to spend most of its time being non-efficient (vertical), and shorter amounts of time being effi­ cient (horizontal). The efficient periods were the most difficult to trade. It took a longer time to notice that the market was always trying to get to efficiency; that efficiency, in fact, was always present in the market to some degree-and, conversely, that the inefficiencies also were never entirely absent. The varying ratio of these two factors is what makes the market dynamic. Being dynamic means that the market is always somewhere between 99% efficient and 99% inefficient. And, most importantly, trying to get to efficiency is the market's goal or purpose. This whole

36

CHAPTER FOUR

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30-year Bond futures for late June and early July,

1 996

fundamental concept can be summarized in two words as dynamic efficiency.

To illustrate the market's process of moving from inefficiency to efficiency, consider the chart in Figure IV-I , which shows 30year Bond futures for early July, 1 996. In this example, we can follow the life cycle of an inefficiency, and see how it eventually gets snuffed out by horizontal activity, preparing the way for a new inefficiency to happen. The second profile from the left, for June 28, shows inefficiency predominating, as the market made a strong vertical move. The market then begins to trade more or less sideways. We refer to the fat part of a profile, where most of the volume is concentrated, as the first standard deviation. Look­ ing at the profiles for the 28th and 30th, the first standard devia­ tions are in the upper part of the daily range, while on the 2nd and 3rd they are at the bottom. It appears, then, that the life of the inefficiency has been taken out by the consistent average activity of these four days. In viewing the background, you can see a change, and a completion, so you know that whether you have a

LOOKING FOR THE PURPOSE OF THE MARKET

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profit or loss in the trade, the life of the inefficiency that caused the market to move is over. On July 5, the next cycle began with a sharp decline. Another way to look at the process is to reorganize the pro­ files, getting away from using chronological time beyond the day timeframe. The idea is to start a new profile when the market shifts into inefficiency, i.e., distributing, and to combine all the half-hour periods as the market works its way to efficiency. In this way a roughly bell-shaped profile should emerge from the mass of data, culminating with a new vertical move. Figure IV-2 shows the profiles from the chart above regrouped according to this scheme. I knew that discovering the market's purpose was the key to objectivity. I had been trying to find it for many years through my work with Market Profile. Many people would assume that the highest possible goal of data arrangement would be a trading system in which money would come out forever. I do not believe that such a system is possible or even necessarily the best thing.

38

CHAPTER FOUR

•

Having a trading system as your goal would mean working for a limited purpose. A deep understanding of the market's dynamic functionality leads to control over your interaction with it. Build­ ing an objective data base where any question can be asked or answered is far superior to having a set of trading rules. On realizing that the purpose of the market was to move to­ wards efficiency, I felt that most of what I had done prior to this point could be understood as a subjective reading of efficiency­ subjective because I had yet to gain a full and complete under­ standing of the market. During the discovery process, insights gained from working with Market Profile had begun to reveal clues that seemed to dovetail with everyday experience. In the early stages of Market Profile, the fact that the market was con­ stantly trying to shift into the horizontal phase of activity was the key ingredient in all our trade parameter classifications. Trading experience reinforced this even further, and the ultimate conclu­ sion was that the market was always to trying find efficiency through a dynamic process.

CHAPTER FIVE

Efficiency and its Role in Market Organization

Efficiency turns out to be very important for two reasons. First, it creates the most readable vertical reference in the market. It generates a fair price, which is the base from which the market can evaluate any change. Even as the market moves vertically, it will constantly try to find efficiency, and therefore bits and pieces of horizontal development can be found throughout the vertical movement. These represent a reference from which further verti­ cal movement is evaluated by the market participants. Then, as horizontal trading becomes more predominant, a more concen­ trated appearance of efficiency becomes evident. Second, an aperiodic cycle of activity repeats itself as the mar­ ket moves itself into the future. Non-efficiency continually flares up and is processed out again and again. The market shows a continuous self-organizing capability that is based upon bring­ ing a data mass to efficiency. Each completion leads to the next one, as efficiency reasserts itself as a natural result of the trading process. The market processes each small episode of ineffiency that is part of a larger move; then, when the move is complete, it brings the entire large-scale data mass to efficiency. Efficiency represents more of a certainty, while the vertical moves are an expression of uncertainty. The net effect is a self organizing sys­ tem that is in control of market activity and only needs to be understood.

39

40

CHAPTER FIVE

Let's take a closer look at the self-organizing process inherent in the market. The initial vertical market movement can be thought of as gathering or attracting those who want to become involved. In this way the market begins by searching for a vertical range from which to apply or define efficiency, and then begins to pro­ cess out the accompanying inefficiency. Thus, the market's pro­ cess has two distinct stages, with the vertical occurring first. The entire process is dynamic and not necessarily easily readable; the data mass that is brought to efficiency is always going to be ir­ regular. For example, too few or too many participants may be attracted in the initial phase. Too few leads to further gathering (i.e., more vertical movement); too many means some need to be processed out, producing extended horizontal or opposite verti­ cal activity. Fundamentally, one says that the market has or has not priced out the users . Market observers in the media provide the "ex­ cuses" for price moves that we're all familiar with: "profit tak­ ing," some news event, a statement by an authority, and so on. Experience has shown that where there is a directional stimulus, and nothing happens, the opposite direction generally ensues, showing that you already have too many participants in the mar­ ket. In either situation, the market is always moving towards ef­ ficiency. The impulse towards efficiency is an unrelenting force that is always present, always active, always trying to get con­ trol. It always accomplishes some part of its goal, so, when it is not present to any large degree, the suggestion is that the market is not done vertically. This is what allows readability-this is what the intuitive trader picks up. For instance, most floor trad­ ers will tell you they try to make the hardest trade rather than the easiest trade; if it's easier to sell, it's usually the wrong way to go, and vice versa. Let's look more specifically at the market cycle. The market first tries to establish one vertical reference point, a point that is very hard to read in the present tense, due in part to the volatile nature of the market at this stage, with its many ups and downs.

EFFICIENCY AND ITS ROLE IN MARKET ORGANIZATION

41

Then it proceeds to find the other outer parameter, i.e., the sec­ ond vertical reference point, again hard to read in the moment. Vertical activity is quite irregular in the data mass (volatility can not be neatly cataloged), and the where and how of these refer­ ences can't be easily established. It's only necessary to know that they will happen. This is the gathering process, the first stage, and is highly unstable and difficult to read. To some extent during, but mostly after, this process, the move to efficiency will begin to develop. The fair price area, or effi­ ciency, is what I call market output, the result of the self-organiz­ ing system. This represents the real "close" of the market pro­ cess-that is, the result that summarizes that phase of activity. It is necessary for the market to find this in order to start the whole process over again. It is important to note that the outer boundaries and the amount of data processed during this cycle will vary dramatically. It is the output of efficiency that is the constant. The cycle from inef­ ficiency to efficiency is a great reference at any stage of its de­ velopment, whether the beginning , middle, or end. Like the de­ veloping ears in a crop of corn, it represents a direct output that can be measured in stages. Price discovery, long thought of in relation to a fair price, has an entirely new meaning in this con­ text: it's defined by where the market is in its process. You may have a fair price generated during the gathering phase, which would be one of the vertical extremes, or a fair price during the horizontal phase, which would represent the consensus fair value. Also note that in the process of gathering the market will try to involve those on the edge of development, because it's easier to do the job once than to do it twice. This explains the volatile nature of the market in establishing vertical reference points and the difficulty in using them. A practical example of a gathering process similar to that of the market comes from my personal experience. As a young man, I had to gather cattle every year on the family ranch after school was out at the end of May. The first thing I did was ride my horse

42

CHAPTER FIVE

to the outer reaches of the ranch boundaries, trying to push the outlying cows and calves closer to the middle of the ranch. If some of the cattle were on the adjoining ranch, I'd have to move further out in the gathering process. While I was doing this I was looking at the condition of the cattle. If I saw four or five cows with only two calves, or four or five calves without cows, I knew conditions were not perfect. This did not give me a reading on the entire herd, only an indication, the answer to which might be over the next hill. I'd be getting some insights as to the overall condition of the cattle. It would be hard to rely on this small amount of information or make a decision based on it, but still it could be very significant. As we moved more towards the interior of the ranch, or to­ wards the natural location of the corral, and I gathered more of the herd, my information would become better and more reli­ able. Finally, in getting the whole herd into the corral pasture, we would definitely know what the condition of the herd was. We could see how many cattle we had versus what we turned out, what the cowlcalf ratio was, what the condition of the cows and the calves was, and we could begin to make plans for next year, which would be a new cycle of development. The market organization process is very similar to cattle gath­ ering. The initial gathering at the edges of the ranch corresponds to a dynamic vertical movement in the market, whose purpose is to draw in participants. The vertical movement is seldom purely one-dimensional; it also means the beginning of the effort to move towards efficiency. The herding of the cattle towards the middle of the ranch reduces their range of movement, just as the market's vertical range of movement decreases as it becomes more effi­ cient. The gathering of the herd in a constricted space corresponds to a more horizontal market where we can get a better reading on its condition. As we get more of the cattle gathered, from a quar­ ter, to half, to three quarters, we get increasingly more reliable information as to what the year was like, and are able to plan ahead for the next year; as the market approaches efficiency, we

EFFICIENCY AND ITS ROLE IN MARKET ORGANIZATION 43

have a solid reference point against which to measure future moves. To summarize our discussion so far, efficiency plays a perva­ sive role in the market when looked at dynamically, since it is always present to some degree. Efficiency is the only market in­ ternal that can be read throughout every phase of the market cycle. In reading the degree of efficiency, you are reading the degree of horizontalness. A reading of efficiency is the information source for all market disciplines, as it is the basis for processing the vertical out of the market. We' ve demonstrated the central role of efficiency. Now we're going to discuss it in a bit more depth, and define a complex of related concepts that will help us understand how efficiency af­ fects the market and how it communicates itself to the trader. In the process, I ' ll be talking through some of the insights that came from my experiences as a trader. Note that in practice both the vertical and the horizontal are actually good trading references. If we examine the extreme ac­ tivity of the market, we would conclude that near or total verti­ calness would be the extreme of non-efficiency, and that near or total horizontalness would be the other extreme of efficiency. Since they both represent the outer reaches of the market, these extreme conditions signify beginnings, and one should be alert for that. Being dynamic, the market tends to vacillate between these two conditions. Neither the vertical nor the horizontal ever disappears, but one or the other is the dominant element in the market at any given time. Market condition could logically be expressed in either di­ mension alone, or in both. The form we choose can be whatever is most convenient for a given study. We must note, however, that one would want the expression of market condition not only to be a meaningful and usable communication, but to offer the possibility of optimal control of trading as it relates to measure­ ment. When the market is moving horizontally in a small range, that is, when it is highly efficient, the penalty for a wrong deci-

44

CHAPTER FrVE

sion on direction is small. When the market is in the midst of a volatile vertical move, then the potential for damage from a wrong decision is much larger. Therefore, we' re more interested in study­ ing the horizontal, and expressing the market's condition in terms of it. I have always approached control by first establishing the outer boundaries of possibility; control then has to be within them. Consider a market that is highly horizontal versus one that is vertical. In the first instance, both boundaries have been estab­ lished through time in a small range; in the second, it's much harder to establish a usable constraint. The dimension of non­ efficiency is extremely hard to confine, since it is not bounded in the present tense. It is very unstable and does not lend itself to internal measurement. Its composition is not that of consensus but that of aberration. It's very abrupt, and forces exposed trad­ ers to react. Each vertical move is unlike any other; therefore, the change towards efficiency is extremely hard to perceive, and is not of much value as a base indicator. It is safer to use the hori­ zontal: efficiency, being accepted as consensus over time, has the very characteristics that lend themselves to accurate and mean­ ingful reading of changing market conditions. Rather than being the impediment to trader success, efficiency is the very reason traders can make money. It's what a trader intuits is lacking in the market and thus takes advantage of. While it's there, it provides a basis from which to sense and evaluate the degree of change. This points up the need to incorporate the concept of change being relative rather than absolute. Traders' expressions of the market being tight, tired, heavy, etc. are based upon reference to the horizontal state of the market. Change is related to efficiency in principle, and the traders' expressions are degrees of interpre­ tation. In understanding the market as dynamic, one needs to think not of bringing a single inefficiency to zero or removing it from the market, as is the current tendency; rather one needs to think of reducing its degree of influence as it relates to a total base,

EFFICIENCY AND ITS ROLE IN MARKET ORGANIZATION

45

which is made up of a varying degree of both horizontal and vertical influences. To attempt to measure volatility is techni­ cally incorrect; one should be looking at the degree of efficiency. Volatility is vertical and hard to measure except by measuring it at the changing outer limits. In a volatile period the increment of change is coming from the outside into the market rather than from the inside out. More accuracy and better trading would come from measuring efficiency. Liquidity is classically thought of as indicative of the depth of a market. Its real value is informational to market participants. Liquidity is a form of counter-directional control in a market. It is a horizontal functionality, a platform that increases the already horizontal nature of a market, or decreases the vertical nature. For most traders, liquidity represents a method of reading the degree of efficiency in the market. Liquidity changes as markets move from the vertical, towards the horizontal, and into the effi­ cient zone of development, so liquidity does in fact reflect effi­ ciency. Unfortunately, it is not a constant force, and can and does move within itself, making it a difficult read at times. Randomness and liquidity are really one and the same. Ran­ domness means that the preceding order has no relation to the following order. Randomness is in effect, then, when nothing is really going on. Liquidity is a force that is an extension of ran­ domness. Liquidity expands the boundary of randomness by al­ lowing successive directional orders to be neutralized. Locals who make a market have in the past received an edge, and should retain the edge if the market stays in the random zone. The more liquidity, the stronger the bounds of randomness, and the harder it is for non-randomness (directionality) to emerge. This relates our notion of liquidity to the classical one of depth in the market. Non-randomness is the start of something directional (vertical) and the shift of control to new forces. The stronger the liquidity, then, the more reliable a change is when it does occur. Liquidity can be confined to a certain zone or portion of the market's range. This type of liquidity in the market may create

46

CHAPTER FIVE

choppiness and a more vertical horizontalness in which the mar­ ket has ups and downs instead of just stopping at a particular vertical reference point. Another type of liquidity comes into play as the market moves directionally, opposing the market every tick of the way. A third way in which liquidity enters the market is when prices go to truly unusual extremes, so that they then become references for participants to trade against. As liquidity lessens, you lose the readability of the market because it becomes more volatile in a random way. Liquidity can no longer be used to gauge efficiency. In other words, a highly liquid market can also be thought of as highly efficient, but an illiquid market is not necessarily inefficient. There was formerly a link created by the floor trader who helped provide liquidity and who was reading efficiency. Indirectly, all this is expressed by your fill and by the fast market indicator you get on your screen. Most traders would agree that when they get a bad fill the chances of winning on a trade are higher than when they get a good fill. I had a good example of this many years ago, when I shifted to be more of a go-with trader. Com was called a couple of cents lower and I decided to sell the opening. I put my order in and the market opened close to and limit down, and quickly bounced several cents off this base. Naturally I was filled at the limit. If I had known it was going to be limit down, I definitely would not have sold it. I now was in a position I surely did not want to be in, and one that I could not do much about. I still felt that I was right, but I was very uncomfortable. But I was with the direction of the market, and several days later had a nice profit. This corresponds to the floor trader who always notices that the easiest trade to make is the wrong one: if it's easy to sell, it means there are lots of buy orders coming in, so selling is a bad idea. I have learned a great deal about trading from the largest or most dominant trader in the pit or arena, from the type of activity that really represents control of the market for that moment. The market is not random in these circumstances, but has a known dominance, where dominance is defined as a directional force

EFFICIENCY AND ITS ROLE IN MARKET ORGANIZATION 47

that exceeds liquidity and is the start of something. The big trader in this case is the source of dominance, and is really controlling the foreground with his activity. The fact that the directional im­ pulse exceeds liquidity means that the background needs to be favorable, in order for the trader to retain control. In order to exit a bad trade with a small loss rather than a large one, the big trader cannot be totally wrong about the background. Regardless of profit or loss, it's always the background one has to exit to. As an aside, to begin to focus on background, which is all­ important in trading even for those who would like to use finan­ cial controls, it's a good exercise to assume that your trade repre­ sents the biggest position in the market, and to ask yourself where you think you would land if you had to get out. With marginal trades, you would find that you would have a big loss. This is relevant to all traders because if in fact there is little liquidity, we have a similar situation to deal with. There are no financial controls that can neatly take us out. Control must again rest with either the background or foreground of the market. In using a financial control (such as a stop) to exit, one never begins to learn about the background. Over a long period of time, this has a devastating effect on one's trading success. The trading floor was a great place to learn the lessons of back­ ground. For instance, one day the beans were trading about 1 5 cents above limit, and prices were on their way down-the back­ ground was definitely to the down side. The market was very volatile, and it was very close to the closing bell. The market hit a bunch of stops in one part of the pit and brokers were offering beans limit down at the same time they were still trading 1 5 cents higher in other parts of the pit. (All this took place in less than 30 seconds.) You have a choice as a trader in this situation either to sell the higher price first or buy the limit down. Good floor trad­ ers would automatically understand that since the background was weak, selling the buy orders was the appropriate strategy, as they were the anomaly or inefficiency. Poor floor traders would look to buy at limit and think it was a steal-but, if they could

48

CHAPTER FIVE

not get it off at higher prices, they would be caught on the bal­ ance limit down, and maybe have a big loss the next morning if the market was limit down again (which in fact it was). This is a good example of background rather than foreground controlling a trade. There were two opportunities that were roughly equal on a superficial level, with the background deter­ mining which one was better. In this case, the inefficiencies (the resting buy orders) were absorbed into the background because they weren't big enough to change the background, where the background comprises sell-at-market type orders. A point to ask yourself right now is, how often is background the deciding fac­ tor in your trade decisions? The best floor traders always took the whole offer. The ad­ vantage to taking the whole offer was that when the orders came in the other way, the trader would be in control, rather than hav­ ing 1 0 or 1 5 people competing to get out. The trader took out the competition of the background by denying inventory to every­ one else. This is an example of the type of floor discipline that I learned in Chicago. I was always aware of trade opportunities where I did or did not do well, but more aware of the lesson or principle involved. Dominance, as we stated earlier, is a directional force that is non-random. When present, it is in control of the market. It does not express itself as a constant very often (an extreme example of which would be successive limit days), but rather intermittently. In other words, it does not operate continuously, but has inter­ ruptions. Its appearance is not consistent; it shows up differently all the time. What was previously a dominance may not occur again in the same manner, or, if it does, may not have the same impact. It is variable and changing as markets change. The only markets I experienced that had a constant expression of it oc­ curred in the 70's for a very short period of time. The vertical movement was very one dimensional and persistent, to the amaze­ ment of most experienced traders, induding myself.

EFFICIENCY AND ITS ROLE IN MARKET ORGANIZATION 49

Normally, traders read dominance on a relative basis versus efficiency, efficiency being the standard from which change oc­ curs and which it can be relatively measured against. Again, when you as a small trader get a good fill, you' ve probably noticed that the trade always turns out a loser. You expected the market to move directionally, as all your indicators were in favor of it. You put your order in, and you got a good fill, because the market really hadn't responded to your indicators at all. Your indicators did not break the bounds of liquidity, and the market, having seen the failure, was going to go in the other direction. This is an example of a subtle information flow in the market, just like the noise factor in the bean example I gave earlier. The intermittent zone between phases of dominance is a very difficult area to manage and interpret. It is a lull or a pause in directional activity. The market activity during a lull tends to be counter to the dominance, and it's difficult to judge at times when the lull itself has turned into a new dominance. Also, one begins to anticipate it occurring as the markets move directionally faster than normal. The tendency is to get out after a rapid move and take a profit, with the idea of getting back in during the lull-but in the best of situations, the opportunity to get back in just doesn't occur very often. It is necessary to have a good understanding of the market's background in order to keep control. During the past several decades, as markets have grown in importance and attracted more participation, changes have taken place that have affected what are mistakenly thought of as mar­ ket internals like support, resistance, retracements, trend lines, etc., and the effectiveness of ordinary trading decisions and fi­ nancial controls. In the past, every vertical reference was severely tested by liquidity, and it, being horizontal, made the vertical internals effectively horizontal as well, since the liquidity at the reference point was what made them hold. In the old days, a flare­ up of uncertainty would be assessed as to degree by the liquidity, and was automatically traded against most of the time. Thus, in­ ternal levels could be traded repeatedly. Now, the internals have

50

CHAPTER FIVE

a different meaning, due to the lack of horizontal testing from liquidity. In today's markets, any unrelenting directional force is essen­ tially free and unrelated to anything that has gone before, and there is no attempt by the market, as there was in the past, to create such a relationship. The "internals" we listed above are really externals, in that the market is not trying to produce them; the market is trying to find efficiency, and they are a side-effect of the market's effort to process out inefficiencies. In removing inefficiency, the market leaves trails or tracks. These trails or tracks do not relate to the next flare-up of inefficiency to come into the market. But, when you have floor liquidity, it is injected into this process, and these so-called internals found their meaning basi­ cally because people thought they would. Changes in liquidity and dominance have sent the market back to its fundamental base of processing out inefficiency, which they previously had hid­ den. Basically, the market has removed the meaningfulness of domi­ nance and liquidity; both need to be redefined in principle. To be useful, any measurement of a quantity like dominance has to be a reflection of the market's single unrelenting purpose. It's the degree of efficiency that provides the meaningful measurement, as it has all along for the subjectivelintuitive trader. It provides a background/foreground basis for trade determination, as well as being the only true market internal. It is the highest form of con­ trol a trader can hope for. And, as we said early on, internal con­ trol is basic to all forms of business. It represents a sound busi­ ness principle, one you have to have to succeed. Let's take a look at the commodity market's change through the years, and classify it broadly in terms of efficiency or non­ efficiency as a base characteristic. In the early 1 960's the market tended to be more efficient, so much so that the percentage of efficiency was a good fraction of 1 00%. This condition allowed the market to be in control of itself-short term changes in effi-

EFFICIENCY AND ITS ROLE IN MARKET ORGANIZATION 51

ciency were traded out fast, and there was no real internal imbal­ ance. In the seventies the percentage of efficiency dropped consid­ erably. But in both instances, the markets held whatever general range of percentages they had for a substantial period of time before changing, and we were given background by default. As we look at the late eighties and nineties, we see such characteris­ tics changing very fast; efficiency pops in and out of control of the background of the market. We now need to know and assess background. This indirectly shows how important background is, and how dependent we are on it. In the more consistent eras we could establish what worked for our trading programs, and proceed through a considerable period of time with whatever edge we had found. In addition, we had a stable liquidity to supplement the existing condition whenever the market was in the process of changing. Liquidity was an extension of the condition at the time, and was a counter-force to change. Therefore change was not abrupt and one could deal with it. I can remember when I first started trading in Chicago that it took several weeks for a market to really change. I also remember holding positions for several months with most of the settlement prices being successively fa­ vorable to the position. Markets were mostly two-dimensional, in that they had both the horizontal and vertical dimensions equally active; most of the time one could buy breaks or sell rallies, and if caught with a counter-directional trade have whatever external controls one was using work to some extent. In the current era, change needs to be the focus. The more modem markets of today are a great deal less two-dimensional, as directional moves are not countered by as much liquidity. Therefore, the one-dimensional verticality is more pronounced, goes farther, and lasts longer. As traders we must make the ad­ justment in our programs so that we fit this new scenario. When I first started trading, Bill Griffin, Sr. was a very good position trader. He once came up to me at the end of a day when I had

52

CHAPTER FIVE

been trading opposite the way the market was going for a little longer than I should have, and he asked me if my goal was trying to prove that I could be stupid forever. Every time I think I have to make a change and I'm debating about it, I reflect back to this encounter. The side effects of this new market behavior are many, but one thing traders should review is how they were successful . If success in the past came from the errors of others instead of be­ ing directly related to market opportunity, then the prospects are dim. The type of markets that are in place now are going to re­ move this source of success , as they really do punish mistakes harshly, and this in tum will reduce trade, and make it more de­ manding. More people understanding the current climate of op­ portunity will provide for a better, more sustainable basis for growth. This is no different from the original reason that got me started trading - trading as a marketplace for ideas . As I look back on my experience with market discipline , I feel very fortunate to have stumbled into the correct path to my future . Time and continued effort were big factors in my devel­ opment, as learning new ways to do the same thing was more or less forced on me . Early in my trading career I learned how to determine market discipline by looking at my results , and asking questions . The markets , being dominated by efficiency, provided a safe environment in which one could learn from mistakes. That environment has gradually shifted over the years to be one that is more difficult to learn in . It would be very hard to follow my earlier program today. If one takes a modem approach, it just means doing the same thing in another and what I think is a better way. The key is to get on the right path and learn the basics of how markets work. Incor­ porate this insight into computer programs that can manage and process enormous amounts of data. Learn to distinguish between opportunities, and limit your trading to the best of these. In other words , you are giving yourself a chance to learn, in that most good opportunities will take care of themselves regardless of any struggles you may have to personally deal with . It took me years to get enough exposure, while today, using a computer, I can get

EFFICIENCY AND ITS ROLE IN MARKET ORGANIZATION 53

more in a week than I used to get in a year. My current program is composed of exactly this. Simply, the more I see, and the more I do, the better my chances for success .

54

CHAPTER FIVE

CHAPTER SIX

How the Market Defines Itself

Producing efficiencies is the way the market continually de­ fines itself. Efficiencies can be highly concentrated , as when the market is caught in a small trading range for weeks at a time , or fragmented, as when small horizontal patches show up in the middle of extended vertical moves . To be able to read the market objectively requires a screen display or print-out that can faith­ fully represent the underlying process in a readable way. We need to start with the market's most fundamental definition of self, its dimensionality, the way it can be measured and recorded. In moving beyond a simple ticker tape or list of numbers to a graphi­ cal representation , it's critical we be able to view and understand the internal market organization unfolding . Graphically, then , we want to catalogue the market's process objectively. The first requirement is to establish the dimensional­ ity of the market. Second, an objective display mechanism needs to be found. This can't be imposed from the outside , since it has to have the capability of freely and completely expressing the dynamics of market activity. Looking at the market from the viewpoint of efficiency, if one answers no to a static condition , believing the market to be dy­ namic , one would have to conclude that the market would both be efficient and non-efficient. From a practical view, you would say that it has two dimensions , a vertical (price) and a horizontal 55

56

CHAPTER SIX

(time) . In bringing both these views together, the vertical would be non-efficient, the horizontal efficient. Each of these viewpoints leads separately to the conclusion that the market has two dimen­ sions. These dimensions are the basis of the way to measure the market. Fortunately, the computer screen is set up to be at least two­ dimensional for viewing graphics . With a representation that com­ bines a vertical and a horizontal , all the data can be captured and displayed throughout the market's development . The Market Pro­ file notation we've introduced already demonstrates the poten­ tial for accomplishing this. Next, the outer limits of possibilities of dimensional move­ ment need to be understood . Can the market move vertically without any horizontal movement taking place? Can the market move horizontally, without any vertical movement? Can they move simultaneously? Can they move not at all? The answer is definitely yes to all of these questions . It's the mix of dimension­ ality that defines market condition. Change , then, can be illus­ trated and chronicled by dimension . Measuring dimension would give the market an objective means of expression relating to its condition . The general history of the market was to be mostly two dimensional and thus in control of itself, due to the fact that both the vertical and horizontal phases were active, with short bursts of one-dimensional vertical activity. The market also had its liquidity to lessen the impact of the vertical phase . In the past, it usually reverted quickly back into the active two-dimensional comfort zone of what can be termed moderate efficiency. In the last few years this situation has changed, and now, as we pointed out earlier, the one-dimensional vertical lasts longer and goes farther. When I first started trading , the markets were more horizontal than vertical . Over the years this relationship has changed many times. Change is always de-stabilizing and has to be gotten used to. The change in market activity can always be described as a shift in percentage of verticalness versus horizontalness within a

How THE MARKET DEFINES ITSELF

57

1 00% cap. (In practice, neither actually ever gets to zero.) It should be fairly easy to establish the best parameters within this spec­ trum for any trading approach . The place where there is little or no vertical movement would be characteristic of efficiency; re­ gions where both dimensions are active would be a two-sided, moderately efficient market; and where only the vertical was ac­ tive is a one-dimensional, non-efficient market. It's important to observe here that change and condition of the market can be seen to be made up of dimensionality. It's through this medium that we can objectively express captured market data. The market is in general control of itself when it is actively gaining efficiency, and this usually takes place when the market has both active dimensions working: a condition that we have become used to , because it is more conducive to trading . It is a more orderly flow, even though the dimensions may work at ir­ regular or sporadic intervals . When either dimension is moving separately, control is with capital inflow/outflow (inefficiency) . When the vertical is in the ascendency, inefficiency is present and is dominating the mar­ ket; when movement is horizontal, it creates a background that is highly vulnerable to change . The market expresses itself directly in the ratio of its dimensions . Once we understand the basics of dimensionality and how to measure it, the other thing we need to monitor to have a complete picture of the market's condition comes from what I call market output. The output, which is the efficent price area, demonstrates what the market is trying to accomplish through its self-organiz­ ing system. An overlay of this on top of dimensionality would provide more control , as the precision would be enhanced; we would know the circumstances under which the market was pro­ ducing its output. If we were in manufacturing, for example, we might change our expectations of output based on the fact that today's plant shift was operating at half capacity due to the installation and testing of a new machine. In the market , if the conditions are

58

CHAPTER SIX

really perfect, and the market doesn't go anyplace , we know that the potential for the trade is over. Conversely, if conditions are barely adequate and we're getting good results , we know we can expect much better results under better conditions . I once discussed this problem with one of the trading floor's favorite old-time traders , William Emory Uhlman, a member since 1 927 . He just laughed, and remarked that maybe I should have taken a little bit more engineering in college , or done a little more work on the farm, so I would be able to understand that wagons are always moving faster at the bottom of the hill than they were at the top . In looking at market output, pit, screen , or specialist based trading are all operationally the same. Differences in these types of markets would be capacity, depth of participation , and so on . Participant activity allows information to be produced and con­ veyed to those using or desiring to use the market. As traders , we want to be in control of this type of knowledge . It is a free market expression . In looking at market output, a better understanding of its self-organizing mechanism is called for. A meaningful amount of data is composed of a vertical data mass that is large enough to have allowed the market to gather participants . This means that somewhere within the data mass the two vertical reference points will have been found and estab­ lished, creating a vertical base . The background pattern , or data makeup , of these bases will always be different, due to the fact that volatility is never the same . This , by the way, is an added factor in the difficulty of reading the activity of the market while establishing the vertical references . But, once the predominantly vertical phase is done, it anchors the rest of the development, because the market now has established a vertical base to work within in trying to bring itself to efficiency. The information coming from the market early in this process is very unstable, and when the process is final the information is very "late." It's only after the fact that we know that the bound­ aries of the range have been established. For example, a market

How THE MARKET DEFINES ITSELF

59

goes from 1 0 to 30; while trading at 30 , it looks as if it is still going to continue moving vertically. When it trades down to 20 , then we can see that 30 was indeed a valid high reference. Once both vertical reference points are in place, the market turns its effort to trying to establish a fair price area within the vertical range - a consensus price for those involved. This fair price area produces more timely information because the characteristic na­ ture of its development is more horizontal . It is more readable sooner because we're dealing with lesser volatility and a smaller range of data. Also, more importantly, it is the most consistent market information . All the various volatilities have been pro­ cessed out. The fair price area is a common denominator in cross­ referencing a market to itself through time as well as to other markets , because the resultant of processing volatility out of a market tends to be consistent. A fair price area is just that. It is change that starts the whole cycle over again. Change impacts fairness by calling for vertical movement away from it in order to reestablish fairness . Or it may be that it just stops the partial development toward efficiency prematurely, and moves to establish another vertical reference point before once again looking for contained development and consensus . Consensus areas , or fair price areas , are the easiest to read and most valuable of all market-produced reference points , in that the market uses them to anchor vertical movement; vertical movement being what we're trading for, since it gives the most opportunity. Instead of the late information of the vertical price extreme in the earlier example, the fair price area or consensus area becomes the new, more reliable, readable extreme that serves as the basis for verti­ cal development. Only the remaining vertical point needs to be found. Consensus is needed in order to begin the market process all over again . And the consensus price is the market output. The result is a true self organizing mechanism. Vertical back­ ground is varied, while consensus output is more standardized (in a relative sense) , and therefore more readable. Consensus output allows consistent readability, which is the best basis to go

60

CHAPTER SIX

forward with. When we combine the free expression of dimen­ sionality with the consensus output on an objective data screen , it's only then that the market defines itself. It shows us what it did, what it is doing and how it has changed.

CHAPTER 7

Capturing Market Data

The purpose of capturing the market on a screen is to put it into an objective format. Just having the data on a screen is not enough. The market is two-dimensional, in the sense that it is vertical and horizontal and the data representation needs to re­ flect this fact. The test is to be able to see independent movement in both the vertical and horizontal dimensions. If you can, you' ve achieved your goal. Most objectified screens have a forced non-varying movement in the horizontal due to the use of chronological time. For ex­ ample, if the market in development of the horizontal should have shown only three slots of usage (because no price was hit in more than three half-hour periods), and actually shows five, just be­ cause five was the chronological time span, you have not accom­ plished your goal of objectively displaying the market. In fact, you have a one dimensional data base, and it's therefore entirely subjective, since it cannot faithfully represent the two-dimensional aspect of the market. It is very important to understand the proper use of the hori­ zontal and vertical axes in developing an objective graphical rep­ resentation of the market. It is logical to assume that the market's two dimensions, the vertical and horizontal, would fit with the screen's capability for two-dimensional display. The vertical axis fits, because it will record any vertical price that the market uses. 61

62

CHAPTER SEVEN

The horizontal axis presents a problem because it's normally as­ sociated with chronological time, which proceeds at a fixed pace. What is time? We naturally think only of chronological time since its use has become so ingrained. But in the case of market definition, it is totally inadequate . Do we really need chronologi­ cal time for order, or do we just automatically assume so? Development, which is horizontal, is the real market time. Development begins with initiation of a vertical move that has to be brought to efficiency. It continues after the establishment of the vertical boundaries (outer limits) , when the market shifts into more of a horizontal phase. This activity cannot be forced to move in lock-step with chronological time. Forced chronologi­ cal time does not allow for free two dimensional expression. It makes the data one dimensional, which leads not only to repre­ sentational problems, but to control problems as well. Chronological time has no relationship to the market's devel­ opmental process . The market's development is almost always inside of an established vertical range, and on that basis is hori­ zontal , because the vertical is not growing . The development of efficiency represents the time clock of the market. If develop­ ment is interrupted , the market can move to extend the vertical and then start the process towards efficiency all over again. Re­ gardless of the circumstances , we must look to development as the timing mechanism for the market: development begins , is at 1 /4, 1 12 , 3/4, and is finally completed. The progress of develop­ ment is shown in the proportion of horizontal slots used versus those available , where availability corresponds to chronological time . (See the discussion of profile in Chapter 3 , pages 29-30 .) This concept represents a huge step toward tradability, since traders need to fit their trades to a naturally occurring market event, rather than to outside parameters . A negative effect of using chronological time is that the data base is forced into a vertical mode, which , with a vital dimension of information sup­ pressed, makes definition and control extremely difficult, since

CAPTURING MARKET DATA 63

efficiency is very hard to recognize in a vertical presentation of market activity. False assumptions have caused a lot of financial wreckage, not only in our industry but others as well. What has been false, and is false, is that technical analysis on a one-dimensional data base can capture the essence of what happens in the market. This type of analysis, which has been portrayed as objective, has never truly been so. There is evidence supporting this contention within just the short passage of time since I started trading. There has been no appreciable increase in favorable results within our in­ dustry compared to the past, notwithstanding the advent of com­ puters and the influx of very bright technical people from other fields. This is not saying that individuals have not done better; it is that, if we had objectively conquered anything, general results should have shown some improvement. While our industry has grown both domestically and overseas (a factor that tends to keep the percentage of success down), it shows growth due to need rather than a breakthrough of new knowledge. This problem can­ not be ignored or glossed over; it needs to be addressed in order to find objective market definitions that will definitely improve results and provide industry growth at a much faster and a more sustainable rate.

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CHAPTER SEVEN

CHAPTER EIGHT

The Importance of Two-Dimensional Expression

The most important discovery related to Market Profile was made by Mike Boyle, vice president of information systems, Chicago Board of Trade; Bob Jirout, the head of the department at that time, also played a key role. This discovery was the data entry system that allowed the market to evolve naturally in mar­ ket time on the horizontal axis within the day time period. It also made the base of the bell cur�e vertical rather than horizontal , allowing efficiency to be portrayed through horizontal develop­ ment. I met with Mike and Bob in Bob's office one afternoon to discuss developing the profile as an on-line proxy for volume data, in an attempt to give the off-the-floor trader the opportunity to make the same type of observations that I made on the trading floor. The earliest volume report was released each day after the first run of the clearing house at around six p .m . , so such a proxy would fill a real need during the day. At that time the volume data was broken down into segments of CTI codes (Commodity Trader Identification codes, such as commercial trader, local, lo­ cal off floor, and other) , and a volume value area of 70% was calculated to approximate the first standard deviation derived from the bell curve discipline . (See the end of Chapter 3 for a discus­ sion of the bell curve .) A flat presentation was the mode of dis65

66

CHAPTER EIGHT

play: volumes were given as numbers opposite the prices. (An example of one of the first such reports is given at the beginning of Chapter I.) We planned to put the profile opposite our volume data in the liquidity data bank report. This would demonstrate the sound­ ness of the profile method, if, as we expected, volume corre­ sponded with the profile mass; i.e., where little time was spent there would be little volume, and where a lot of time was spent there would be a lot. This would validate our concept that price plus time equals volume, and would mean that the profile did indeed capture market activity. It was, after all, a record of ac­ tual usage of the market by participants. And, in fact, our expec­ tation was fulfilled: there was a close correspondence between the width of the profile and the volume at each price level. Briefly, the formula for the profile was, as we described in Chapter 3 , to use the ranges of the half-hour chronological bars, using letters of the alphabet instead of numbers to represent the range, in such a way that the accumulation of letters would sig­ nify acceptance of the corresponding prices in the lettered mass of the profile. As the market traded during the day, each live quote that increased the range of a half-hour time period would build the profile on-line, and thus approximate the actual distribution of price usage by market participants. It was our intention at the meeting where the profile was de­ veloped to have the profile data mass also reflect the properties of the bell curve, especially its first standard deviation. That is, we expected a daily profile to look like a textbook illustration of a bell curve, with its first standard deviation corresponding to the 70% volume value area in the LDB (Liquidity Data Bank), and with the base being vertical rather than horizontal. The meeting ended after about twenty minutes, and Mike said that it would take about two weeks for him to prepare something for us. A little before the end of the two week period, Mike was ready to show Bob and me his ideas. He had done it a couple of ways and I could immediately see the one that was just perfect.

THE IMPORTANCE OF Two-DIMENSIONAL EXPRESSION

67

We decided to go with it. The decision was visual , based on resemblance to bell curve examples in a textbook, and volume data in the first standard deviation was perfect proxy of the pro­ file. Because the correlation was so exact, we felt that we had indeed captured the market. It was much later that we added the S&P to the floor data terminals . I was concerned to see if the relationship would hold as far as getting a realistic profile that mirrored the volume data, and it turned out to be as close to perfect as possible . The key, as stated earlier, was Mike's method of data entry in the two-di­ mensional display that allowed the data to form a bell curve, which was our main purpose. It also allowed natural market time to evolve on the horizontal axis, a fact we were not aware of or interested in at the time. That is, chronological time was sup­ pressed during the day, although the day and beyond were still chronologically oriented. The result of this type of data arrangement was to allow mar­ ket usage to determine the number of horizontal slots used. For instance , consider a six hour trading session. There would be 1 2 half-hour opportunities (and thus 1 2 half-hour bars) on a chrono­ logical time scale. With the Market Profile data arrangement, there would be a maximum use of 1 2 slots , but usage could be less if no one price was hit in all 1 2 half-hour periods . The difference would be the amount of horizontal usage on a comparative basis to other days. In the early 1 980 's, we were totally oriented to trading and trading disciplines , and were looking for objective data to help people trade . We were not aware of the deeper significance of this finding . I am going to insert here a statement from Mike relating his side of the story, which is quite interesting and re­ vealing . In approximately

1 982,

when Pete and I first sat down to

discuss how the Liquidity Data Bank physical presentation might look , the computer systems in place at the CBOT pro­ vided few display alternatives . The nature of this information

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CHAPTER EIGHT

and the requirement that interested parties have access to mar­ kets of their particular interest necessitated the use of then state­ of-the-art alphanumeric display terminals . ( The first PC was commercially available sometime around mid

1 98 1 , if I recall

correctly.) These terminals provided the typical

24 lines by 80 charac­

ters of display capability, and although some limited graphics could be constructed , the computer system which supported the LOB did not have such software support . As a result, Pete's input as to what types of information to display, and how the time factor (i.e . brackets) would be repre­ sented were viewed in light of this physically restrictive dis­ play technology. In addition, the time representation whereby the brackets were collapsed at a given price level was also a limitation of the

80 characters per line restriction .

In addition ,

a collapsed display effectively made the programming easier since the software did not need to make any determination as to what column to place a specific bracket character. Also , in planning the ergonomics of the display (i .e . , keep­ ing a price per line approach) , the possibility existed that the

20 available 4 lines of header type infor­

number of unique prices would be higher than the lines of displays (assuming about

mation are needed) , which also made a strong case for the col­ lapsed bracket display per line (price) . As of this day (July

1 996) , the CBOT computer system displays of Market Profile remain in place today, via the same terminal-orientated for­ mat. While terminals are often replaced by PC 's , a terminal Emulator operates on the PC so the user interface established in

1 982 remains today.

As we look back on this period of time, we are going to find that the sum of the parts was greater than the whole. The current Market Profile methodology is something we were not even think­ ing about. It came about because an effort was being made to do something toward more understanding of markets , to make them more tradable. This data entry system can be and has to be used in all creative data arrangements .

THE IMPORTANCE OF Two-DIMENSIONAL EXPRESSION

69

Almost all data arrangements up till now have been in support of a search for trading parameters that are immediately back­ tested as to financial goals and requirements . Most of us never get beyond the objective trading parameter stage , especially if we've been successful . Our dreams never get beyond a trading system that does nothing but print money, this being construed as solving the market in the everyday world. In reality, because of the constantly changing markets , this is not highest goal we can strive for. The new view comes more from awareness and experience than from any direct change . This means having a market focus , on market disciplines related to the market as a whole , rather than a trader or financial focus . This attitude has been able to move our market operations to a higher plane , giving us a sound business approach. It gives us an opportunity to understand what we are about, and what we are working with. We can assess how we are doing with it, where control really lies , what the condi­ tions are , and how they may have changed. The ability to answer such questions objectively allows a whole new approach to trad­ ing , and the key to this ability is to create a truly representative data base. This is the new role for Market Profile - as a data base. It has the means to accomplish what no other data organi­ zation method does . It's vitally important that any data arrangement allow the data to be evaluated relative to its context, which lends support and smoothness to change. By allowing the singleness of purpose of the market to express itself in varying ways , we allow this to happen . The data entry system can produce a Market Profile data base that represents what the market is doing and allows the mar­ ket free expression , giving us a formalism that is true and repre­ sentative . This is using Market Profile on the highest plane pos­ sible. Once the data are correctly organized, there are two additional aspects that come into play. First, computers: in trading they have always worked best in defined objective formats like arbitrage .

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Second is trader control . Now, in order to be successful, traders can work to gain control over the market process by gaining ob­ jective answers to their subjective questions about such matters as dominance and background. Answers are available that come directly from collected market background and foreground in­ formation , and are communicated in a uniform language or for­ mat: in terms of efficiency. This produces a framework for ob­ jectifying the market. Let's use as an example the concept of lull introduced in Chap­ ter V. A lull is an interruption in the dominance that propels the market directionally. As in most vulnerable situations , a deterio­ ration takes place to some degree in whatever has been going on, and the lull is likely to be a stressful time calling for adjustment. We can ask our data base to define it, compare it, compare dete­ rioration to when it occurred previously in this market, to other markets , to the condition of all markets , etc . Is the lull becoming dominant? What are we going to do when it's over? Is it over? Why? How do we know? With dominance and lull defined by objective market conditions , such questions can be posed and answered . Understanding, experience, and market differences are all com­ parative and relative . It is easier to deal with this relativity if there is a standard data base that is truly representative . Finding the self-organizing mechanism within the market that is depen­ dent upon the completion of efficiency was a conceptual break­ through. It would never have been possible without the data en­ try system . The details of finding it are like those of most good things , in that the discoverer is looking for something else . Also , since the concept is completely out of the norm of our logical behavior related to cataloging market activity, the eventual suc­ cessful direction had a very small chance of being pursued . A great deal of my early data arrangement was visual . It con­ trolled what I did. It was a very limited approach because I was trying to force the output. If the data for a day did not create a perfect little bell-shaped profile , I would combine data until I got

THE IMPORTANCE OF Two-DIMENSIONAL EXPRESSION

71

one . This was a logical approach: the larger the data mass, the more likelihood of finding efficiency, as efficiency was commonly expressed in this manner. I could only see opportunity in this context. It's logical to want to always trade order, but the oppor­ tunity is often in disorder. Other than intuitively, I was not aware of this . I remember when we first started with the software; we were actively arrang­ ing the data by breaking up and combining daily profiles, and were having a good deal of success . I said that it was wrong to do it that way. Most of my supporters were really taken aback that I could drop what I had been doing for something so seemingly unreal . My inability to logically explain the change made mat­ ters even more complicated. I admitted as much and asked them to trust my judgment. The result was a discovery process that eventually led to a data arrangement algorithm that produced the foundation for all our future accomplishments . A good example of the importance of accepting disorder is the self-organizing methodology displayed on the screen I call "Page Two" in our software . The output, or resultant, from the data arrangement algorithm was consistent in meaning. What was not consistent was the background. We did not use a single output scenario; instead, the triggering of a new cycle was data dependent rather than predetermined. When we released the software to our clients , the program­ mers responsible for the program, Bill Pollack and Gordon Kummel , received a number of calls concerning what appeared to be several inconsistencies in the program. The output was dif­ ferent on different machines, as a result of small perturbations in the data received, plus some internal procedures of the software . This was counter to the rigid order most of our clients expected, which in and of itself was quite normal. In addition, the market output would mostly take place in the present, and be located within the data itself. At other times, though, the program would mark the resultant back in the data, saying in effect that it was not immediately recognizable at the time . So our resultant would

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sometimes occur well after the fact. When the resultant indicator is outside the data, and late, it has its own significance, in that the associated move is usually quite strong . The superficial lack of sameness is simply a reflection of reality. We are not trying for the impossible , but the practical . In fact, the output actually rep­ resents sameness of a higher and more functional order. I personally thought that .all of the irregularity was a great feature, in that we experience this type of output in the markets all the time . In the active trading pits , all the traders do not get the same feelings or trade indicators , yet the information is there . The difference is in the way they subjectively organize the data, into different size groupings that give a distinct feeling for the same information. If this weren't the case, if all traders had the same perceptions all the time , the markets would never trade . In our software, we avoid the problem of everybody getting the same conclusive information in the same way. This goes a long way towards rebutting the "self-defeating" prophesy, which says that as soon as a good trading system becomes widespread, it fails , because too many people are trying to do the same trades at the same time. Let's consider the idea of "disorder" in the light of the graphi­ cal display systems currently in use, in comparison to the ticker tapes and clacker boards of the past. Is market change informa­ tion getting out through the current systerms, or has the informa­ tion been narrowed from everyone doing their own organization and interpretation to a mere trading focus, where everyone is look­ ing at the same half-hour or hour or five-minute bars and the same studies to decide where to trade? The functionality of this process , not only for the trader, but for the exchanges that are trying to disseminate the information, is questionable . Why is the information being distributed so impoverished in comparison with the information available on the floor? Basi­ cally, the information is processed and packaged for the conve­ nience of trading programs whose net result is a profit or loss, rather than market information. How many opportunities are de-

THE IMPORTANCE OF Two-DIMENSIONAL EXPRESSION

73

fined per minute, or per quote , versus actual opportunities that are present in the day? How many updates do you need to moni­ tor a winning trade? First a lot of information is filtered out, and then noise is added back in, by providing and continually updat­ ing various studies , giving the illusion of a richness of informa­ tion that is really no longer there . The essence of floor information is to take a segment of the activity and assign it to a direction, and then view it in terms of one's background and experience of similar situations , rating it as being at, above, or below normal for similar circumstances. There is no one outright order or price in the stream of informa­ tion that is as important as background. If a trader can use this information to establish the existence of a barrier to a directional price movement, it makes trading a lot easier, since all the indi­ cators in that direction are going to be invalid. The goal of our software is to allow the trader who is not on the floor to simulate this experience by constructing a background, finding similar situ­ ations , and assessing the market's performance in relationship to this information. The bottom line is that, despite some differences in the output of our software on different machines , the meaning of the output is consistent with the data sample size being processed. On the floor, the markets currently trade very well, due to the individu­ alistic way the traders view the information in relationship to what they 're doing . The information provided by the software allows traders to understand what the market is doing in relation­ ship to what they are trying to do, and thus has retained the indi­ vidual value concept. The main reason for mentioning this issue here is to illustrate how ingrained a sense of visual order and sameness is for most of us . Prior to the discovery of the new output algorithm, and immediately afterward , I did not know what I had done . It was really a higher sense of order than what I could immediately handle . The new output was a free market expression that above all was consistent, and I recognized that aspect of it. All the vola-

74

CHAPTER EIGHT

tility had been processed out, leaving consistency. Logically, vola­ tility cannot be neatly cataloged, as in reality it does not leave footprints of the same dimension. The result of our new algo­ rithm was an entirely free market expression , which went a long way towards furthering our new data base concept. The overall benefits of this data base are many and in my opinion complete: it gives you everything you need to trade . Opportunity can be defined and evaluated. Expectations can be measured against reality. Experience and knowledge are the fruit of natural occurrences . Growth of the trader control process can begin. The ability to be in step with the market increases as the quality of the trading opportunity improves , because the oppor­ tunity is related to natural market development instead of just financial management. Natural market events are at the heart of market discipline . Data arrangement with this type of result is possible only because of the two-dit f

CHAPTER NINE

The Bell Curve

My interest in the bell curve began in 1 95 8 , in a statistics class at Berkeley. A statement in the textbook about "bringing order to chaos" got my attention. From the beginning, I wanted to use the bell curve as the basis for formulating a market discipline . I could see that it had many qualities that helped reveal internal market organization. The most important was that it presented a visual sense or feeling of what was going on . At first, I was much like a first grader with a coloring book, tracing the outline of the mar­ ket within a bell curve , and this was a great boon to my program of exploring and using market discipline . When the time came to formally develop Market Profile, after I had been trading for over twenty years , I could draw on my experience of always thinking of market activity in relation to the bell curve . The bell curve discipline, being a dynamic two-dimensional data organization tool , fit the framework of my practical experi­ ence . Within the chronological day timeframe , I as a floor trader traded according to how the market felt: was it slow, tired, re­ sponsive, tight, or what? I would compare these intuitive terms to the profile . Each discovery always led to the next, and the next, and allowed me to move towards a more complete under­ standing . Statistical theory states that in a bell curve, almost all data points will fall within three standard deviations from the mean 75

76

CHAPTER NINE

(the average price of the entire data sample) . For our purposes , we use the mode (the longest horizontal line) as a surrogate for the mean; it's much easier to locate visually, is often exactly the same value, and gives good results . The mode is the anchor for development as the data stream continues. At first glance , it ap­ pears to be a fixed quantity, but in fact it adjusts to increased activity as more data comes in, making it dynamic . The standard deviations are groupings of the data mass being observed, and provide the basic organization within it. Each one has a prescribed amount of data in it, and the total of the three is very close to 1 00%. The first standard deviation has the most data at approximately 67% , the second has roughly 26% , and the third about 7% . These standard deviation intervals are used to capture and define data . Figure III-3 shows a symmetrical bell curve with the standard deviations shaded in; a more off-center data mass would not create such a pretty picture , but the basic idea is the same. As I began to develop insight into the market disciplines that controlled my trading, I also incorporated the disciplines of the bell curve as more or less distinct unto themselves . I benefited tremendously when I sensed an ever increasing unity developing between the concepts related to the bell curve and what I had been doing all along in my trading . I gradually became aware of how it all fits together as a single entity. In other words , there was no reason for separate and distinct analysis , because the bell curve was able to accommodate all the properties of the data stream that we were collecting and present it in a natural way. Personally, this was when it all came together for me . When the market disciplines and the discipline of the bell curve converged, the light started to come on. Let's list some of the commonalties between innate market discipline and the discipline of the bell curve as applied to the market.

THE BELL CURVE 77

The market has two dynamic dimensions, vertical and hori­ zontal; the bell curve needs to have the same in order to function. • The market uses the outer limits (vertical extremes) as a base to begin the development process; the standard devia­ tions are collectors of outer data which the mean controls . • The market brings the data to consensus somewhere within the established vertical range; the bell curve's first stan­ dard deviation begins to develop somewhere within its ver­ tical range . • Market development time begins , proceeds , and ends; in a market context the bell curve develops through completion of all three standard deviations , and ends with price in the first. • When change affects the consensus , a new sequence be­ gins , in the cyclic progression of market activity; the bell curve discipline starts a new data unit after finding a com­ plete first standard deviation , again in a cyclic pattern. • Background data leading to market consensus is varied, di­ verse etc .; background data leading to the first standard de­ viation is varied, diverse etc . • Market output (consensus) tends to be consistent, repeti­ tive , more of a standard than the vertical phase of market activity; the first standard deviation is likewise standard­ ized, repetitive , and consistent. • Location of consensus can be varied within the background range, but is mostly limited to either extreme , or to the middle; location of the first standard deviation when mar­ ket data is plotted in the bell curve is the same. • Market sequence is from a more volatile vertical to a less volatile horizontal; the bell curve organizes from vertical extremes towards horizontal development. • Consensus and first standard deviation are the only infor­ mation-producing moving parts in their respective environ­ ments . •

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CHAPTER NINE

This match-up has allowed me to attain a focus that had eluded me for a long time . The disciplines of the bell curve that we initially used for trading can be re-framed as market disciplines. This means that the bell curve has been completely neutral within its disciplines, in the sense that there are no harmful side effects from using it, as it fits market behavior well enough to allow free and natural market expression . This single expression is simply the degree of efficiency present in the market: a reflection of the process of dynamic efficiency. From this , everything else follows. It means that randomness , liquidity, and efficiency are all the same, i n that they are horizon­ tally oriented . It means that one-dimensional vertical data bases cannot objectify the market. It means that dominance is expressed as non-random and non-efficient. It means that the condition of the market is expressed dynamically as a percentage of a whole number ( 100% ) , and that the best choice for this measurement is the degree of efficiency. It means that background and foreground can be expressed in the same type of measurement, illustrating contrast between a sample and a subset of it. It means that traders can express their trades in the same measurements for control. It means that trader control can be internal to the market. It means that total objectivity is indeed possible . It means that we have found the highest point of market discipline from which to begin to approach trading . It means that we have the path to our future . As we explore these concepts in the next chapters , I think you'll see how beneficial the bell curve concept is in bringing an objec­ tive background to our aid. It also is a metaphor for our own progress, being at the outer boundaries initially, moving inward towards the goal , and finally arriving at the single central issue of market purpose .

CHAPTER TEN

Up dating Our Understanding of Market Profile

The development of Market Profile took place over many years . Over the course of time , changes were made, some as a result of gaining more knowledge and some that were forced by the market . We started at the outside rough edges of market or­ ganization and moved inward, led by the ability of the profile to educate us visually and to represent the market through time . The underlying reality remained the same throughout, in that the market was able to express itself dimensionally and that it was indeed trying to accomplish something dynamically. Early on, we generally thought of ourselves as working to understand development, as it could be read in its various stages. Later, as everything we were doing seemed to lead to the same type of conclusion, we were brought to a singleness of purpose which allowed us to realize that Market Profile's contribution really was going to be as a database from which market objecti­ fication could emerge , because it was able to provide the frame­ work for expressing the dynamics of efficiency. The first thing to point out is that our approach was subjective in its early stages . The main reason for this was that we had not defined the market's purpose. We were not even interested in doing so , nor, for that matter, were we interested in objectifying the market; we wanted to trade and we were looking for objec79

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CHAPTER TEN

tive trade parameters . We did not understand much other than that. Although the profile did take us out of chronological time during the day, it did not take us out in larger time periods . We did not understand the difference between chronological time and market time anyway. At this point, chronological time and mar­ ket time were one and the same, due to the fact that the floor population was really in control of the capital flows. Not that they had all the money; it's just that all money entered and exited during their market hours , and whatever was going to influence the market was in most instances readable from the floor envi­ ronment. There was no reason to be aware of any difference if one was not looking for it. To further illustrate the subjectivity of our approach at that time , I can remember giving classes where I would be discussing indicators , and I would weight them for that occasion . In short order, a situation would arise were I would use them in a differ­ ent context, and I would adjust the weights . In other words , the use of the indicators was somewhat subjective based on the mar­ ket context as judged by the trader. The markets were very read­ able because floor liquidity was very high, so when we had an indication of direction it was usually a dominant one that either carried on or held the general price area, giving us time to ex­ ecute vis-a.-vis entry/exit. Our objective trading parameters arose from the discipline of the tools used to create the profile , i.e. the data entry system and the bell curve. We were incorporating market discipline into our work gradually because it was there both in a conscious and non­ conscious manner, mostly due to the visual aspects of the profile. We could see things better than we could explain them . For the benefit of those who may be familiar with earlier ver­ sions of Market Profile , and also to show how our later ideas refined and improved on our early work, I'd like to go back and reconsider some of the early Market Profile concepts . Looking first at the data entry system, and the task of creating a dynamic

UPDATING OUR UNDERSTANDING OF MARKET PROFILE 81

relationship between the vertical and horizontal dimensions , we used the following terms: range extension: This was a vertical movement beyond the first hour 's trading range (which we called the pioneer range) . It assumed that after an hour the floor liquidity would be in control , and that this event would be the result of dominance. type of day: We were still mentally tied to chronological time, so we classified day activity into four types . First were normal days - those days where range extension was very slight or non­ existent. We would use this information to help us understand expectations; we'd say something like , "In this case , it isn't go­ ing to go a lot further, so let's get out," or " let's go short," etc . Next in line were what we called normal variation days , those in which the range extension would have doubled the original hour's range . In terms of what we might call offensive versus defensive trading , these were a little more offensively oriented in that we would trade for them because the potential range was larger; if we did not get a normal variation day then at least we would end up with a normal day, which would be disappointing but would not hurt us . Trend days triggered the most aggressive of all trad­ ing programs , but we tended to miss them more often than not. You almost had to anticipate them , because in those early days we did not like buying bulges or selling breaks . We consoled ourselves with the thought that at least we were not opposite the trend . This type of day had two distinct patterns . The most obvi­ ous was the double distribution , where two bell curves would be stacked one upon another. The other was more of a steady grind­ ing affair, in which the horizontal width of the profile was usu­ ally not more than four time periods (slots used) . Also, we noted that trend days at times would be a good exhaustion indicator, as the market's opening the next day was usually just slightly dif­ ferent from the close . Trend days also tended to close on the ex­ treme . The last type of day was what we called a non trend day. It was a day where the vertical range was very small and the market was mostly dead and horizontal . They were a favorite of

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CHAPTER TEN

position traders , as the market would tend to tum around and go opposite from the way it had been going when it got to the non trend day. Further, if it did not change directions , it usually traded opposite to the previous day and then continued in the original direction at an accelerated rate . Later we added another type of day called a neutral day. It was similar in meaning to the non trend day and physically had a range extension in both direc­ tions, but it was a lot more active . TPO's: "TPO " stands for "time price opportunity " ; in other words , each individual letter in the profile . The principle behind their interpretation was the relationship between the high TPO line , or mode line, the price in the profile that had the most use , and the imbalance of usage above and below this line as it related to the developing profile . We noticed that the market tended to go directionally to the short count side. The reason it did this was that the high count side was more horizontal and had reached acceptance, and that the market had generally moved to get there. This was quite important because it meant that the dominance was being reined in by participants . Also, if the market did not have a move to get to the mode, there really was no dominance to deal with. The need to find efficiency would create a need for this range to be fair, so the market would tend to trade above or below the high TPO line to fill out the profile in a balanced way. failed auctions: In terms of immediate acceptance , failed auc­ tions were the most popular of all the concepts . They seemed to work in spite of the various interpretations used, and were easier to objectively define . Physically, the profile would have a single range extension (only one TPO) beyond the first hour's range . Failed auctions were used in many ways, some of which I'm not totally aware of, but mostly based on two observations . In the short term (a day or two) , the market would exhibit a propensity to move opposite the failed auction's direction, and after three to five days it would begin to move to take out the failed auction , and it would then have a rather significant move that was sus­ tainable over time.

UPDATING OUR UNDERSTANDING OF MARKET PROFILE 83

In hindsight, the real market factor behind these observations had to do with floor liquidity (see Chapter V). At the time, it was the dominating force in the market, and worked to counter any directional movement, so it provided an environment that was very readable . Liquidity was dominant in that it had the capabil­ ity of usually being in control of the forces coming from other environments . When it was not, the dominance coming from the outside had to be significant- thus the reliability of our trading parameters . The day profiles were essentially carved out of floor liquidity, the way a force exerted by an artist changes a solid block of granite into a form. The same was true of the balanced and unbalanced bell-curve structures we developed later. In ret­ rospect, the type of day related to the amount of activity and was actually an indirect measure of the efficiency in the market on that particular day. In a blind way, the day type classification was leading us to what we needed to know without our ever being consciously aware of it. Trend days were the most inefficient, while non-trend days were the most efficient. Also , the markets were mostly still two-dimensionally active, which meant that they were really in control of themselves , following their preferred pattern of grinding out the excesses in a pattern that adhered to the bell shaped curve , rather than being at the mercy of outside forces . And they gave us a background by default, by staying in that condition for several years . In terms of the Bell Curve we used: extremes (3rd standard deviation): These were the very top and bottom parts of the profile. Typically, to be an extreme, an area would not have much acceptance, and therefore would not have much horizontal development opposite the price range. (I think we stated the objective amount was a width of three or fewer TPO's ) . As they related to the bell curve , the extremes were the third standard deviations . They illustrated movement away from the price area, or non-acceptance. Traders would pre­ fer to have these extremes in a favorable location supporting their position (under for a buy, over for a sell) , and did not like to have

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CHAPTER TEN

an extreme positioned against them. We also used extremes in a broader sense over larger sample sizes of data, in the time infor­ mation list, and in the long-term market activity chart. first standard deviation value area: This was composed of 70% of the data, whether TPO or volume , in the region around the longest horizontal line . It was called the value area, and had significance as an area that the market was either within or out­ side of. Its vertical range was important, in terms of whether it was large or small in comparison to the average value area over several day 's profiles . The change in value area size , i .e., the vertical range of the value area, showed either decreasing or in­ creasing activity over the larger sample . It was used in a number of ways for trading purposes in conjunction with other param­ eters , but it was also used in a direct sense in that once the market reentered a value area it would usually traverse to the opposite end . initiating versus responsive activity: The tendency of trad­ ers at that time was to use support and resistance in putting on their trades . This called for them to go against the dominance , which was not necessarily the best approach as markets began to change . For the more dynamic markets , classifying activity as initiating versus responsive was a way to define objectively what the condition of the market was in the trade set-up. Initiating activity was when the trader went with the market, either above the first standard deviation value area for a buy or below it for a sell , and responsive activity was when the trader did the oppo­ site. Naturally, a trade made under initiating activity should pro­ duce more immediate results as the move should be already hap­ pening , so to speak, and those taken in the responsive mode would take longer to develop and generally had to be held longer. parallel days: These were consecutive active days where the profiles were very similar looking , usually being normal varia­ tion days . The second profile would be either slightly lower or slightly higher in range than the first. This profile configuration meant that the market was making a good effort in either con-

UPDATING OUR UNDERSTANDING OF MARKET PROFILE 85

tinuation or in trying to reverse , and it pointed to the next day's profile as being significant to what the market was going to do next in terms of direction . It was viewed as a set-up for a trade opportunity, and the trader was alerted not to hesitate . long term market activity chart: In the early days of Market Profile, most traders thought it was a short term/day trade type of program. It really wasn't, but I think the fact that it was an active screen-developing program caused people to look on it in that manner. The long term market activity chart was a running sum­ mary of range extensions , extremes , value areas , and TPO counts , that were noted as either initiating or responsive . It was divided into buy and sell sides so that consistent activity would be con­ spicuous on either side. It never really caught on, as it was cum­ bersome and did not easily lend itself to graphic display with the equipment available at the time . As is usual in cases like this, it was actually very good, because its principle was fundamentally sound in terms of portraying the collective dominance , which corresponds to market background. It was especially so in view of the dominance of floor liquidity prevalent at the time . In other words , it gave us a plural instead of a singular reading: a reading over a larger sample size of profiles. In fact, it is still a very good idea in today 's markets . It was essentially a spreadsheet and, to use it today, one should reconstitute it to include the more mod­ em interpretations that you will see in later chapters . Also , there are a lot of software programs that can do the same job easily today. time information list: This grew out of traders ' need to re­ solve the objective/subjective problem , and their desire to have lists of things to reference. I refer to it now as packaged objec­ tivity -the orderliness of it made for a more comfortable feeling . I cannot remember exactly what was included in it because as a trader I never really liked using lists , nor did I really like present­ ing them in class. I did so only in the hope that it would help people in their trading .

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CHAPTER TEN

trade facilitation:

This was recognition of what the market was doing; it was a term used to describe the dominance dis­ cussed earlier. The basic question was whether the market was doing more business or less in a direction . This again was a lot more subjective than objective , and called upon traders to bring their understanding to a focus . li the market was doing more busi­ ness , it would keep control away from liquidity; if less, then it would slip back into liquidity, which was going to be horizontal at best. Trade facilitation was a condition that directly impacted whatever reason you had to trade . As a market discipline it tran­ scended all other analysis by being closer to the top of the food chain , so to speak: if no business was going on, or if business was not increasing , then there wasn't much going for you . It was also intuitive rather than exact. It was very similar to volume , but was a subjective indicator that could measure the activity that had moved liquidity to the background. trapped money: This came later in our program, and was very similar to the neutral day or non-trend day in meaning . The mar­ ket would complete a small distribution with the first standard deviation on the extreme , or a small-range trend day where it was moving directionally. This would occur near the bottom or top of a longer-term range, and would signify a potential exhaus­ tion phase in the market. When the market reversed following the distribution in question, it would always stay above or below the starting point of the distribution in its subsequent activity, thus providing an excellent reference point . We can now return to the meaning of dominance . It corre­ sponds to a concentrated force , capital flow, that overcomes the randomness of the market, thus giving it direction. As profile theory has developed, dominance has gone through three distinct methods of expression . In the early profile days , when we classi­ fied market action in terms of types of days, dominance meant directional activity overcoming the efficiency of the market; that is, overcoming liquidity, which we might call the market's de­ fense . Dominance had to prove itself beyond the boundaries of

UPDATING OUR UNDERSTANDING OF MARKET PROFILE 87

efficiency. In the second phase of market profile , when we were combining profiles to form large bell curves, dominance repre­ sented an offensive force that prevented efficiency from happen­ ing , giving rise to the term "minus development" to describe a period where inefficiency predominates in the market. And fi­ nally, in the current database-oriented phase of market profile, the measurement of dominance comes directly from dealing with efficiency; that is, with any change in the vertical/horizontal re­ lationship. It is necessary to recognize dominance . What makes it diffi­ cult, though , is that dominance has interruptions: it is there, it is not there , then it is there again . I have termed the interruption period a lull . In the early days of Market Profile, the background of the trade always handled the lull period , by reassuring us that longer-term direction, and hence the collective dominance, was in our favor. Lulls always induced activity of an opposite nature and needed to be looked upon with perspective . The perspective or background we had at that time came from the type of day classification system, which had its strength in having evolved from the floor liquidity. For example, a normal variation day had more dominance than a normal day, and the fact it could evolve meant that the background would not just disappear but would at least hold on. Trades were not made in isolation but as part of this background. Background was , and remains , an essential part of market discipline. I have always tried to look outside our industry for examples, because for me it has always helped to clarify the situation. In looking at dominance from my background of ranching/farming , I know that if you get careless when things are going well, you're in for a long and painful process if conditions turn against you . The recent Quaker Oats/Snapple merger is a case in point. If Snapple's demand had increased rather than decreased, the amal­ gamation of the two companies would have been easier to man­ age. In this case demand was the immediate dominance . The lull was the period when attempts were made to improve demand ,

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CHAPTER TEN

and the background was stockholder patience with quarterly per­ formance . I have had many funny experiences relating to this . As a young trader, whenever I started to recalculate my net worth, that mo­ ment would be the high point for quite some time. Or, if I had a very satisfactory position in something and I got the feeling that my position was not big enough , that too signaled the end of the move . Dominance was finished. All this points out how difficult it is to keep things going when they appear to be perfect . This is something you have to learn in order to go forward. You have to proceed on the basis of a strong foundation , and not try to build on the pinnacle of success , be­ cause it has no base. It is the background that helps hold every­ thing together: the outward control over dominance and its inter­ ruptions . Change can be both frightening and a good opportu­ nity, depending upon the circumstances . If you have built up something over time , change tends to be a foe; if you're seeking opportunity, change is the bulwark of it. When Market Profile was introduced into the London mar­ kets (the LIFFE exchange) in the late 1 980 's, it was at a very favorable time. Their liquidity was extremely high and was more sustainable than ours here in the U.S . Many of the large trading banks were members of the London Exchange and had floor trad­ ing operations , and so the floor liquidity had a good and active financial base . The state of liquidity of the U .S . commodity mar­ kets had changed. Capital flow into markets had overwhelmed the floor liquidity, causing chronological time and market time, which had formerly been coordinated on the day timeframe, to diverge . Beginnings and endings no longer related to market open­ ings or closes . This was a big change for Market Profile to handle. It was countered by moving to larger and different samples of data - the second phase of Market Profile . Time has brought the London and U .S . markets closer to par­ ity. (The SFE in Australia is currently going through this same type of metamorphosis.) The time lapse in developmental change

UPDATING OUR UNDERSTANDING OF MARKET PROFILE 89

between London and the U.S. helped define the change in the U.S. markets. It did even more to verify that moving from the first towards what would become the second phase of Market Profile was the right thing to do. It helped enormously to validate in a very direct way that the change I was in the midst of was correct, by clarifying why the first phase of Market Profile worked. When you're in the throes of change, you get all kinds of con­ flicting thoughts, and the best thing that can happen is to find a clarifying example that shows that the new direction is indeed valid. Prior to this change, we had already started to remove chrono­ logical time from the day profiles, so, as the market changed, we could change with it by removing chronological time altogether. This was accomplished by splitting and merging market data into smaller, larger, and different segments of market activity regard­ less of their origin date. These provided development structures and gave background control, promoting the move to market de­ velopment time. (See Figures IV-l and IV-2 for an example of this type of data rearrangement.) All the repercussions of this were still not consciously understood by anyone, especially me. Any data arrangement that retained Mike Boyle's entry system was valid, and this was in fact carrying us correctly forward even though we did not know it. As you will see in later chapters, the data arrangement is a breakthrough that will change the very struc­ ture of the industry for the better. The concept of data arrange­ ment into segments that represented market structure began here, and gave insight into the need to have a representative data base. It was really the visual data arrangement that showed how the market developed. Using the bell curve as a focus in this second phase, our data arrangements took on a shape determined by where the first standard deviation was located, which could be in one of three places: on either extreme of the vertical data range, or in the middle. We classified these profile structures as being either a 3-1-3 (first standard deviation in the middle; see Fig. X-I, page 94, profile for Sept. 19 and Oct. 4) or 3-2-1 (first standard devia-

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CHAPTER TEN

tion on an extreme; Fig. X-I, Sept. 30). At this juncture the per­ ception also began to present itself that the only significant mov­ ing part of the profile seemed to be the first standard deviation. It took a long time for this to really register; the horizontal aspect of building the first standard deviation seemed at the time to cor­ respond to the dead period just before a vertical movement. Market time was related to the complete development of the profile into either type of bell-shaped structure, 3-2-1 or 3-1 -3. In order to delineate market time, we soon learned that there were four steps to the blueprint of development. Step 1 is the start of the vertical movement, the laying down of the vertical range that is to be developed. In this step the market establishes a series of prices in one direction; it represents the most profitable trading opportunity. Step 2 occurs when the market finds a price that stops the vertical movement and begins to build the first standard deviation. The third step occurs when the market begins to move sideways, as it begins to develop around the area where it stopped in the vertical range, and the first standard deviation begins to emerge. Lastly, in Step 4, the market tries to bring the whole structure to efficiency by moving the first standard deviation down towards the middle of the range. We also noted that the first step was vertical and the three remaining steps were mostly horizon­ tal. The most important result of arranging the data in this format was that we could watch the four steps developing. This allowed us to observe the cycle of change as really coming from the hori­ zontal, the place of focus and increased control. Development was horizontal, and studying it was more fruitful than working with the unstable vertical. At the beginning we were looking for vertical distributions coming after the completion of either struc­ ture (3-2-1 or 3-1 -3), either of which would have ended with hori­ zontal development. Such a vertical move was the start of a new development that would become either a 3-1 -3 or 3-2-1 in its tum.

UPDATING OUR UNDERSTANDING OF MARKET PROFILE

91

When the market started out looking as if it were going to be easy to classify, and then would suddenly change, short-circuit­ ing the four step process by skipping a step or part of a step, our trades were harder to control. I also observed that when a step was missing because the market had skipped it, market direction was dimensionally vertical, and for a sound reason, namely that capital flow was causing a disruption or change in procedures. I knew from experience that it took dominance to cause this re­ newed vertical movement. Dominance was synonymous with minus development, a new concept that related to our work with the stages of market devel­ opment. The term "minus development" came up one day in a discussion with John Stafford. He repeated a "saying" from an old trader: "It's what's not happening in the market that's impor­ tant." We could deal with the interruptions in dominance (dis­ cussed earlier) because we had the structure of the four-step pro­ cess to fall back on during the lull. We knew where we were in the four-step process, and I felt comfortable because we had the same dominance and lull combination we had earlier, just deal­ ing with it from a different perspective. The old base for recognizing dominance was the floor liquid­ ity from which dominance could be measured. The background had now become the four steps of market development, together with the potential existence of minus development which would not allow the market to complete its cycle and reach efficiency. This implied a change from a defensive, floor liquidity oriented, view of dominance, to what we might call offensive dominance. The way we measured it was through minus development and the four steps: if we were missing a step or some part of a step, we knew dominance was in place. Again I must state that I was not consciously aware of all this order and symmetry between both phases of Market Profile. I just had a lot of peer support and my intuitive feelings to go on. This allowed a continued movement to market disciplines of a

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broader order. I was steadily progressing to a more abstract and objective formulation from a more subjective and intuitive one. This process also reinforced my receptive attitude toward change. For instance, one of my dreams was to organize data into large data masses, and be able to find a small change within the large mass that would lead to far bigger things. Much to my disappointment, I had never been able to do this. I think the source of my failure was to always think about the large data mass as a single unit. Instead of thinking of a large mass as I had been, I changed to thinking of large in a different way, as a composite large where the individual parts would be in place for me to see specific change. Just finding this minor change of perspective was instrumental in removing the blockage and allowing forward movement. I like forward movement; it's necessary for all of us. So I encourage change as a foundation of one's development. As we leave this second part of Market Profile history, sev­ eral things stand out as instrumental in taking us further. The vertical alignment of the base of the bell curve gave it the format to illustrate efficiency through its horizontal development. The real role of the bell curve was the fact that you had to find the first standard deviation, or at least some part of it. The relation­ ship of the first standard deviation to the horizontal was very meaningful, and provided insight into development time (the stage of development that was under way). Reading the bell curve through the first standard deviation gave direction to the thought that this was probably the way to read the market. The similarity of the first standard deviation to efficiency gave reason to ex­ plore that relationship further. Our software had developed to the point where I could try some different data arrangements. I began to trade stocks actively, and this brought even more focus, as it was far different from commodities. Using the software, I came up with a way for the computer to scan for efficiency, both for stocks and commodi­ ties, and got some really profound results when running these efficiency scans on live market data. I had no monetary goals for

UPDATING OUR UNDERSTANDING OF MARKET PROFILE 93

these studies; it was just something to try while I viewed the markets for trading. The scan results popped up where I thought they would on my screen, and also where I did not think they belonged. Both worked equally well, with the ones I thought to be out of place being the best. I knew I had done something very right, even though at the time I didn't completely understand what I had done, or why it worked. I could tell that the results were better than the normal trading indicators that I was used to. I also knew that I had not yet found the market's purpose, and that I would need to do that in order to go further forward. Later, the impact of many differ­ ent types of results provided great insight into the market's pur­ pose. But most importantly, I gave myself time to learn more, and I made the sacrifices called for in doing so. I paid no atten­ tion to other people's standards Of success or failure. The growth towards attainment of many goals during this period was very large. The evolution of the fundamentals of Market Profile has been lost on the majority of users because most of the interest was in using it to make trading decisions, rather than in understanding the market. Development for purposes of understanding did in fact continue, but the results were not widely disseminated. In the past, for many who were and are interested, it was hard to determine just exactly what the teachings were. The explanation of the basic principles that we've already given, together with the material that follows showing how I think they should be applied, should go a long way towards clearing up the confusion. For example, let's take a look at a very typical early display of day profiles using Dec. Cocoa futures, starting on the 19th of September 1996 (Figure X-I). The interpretations will be drawn from both phases of earlier Market Profile theory, and are thus subjective as to what the market is doing. We are going to be helped along by the visual display alone. First, look at what you'd like to do as a trader. Go through the chart and identify the trades you might make in hindsight. I al-

94

CHAPTER TEN

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ways start out by visually reviewing groups of profiles that have a similar orientation as to direction. I don't just look at the latest profile, rather I look for an insight into the background. In this case, the 19th through the 24th are moving sideways, the 25th through the 27th are moving up, and the 1st through the 3rd are moving down and then reversing. I look to find the first standard deviations, and to compare what the market was trying to do. I then look at their respective ranges. Look at the profiles from the 19th-24th. The first standard deviation is evident on all. It starts in the middle on the 19th and ends in the middle on the 24th In between, its location is near the bottom of the range on the higher day of the 20th. On the 23rd, the last time-period spills sharply down, which has the effect of making the first stan­ dard deviation for the day be in the middle of the range; prior to that it was at the bottom of the vertical range. This is not a very strong dominance. Notice the extremes on the 19th, 20th and 23rd, as they are again indicators of a struggling direction. The quick move late on the 23rd brings a balance to the laggard vertical that

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had been in place on the up days. Quick moves also bring things to more of a focus, and you need to get more intent. The activity on the 24th is bringing the opposing forces to­ gether as the market is now balanced, ready for a new dominance to emerge. This can easily be seen by putting all four profiles together, giving a well-proportioned 3-1 -3 structure. By arrang­ ing the data a little differently, one can see that the J time period of the 23rd was indeed contained by this background (Figure X2). One could also note that the first standard deviation or value area of the composite profile would correspond to the J period range, and that J period traversed the value area; this is normal for any such movement, as we explained earlier in the chapter. By trading on the 25th one would at least be at the start of something where either trade (buy or sell) could be evaluated from the market. The next day was a trend day where the market moved higher, and all was well if you bought, or sold and had covered. The latter means you did a good job of exiting, which really is a quite important trader function. The following day is

96

CHAPTER TEN

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typical of what takes place now, in that the dominance disap­ peared and the lull was testing the longs' resolve. The 27th brought early joy but again was cause for concern late. Notice that the ranges are larger on the 25th-27th than on the 19th-24th, and it's hard to find the first standard deviation early on the 25th and 26th - it became more obvious on the 26th and 27th. This is indicative of a good effort to move vertically, and the market seems to be having the same difficulty as before, be­ cause it's staying in the same trading range. The background of dominance hasn't changed from the earlier set. Looking at the data as a new composite, one can see an almost completed struc­ ture of a 3-2-1 nature. (see Figure X-3). Collectively it is easier to see the first standard deviation now. Subjectively, we must weigh the background, and it is one where the vertical move­ ment has had earlier difficulty. There is no evidence that that situation has changed. The real question will be whether or not the lull which is al­ most certainly going to happen will be contained by the struc-

UPDATING OUR UNDERSTANDING OF MARKET PROFILE 97

ture. It would be prudent to err on the side of caution. The 30th confirms this. Notice that the 26th and the 27th are what have been termed parallel days. (Figure X-I.) On the 27th the market made a good effort to move higher, and really could not do much. The following day is usually the clue, and it had the first standard deviation in the low part of the range. Clearly the life of the inefficiency in this example is not very robust. (This is a parallel to the earlier Bond example discussed in Chapter IV). In making an assessment of the market, one really cannot conclude that the market is weak, but it's clear that it also can't rally much. A strong dominance is missing. It would be best to liquidate if long. Looking at the market from the 30th to the 4th sheds some additional light on the subject. (Figure X-I.) The vertical ranges of all the profiles are smaller than when the market tried to rally. The first standard deviations are present except on the 3rd. That profile was a trend day where the market worked slowly lower and the range hardly expanded. Additionally, it was a potential trapped money situation, as it was a market culmination near the bottom of the trading range. The background of weakness to the up side did not in this case translate into strength to the down­ side, as there is no other evidence that supports it. The 4th confirms this as it is opposite the high end of the 3rd. As a composite (combination of the 3rd and 4th) the picture is changed entirely, as it resembles a 3-2-1 up structure. (See Fig­ ure X-3.) A great deal of change has taken place here, but it could be expected if one has followed our analysis so far. If the market were to spend less time in this low area on the 3rd and 4th than in the high area (27th-30th), it would be a minus development situ­ ation, and, given the background, this could be anticipated. Right here is the crucial part of trading. The market is in good condi­ tion to move higher and one has to act now. It is safe to buy and it would be best get some type of activity on the 7th rather than several days later, otherwise minus development would not be there at this same price level.

98

CHAPTER TEN

This probably is the biggest characteristic of learning to be a good trader- being able to see the opportunity early and not hav­ ing to wait for it to become more developed. As we look at the vertical on the 25th-30th and compare it to the 3rd-7th , it is very clear that the former had more horizontal movement than the lat­ ter. Therefore, the most logical trade would to be try to buy early on the 7th and hope for the best. Remember that the market still is going to have the same problem of vertical indifference unless we see some evidence of change. Don't just focus on the fact that you have a profit on the trade, focus on the situation that you need: for the market to show a little more in the way of domi­ nance to the upside . You can now compare what we have done with the trades that you could have made in hindsight. We probably did not do as well, but we were in control of whatever we did. I would suggest that those who like to use day profiles also try to work with larger samples of study data as we did in the above example. Most software has the ability to split and reorganize the profiles beyond the day time frame. If you do this, then the same simple display you've been using can take you further into un­ derstanding the structure of the market. The basic 3-1 -3, 3-2-1 distributions will become apparent. Either or both of these pro­ grams (working with day types and forming composites) will force you to focus on the same thing in different ways. It will start you toward more trading self reliance, because you will be making a start on developing your market discipline from the market it­ self. There are just a few things to focus on as you work through this program. The first standard deviation is the way to read the market through the profiles, whether individual or composite. It also defines efficiency as being present, and the sharp vertical moves define non-efficiency. Be very alert for quick moves that continue or reverse themselves. The range of the selected data segments (day or composite) is important if the direction is clear. Try to trade as early in the opportunity as possible by under-

UPDATING OUR UNDERSTANDING OF MARKET PROFILE 99

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standing the background. It's sort of natural in trading to try to be sure of the trade, but by the time you're sure it's often over. This will provide the basis for your continued education, which is mandatory for all of us. Its value is that it is not dependent upon any participant but yourself, and the whole of activity III the market. I am now going to introduce some basic studies from our soft­ ware that have the computer doing all the work. These studies come from data that has been rearranged into a data base that is completely free of chronological time. There is a great benefit to this in that the workload is a lot smaller and traders can select whatever condition suits their style or preference. In other words, one can trade from only the best of situations. In Figure X-4, I've overlaid the cocoa chart of Figure X-I with a compression study that is derived from the new data ar­ rangement. This study is very similar to the old value-area con­ cept. It is flexible in that you can show any chosen percentage of activity of any mass of data as a new mass within the old. The

100

CHAPTER TEN

scope of the study is shown by the large rectangle encasing the range from the 1 9th through the 4th; the study area is shown by the horizontal lines inside the large rectangle. In this instance, I have determined where 93% of the data is, and thereby exposed the extremes or third standard deviations in the total sample. They are above or below the range of 1343-1384 enclosed by the hori­ zontal lines. The profiles of the 25th through the 30th are then defined as possible third standard deviations and are equivalent to a profile extreme, and the same is true on the 3rd . The interior of the compression serves as the container for the lull. Notice minus development at the bottom of this area as compared to the top. Another overlay from the new database is the output of the market's self-organizing system. This is depicted by the smaller horizontal rectangles. These are areas where one can expect ver­ tical movement away from this type of efficiency. Therefore, they usually represent the start of something. One looks to have the market stay above or below these areas. We intentionally used a broader brush in the overlay in depicting the price as a heavy horizontal block, as this brings more focus to what it really is: a fair price area. In deciding what to do, one tries to focus on the activity in and around the block or mark, as well as looking at the background. The point is that since something vertical is going to happen from this area, one is focusing on a potentially good opportunity most of the time. The first mark forms at the price of 1 364 at 9.00 0' clock on the 20th. The market is moving 1 00% horizontally on the bal­ ance of the day and again on the 23rd. You can see this in that every time period (i.e. every letter) is used at the price of 1 363 on the 20th and at 1 367 on the 23rd. At the same time, the market was trying to move vertically higher. It's not a very strong situ­ ation. One could sell it and look for the market to stay under it, and if you did you would find the same condition in the horizon­ tal occurring at the lower level on the 24th , again at the 1 363 level.

UPDATING OUR UNDERSTANDING OF MARKET PROFILE

101

This shows that it is very hard to move vertically when the market is experiencing 100% horizontalness. This is why one needs a two-dimensional data base. If we were looking for price movement, it would have been better to have experienced less horizontal; a dynamic data base would have been more vertical. If we had had 90% horizontal instead of 100%, the difference would have translated into more vertical. Looking at the number of time slots used versus the potential is an objective way of measuring dominance. If you did sell on the 23rd under the out­ put mark, you were not getting what you wanted, as the market was staying efficient. In other words, our mark was at the begin­ ning of efficiency, and efficiency just extended itself. The mar­ ket is still going to move from this to a vertical. It started late on the 24th and continued on the 25th. The other mark on the chart, at 1375, occurred on the market's open on the 1s1. The market was already beginning to move vertically down, so the zone of market efficiency was not ex­ tended as it was in the first case, but cut off. The consensus or fair value area (efficiency price level) then was the reference point that the market used as a base from which to further develop the vertical to the downside. Although I am giving a subjective interpretation to you to help explain this situation , all of this can be read by the computer, as you will see in the next chapter. Note that the market output overlay does not indicate anything on the 3rd, which subjectively was a good opportunity. Notice that the compression does. This is why one uses different types of studies all looking for the same thing-market-created opportunities in the dynamic setting of an objective data base. The examples in this chapter show what can be done subjec­ tively, as well as indicating the increase in understanding pos­ sible by using an objective data base. I've continued to move in the direction of increasing automation and objectivity, which gives a real boost to my productivity.

102

CHAPTER TEN

CHAPTER ELEVEN

Looking to the Future--Data Arrangement

From a historical viewpoint, any achievement of mine has been entirely due to having the correct base from which to begin. The market only spits out transactions; it is up to us to record them correctly if in fact there is informational value in doing so. I have never found any reference to the author of the current bar-chart method of data recording, nor have I found any logical explana­ tion for it. It just sort of arrived, and has been just sort of ac­ cepted. Most people's focus to date has been more towards get­ ting good trading results, with market prices fed into programs that are thought capable of producing them. It is the program results that are in control. But data arrangement is the real basis of control; it is the first link to the market, and it requires active direction in terms of organization. I've always arranged my own data, rather than accepting the default. The real key in objectifying the market is to find its purpose, which is single. The benefit of such a discovery is less subjectiv­ ity and more productivity. The data base plays a critical role in this process of objectification. It is the basis of measurement, so it needs to be able to represent market activity faithfully, without distortion. It is the framework from which to ask questions about data; it makes the data available as a fundamental resource.

103

104

CHAPTER ELEVEN

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The ideal data base would be one where each data element, or unit, would be one-dimensional and would be a measurement of either verticalness or horizontalness. The units themselves would start out with a neutral two-dimensional base, and, as soon as there was any indication of being one-dimensional, they would be completed. The units of the database would then be the small­ est possible increments of change. The algorithm for unit forma­ tion could not force completion, but must allow each unit com­ plete freedom in its expression. Each unit then must be devel­ oped in natural market time. All units would be dissimilar, as they would define themselves. Some data units would have more data than others. They would all have a dynamic nature which is potentially of either dimension that would be formed from the neutral setup. The definition of each unit would change in a com­ parative way as successive units were added. This would allow for relativity in terms of the background, which is very important when collecting data sequences for trader viewing and analysis. In essence, the algorithm would be identifying the basic elements,

LOOKING TO THE FUTURE--DATA ARRANGEMENT 105

the phonemes, that make up the language of the market. Any and all studies in the data base would then be giving a different view of the same underlying process. Any further data arrangement would have a sound basis on which to build. The practical side of this list of requirements as it relates to our software is that we have had the data base in place for several years, but we did not have the market figured out as to its pur­ pose. (Figure XI-1 shows a typical set of basic units, using the Dec. Ten-Year Notes contract for 1996.) I made a lot of progress through doing different data arrangements and efficiency scans that started producing indications at exactly the points where we were making subjective trading decisions, as in the earlier cocoa example. I would be talking to some friend who was a good trader, and he would say that he really liked bonds, and had bought some. So I'd bring up bonds on the screen, and more often than not there would be a scan or data arrangement output on the screen at the same level. I was experiencing the same thing myself; wher­ ever I wanted to make a subjective trade, it would also be indi­ cated on the screen objectively. I started looking at a screen with just the data base and no studies on it, going through and determining in hindsight what was the best trade. I would then run my programs, and the indi­ cations would be very close to the artificial level on the hindsight trades. But I was more interested in finding the market's purpose than in finding things that worked as far as trading was con­ cerned- thus the chapter title. All this went on for about three years before the insights I related in the first chapter dawned on me. In essence, market discipline is really efficiency in action, and finding efficiency is indeed the market's purpose. It is very difficult to make money when the market is efficient, so the less efficiency there is, the more the opportunity. With my computer studies, dynamic efficiency was being captured and measured. This was the critical information our data base was producing, and we only needed to understand it in this light. We had some­ how managed to put the system together as an outgrowth of a

106

CHAPTER ELEVEN

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solid base of practical experience. The whole development pro­ cess was completely opposite to the current back-testing mania. We were trying to find something, not just anything. Having the answer emerge from the data itself is a basic or­ ganic way to approach analysis with any program where there is no theoretical basis to work from. By having the right data orga­ nization, working with it, and making it the central focus, one would logically be in step with the market. It is what the market itself is referencing. The market has never ordained a data base or arrangement other than successive quotations. It is not pro­ ducing a one dimensional representation, nor is it producing trend lines, moving averages etc., or referencing them. These are out­ side the market, at least once removed, and are subjective. They do not provide a control that comes from within the market, and therefore have to be supplemented with further financial con­ trols. What the market is producing is some degree of efficiency, and it is this information that needs to be found.

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The last step in getting control over the market is to under­ stand its condition. We talked about dimensionality in an earlier chapter, and said that the way to measure the market was through its dimensions. Based on the argument of this book, its dimen­ sions thus have to be measuring efficiency. Dimensional mea­ surements reveal the present state of the market with regard to efficiency, and therefore a change in dimensionality is in fact a change in the state of this primitive, basic process. We can mea­ sure dimensionality by monitoring the vertical/horizontal rela­ tionship in an appropriate data base. The trades that seem to work best always come from the best background situations. The back­ ground is composed of the degree of efficiency in the data mass that is under consideration. Testing the market for efficiency characteristics could eliminate a lot of wasted time and money. Let's make these ideas more concrete by looking at some ac­ tual examples using the modern Market Profile database. Our examples involve the December British Pound, Canadian Dollar, and Silver contracts for 1996; the relevant charts are given in

108

CHAPTER ELEVEN

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cessor identifies a significant control price for each bar; it's shown as a small dark rectangle on the bar.) In all three examples, the data representation in the foreground is practically identical. Each chart shows two data outputs from the market's self-organizing system (shown as approximately square-shaped open rectangles) at roughly equal prices, which is indicative of extended efficiency, followed by a scan indicator (large black rectangle) marking a short-term inefficiency to the up side. If only the foreground is considered, all three look like potential rally situations, and trades in all three commodities would be made and managed in the same manner going forward. If you had the ability to analyze the background condition of the market, you would see that while silver was a foreground opportunity, it was different from the other two. Running a back­ ground efficiency scan on all three charts (shown by narrow open

LOOKING TO THE FUTURE--DATA ARRANGEMENT 109

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rectangles), we see a lot more hits on silver, which indicates a more efficient condition, presenting more of a trading rather than a trending atmosphere. The Canadian dollar and British pound had a more inefficient background, and this, coupled with the inefficient foreground, made the opportunities more of a go-with and stay-with trading opportunity. In the silver trade, the near­ term inefficiency would soon be absorbed by the background; in the others, it would tend to make the background more ineffi­ cient. If we look back just a little farther in the data on the Canadian dollar contract (Figure XI-5), we can again see the same set-up, but one that has more hits of the efficiency scan in the back­ ground. As the market trades forward in this instance, the effi­ ciency scans did not materialize, indicating that the background was not absorbing the foreground inefficiency. The market was in fact separating itself from the prior condition. In the earlier Canadian dollar and British Pound trades, and in this chart, the life of the inefficiencies was sustained - a favorable condition

110

CHAPTER ELEVEN

for the trader to capitalize on from an objective point of view. In the silver trade, the objective near term condition would have had to prove itself by not producing scan hits; since scan hits continued to occur, the trader would know to exit the trade be­ fore a loss was incurred. With all this information available in the data base, it is only necessary to develop varied formats that will present it to us in a readable way. They do not have to be the optimal solution, but the process needs to get started. With any new format, one first has to explore the outer limits of possibility. What are the ways the market can change? Fortunately, the conditions that are pos­ sible in the dimensionality of the market are limited. It can have vertical growth without any horizontal, which would be charac­ teristic of an inefficient situation; vertical and horizontal growth taking place together, which would be characteristic of an ac­ tively efficient background where the market would have a ten­ dency to rally off lows and break off highs, while keeping to a traditional trading range, and where the inefficiencies are absorbed into this active background; horizontal growth without any verti­ cal, which would be characteristic of a developing efficiency that is closer to completion, where one would eventually find that the first bit of change occurring in it triggers the efficiency output itself; and lastly no growth in either dimension, which represents a very dead situation in which efficiency would be present, and a condition that could not absorb any near-term inefficiency but rather would be influenced by it. One can see that there is scope within these four categories for a spectrum of relativity between horizontal and vertical. For instance, we might have a numerical vertical reading in succes­ sion of 21 , 22, 23, 24 ticks in a range, and a horizontal numerical reading of 10, which is unchanging. In another instance, the ver­ tical sequence could be the same while the horizontal might be 26. In the first example the vertical is leading, and in the second it's about on par with the horizontal, even with the horizontal being locked. This measurement is taking place within the mar-

LOOKING TO THE FUTURE--DATA ARRANGEMENT 111

ket and is measuring efficiency objectively in natural market ex­ pressiveness. The comparison then is going to be quite relative even though both are non-efficient, being engaged in one-dimen­ sional vertical movement. We've talked about how the background of the market has changed since the early days of Market Profile. The change in the markets has also shown up in other related areas, as we have seen in earlier chapters. Liquidity is now quite weak, and also quite variable. Because of weak liquidity, and because domi­ nance is less concentrated and has a more diversified meaning today, dominance has become more or less destandardized. The lack of liquidity and change in dominance create a need for rede­ fining trading information compared to what was done in the past. Now that we understand markets better, reading the degree of efficiency and the change therefrom is the new and future way to go. Efficiency can now be used the way liquidity and dominance once were, and liquidity and dominance can be removed from their prior role of being a superimposed structure within the mar­ ket. At one time they mirrored the efficiency concept, much as my trade facilitation idea did, but, because they were derivative rather than fundamental, they ceased to reflect the situation ac­ curately when the underlying conditions changed. The background is no longer a given, but is quite variable, and measuring dimen­ sionality is a means of understanding it. Dimensionality would now express efficiency, and provide a contrast between foreground and background, making market analysis more direct; it should therefore be the new market measurement. It is important to note that the background and foreground are now being defined objectively in the same terms, using different studies, those terms being the degree of efficiency. To gain con­ trol, a trader can express a trade opportunity in these terms, and change can then be directly related to the opportunity. An ex­ ample of the use of background in trading could be a situation where the market had been moving vertically lower without any horizontal increase, changing to one where both vertical and hori-

112 CHAPTER ELEVEN

zontal were actively involved. Seeing the change, you decided to buy, and were fortunate enough to have the market move ver­ tically up. The overall condition is that the market is moving down in a controlled way, with both dimensions active. The foreground is doing the opposite: moving up with both dimensions active. Now you face a lull where the market has begun to move only horizontally in the foreground. There has been a slight change in the background sample; it is still moving down, with both di­ mensions active. In this case one could not face very much dete­ rioration in the new dominance-otherwise, the dominance would be absorbed by the background. Focus, then, would be on the near term activity being dominant enough to gain and keep con­ trol. Another example could have the market's background as effi­ cient, with no dimensional movement. The market moves verti­ cally up in the foreground, with both vertical and horizontal di­ mensions active, the same as in the first example. It then shifts into a lull and begins to move just horizontally in the near term. The background now shows a changed condition, in that having been neutral or efficient, the more recent activity has changed it to where it is now moving both vertically and horizontally higher. This would be a positive change in the direction of the trade, so the near term situation is not as demanding as in the first ex­ ample. Therefore the strategy would be different; you would al­ most have a free peek at the market, which will be either continu­ ing the dominance or moving sideways, since a faltering in the short-term dominance would at worst throw the market back into efficiency at the higher price level. At the end of Chapter V I we said, "When we combine the free expression of dimensionality with the consensus output on an objective data screen, it's only then that the market defines it­ self." In our software we have created a spreadsheet that does just that. We call it our data base controller. Its function, among other things, is to give an objective reading on the market's di­ mensions and other objective conditions related to market disci-

LOOKING TO THE FUTURE--DATA ARRANGEMENT 113

plines. Using the controller is similar to being in the pit, where one can see a change in conditions taking place over and above just a series of price changes. It is not price change, but market change, that is being recorded. The data base controller also de­ picts the near-term inefficiencies as they relate to the background, either being absorbed into it or in effect influencing or changing the background. More importantly, it objectively defines the lull, which is an activity that is usually counter to the direction of dominance. The data base controller is similar in principle to the old long-term market activity chart, and, as we add more func­ tionality to it, it will eventually fulfill the goal of making the market's inner workings clear. To best get a handle on dimensionality, we have tracked infor­ mation for two time frames: a slowed-average type program for increased stability in reading the background, and an actual ver­ tical/horizontal development from the last market overlay of out­ put (the "Page 2" mark) for foreground information. Change in dimensionality defines the dominance in the near term. The back­ ground condition is defined with a broader reading of the same kind. The key here is the word "define." We have not placed faith in a power big enough to overpower something else, as we did in the past with liquidity or market structure. W hatever is there is there, whether large or small; it's there to be measured in the whole of the market. The first two data base controller examples illustrate the more common horizontal efficiencies found in the market. We have found it extremely exiting to work with uncommon efficiencies, which are fragments in the vertical, as well, but the software to deal with these is still under development. Our third example gives a look at this kind of market situation. Table XI-1 shows a typical section of data base controller output.Let's consider the overall format first. As the time column suggests, the data is sampled every hour and a half. The columns labeled "Bands" and "B-Horz" characterize the background in terms of numerical studies run by the software. Bold numbers

114 CHAPTER ELEVEN

Contract: FVZ6 Samples: 249 %Chg: 1.95% Bands B-Horz Holds Page2 Vert-2 Horz-2 Time Price Date 10/23/96 15:00

106130

10/23/96 19:30

106130

10/24/96

3:00

106130

10/24/96

5:00

106130

10/24/96

7:30

106110

10/24/96

1 Dn 2 Dn 2 Dn 2 Dn 3 Dn

10/25/96

4:30

106130

4 Dn 4 Dn 5 Dn 5 Dn 6 Dn 6 Dn

10/25/96

7:00

106110

7

10/25/96

8:30

106120

7

10/25/96 10:00

106170

10/25/96 11:30

106160

10/25/96 13:00

106160

10/27/96 20:00

106170

8 8 8 8

10/28/96

8:00

106170

10/28/96 9:30

106160

10/28/96 11:00

106150

10/28/96 12:30

106140

10/28/96 14:00

106140

10/28/96 16:30

106140

10/29/96 8:30 10/29/96 10:00

9:00

106100

10/24/96 10:30

106090

10/24/96 12:00

106110

10/24/96 13:30

106130

10/24/96 16:00

106120

8 8 8 8 8

Dn Do Dn Dn Dn Dn Dn Dn Dn Dn Dn

4

70

4 5

70

13

70

13

13

7

70

13

9 10 10 10 13 13 14 14 17

70

14

70

15

18 18 18 18 18 18 18 18 18

106150

70

18

70

19

10

2

12 18

4 4

18 52

8

68

9

5

68

9

68

9

68

10

68

12

68

15

68

16

68

16

68

16

Up

2

68

16

106240

Up

3

94

17

107000

2 Up

3

128

17

10/29/96 11:30

107010

3 Up

6

128

17

10/29/96 13:00

107030

4 Up

7

138

17

10/29/96 14:30

107050

4 Up

7

142

17

10/29/96 16:00

107050

6 Up

7

148

17

10/29/96 18:00

107050

7 Up

7

148

17

10/30/96

1:30

107050

9 Up

7

148

17

10/30/96 3:30

107060

10Up

8

148

17

10/30/96

5:30

107080

12Up

8

158

17

10/30/96

8:20

107070

13Up

8

178

17

10/30/96

9:30

107030

14Up

10

178

17

10/30/96 11:00

107040

15Up

11

178

17

10/30/96 12:30

107020

17Up

11

178

17

Table XI-I. Database Controller Output, Dec. Five-Year Note, 1996

LOOKING TO THE FUTURE--DATA ARRANGEMENT 115

indicate a downward orientation of the background. The columns at the far right, "Vert-2" and "Horz-2", describe the foreground in terms of the relationship between vertical and horizontal devel­ opment. Bold numbers in these columns indicate a downward orientation of the foreground in relationship to the "Page 2" con­ sensus price area,the output of the self-organizing system, shown in its own column near the middle of the page, W hen a number appears in the Page 2 column (as 1 061 50 did at 1 3:30 on 1 0/24), it causes the two right side foreground columns to begin their calculations anew, thereby giving us quicker and more current information. It does not affect the calculations of the left-most columns. In looking for general change in conditions, it is best to group the lines of change into loosely defined units of group activity for purposes of analysis, rather than using each individual line. For more specific reading, one does focus on an individual line in relation to this general reading. Market change is much smoother and less erratic when read in this manner. For our pur­ pose we will look at both columns in loosely defined groups of four or more in relation to the specific change line. Our first specific example is that of the five year note which is traded at the CBOT. We'll start by reviewing how the data changes in a more general sense. In looking at the whole page, notice that the right-most set of vertical columns first change direction on the 25th just shortly after the Page 2 mark. Going to the top of this column, notice that the numerical value of the vertical, 70, is not changing in front of the Page 2 mark, while the horizontal is at first locked at 1 3 but then begins to grow. We get a new start, which shows some continuation to the downside on the first five units after the Page 2 mark. Now let's look at the slower-developing column on the left. Looking from the top down to the same point on the 25th, we can see that both columns are growing, which is an indication of an active two-dimensional market to the downside. Comparing the numerical values in the two background columns, the horizontal

116 CHAPTER ELEVEN

is more than twice the size of the vertical, so on a relative basis the market is not that weak. The conclusion is that one can usu­ ally buy breaks or sell rallies in this type of environment. If we now look to the 10:00 line on the 25th, and look at the Page 2 column, we can see that a sudden, quick, and dramatic change has taken place that causes a directional shift from down to up. You can tell this by the amount of numerical change. The number in the last down line was 52, and the number in the up line has changed to 68. This represents a non-efficient event that may be dominant enough to change the current situation. The following ten listings show no more vertical change, but increasing growth of the horizontal, as the market adjusts to the change. Notice how the activity in the slower background col­ umn decreases until there is no vertical or horizontal movement­ a dead state of efficiency. Both of its dimensions stay locked at 8-1 8 for nine successive units, which represent the effect that the faster Page 2 column changing has had upon it. Notice further that the prices in the price update column stayed relatively calm for the period within in this same zone. Clearly there is not a background condition that has to be overcome. (Background does have a tendency to absorb the foreground in­ efficiencies.) The issue is whether the upside inefficiency is go­ ing have a life. We can see that it does, as in the foreground vertical column it begins to increase vertically, and the horizon­ tal locks at 1 7 while the vertical continues to grow. Activity of this nature is one-dimensional vertical, a very strong situation for the trader. It also creates a favorable background as we leave the example-one where it is growing both vertically and hori­ zontally, and where the verticallhorizontal relationship has the vertical leading (being greater than the horizontal), in contrast to the earlier relationship in the background where the market was moving down with the horizontal roughly double the vertical. Our next example is in the D-mark, which is traded at the CME. Notice that the foreground vertical column is up ahead of the Page 2 mark, and that initially the background vertical (the

LOOKING TO THE FUTURE--DATA ARRANGEMENT 117

Contract: DMZ6 Date

Time

Samples 457

%Chg: 0.45% B-Horz Holds Page2

Vert-2 Horz-2

Price

Bands

14 Dn 16 Dn 17 Dn

13 13 13

53

12

53

12

53

12

13 13

94

12

94

12

11/06/96 13:30

6605

11106/96 15:00

6605

11106/96 17:30

6613

11/06/96 19:30

6645

11/06/96 21:00

6646

17 Dn IS Dn

11106/96 22:30

6665

2 Up

3

114

12

11107/96

0:00

6664

2 Up

6

114

12

11107/96

1:30

6648

4 Up

7

114

12

11107/96

3:00

6652

4 Up

7

114

12

114

12

11107/96

4:30

6644

5 Up

8

11/07/96

6:00

6649

6 Up

9

114

13

11/07/96

7:30

6646

6 Up

12

114

15

11/07/96

9:00

6638

7 Up

13

114

17

11/07/96 10:30

6648

8 Up

15

114

19

11107/96 12:00

6650

9 Up

18

114

22

11107/96 13:30

6629

10Up

18

11107/96 15:00

6629

11Up

18

11/07/96 17:30

6628

13 Up

18

11107/96 19:30

6624

13Up

18

11107/96 21:00

6621

13Up

18

6623

14

1 3

11107/96 23:00

6623

15Up

18

11108/96

1:30

6628

16Up

18

16 16 16 16 16 16

11/08/9

3:30

6637

18Up

18

23

10

11108/96

5:00

6638

19Up

18

23

10

11108/96

7:00

6637

21Up

18

23

10

11108/96

8:30

6632

22Up

18

23

12

5 7 7 8 9

11/08/96 10:00

6656

24Up

21

43

12

11108/96 11: 30

6657

25Up

21

50

12

11108/96 13:00

6664

26 Up

21

50

12

11110/96 17:30

6666

28Up

21

50

12

11110/96 19:00

6665

29Up

21

52

12

11110/96 20:30

6670

30Up

21

52

12

11110/96 22:00

6672

31Up

21

55

12

11110/96 23:30

6671

33Up

21

55

12

11111/96

1:00

6666

33Up

21

55

12

11111196

2:30

6666

34Up

21

55

13

11111/96

4:00

6662

34Up

21

55

13

Table XI-2. Database Controller Output, Dec. Deutschmark, 1996

118

CHAPTER ELEVEN

left hand columns) is down for the first five listings before chang­ ing to being up. The down background is relatively strong, show­ ing increases in the vertical while the horizontal is locked for the first five listings. The foreground is extremely strong, and is not being absorbed by the background. You can see the numbers in­ creasing in the vertical foreground from 53 to 1 1 4 without any horizontal movement. It almost doubles its vertical base. It changes the background, which was moving vertically down, to where it is vertically up, with both dimensions now active. No­ tice that the vertical and the horizontal in the background were about equal. Thus, the ability of the sharp foreground move to change the background. The foreground, in contrast, is making a very strong showing to the upside with good vertical change, with the horizontal be­ ing locked from the same sample size. The verticallhorizontal imbalance here increases from four times larger to over six in favor of the vertical. The foreground has been and is clearly in control and dominant. One must remember that dominance has interruptions, and that usually one faces a deterioration or test that serves as a basis for renewed vigor if it proves only to be an interruption. Such a lull usually starts after having a period of strength; the vertical refuses to grow for a period, and then it starts a move to the downside. We can clearly see this in the foreground column, where we had ten successive unchanging vertical updates at 1 1 4 with the horizontal locked at 12, then grow­ ing to 22 just before we got a new Page 2 mark at 6623. The ten successive unchanging vertical updates represent the beginning of the lull. The Page 2 mark indicates the sample's efficiency, and that usually means that a vertical move will follow. Subsequent to this mark, the market changed to down, continuing to expand the lull. The background column opposite this in the same time pe­ riod was moving in a one dimensional manner, in that the verti­ cal was growing upwards with the horizontal locked at 1 8. The

LOOKING TO THE FUTURE--DATA ARRANGEMENT 119

background is in control here, and can absorb some counter ac­ tivity that can take place in the lull. The down period in the foreground includes six listings where the vertical stays locked at 16 and the horizontal grows through­ out. This illustrates that the market again has found efficiency in the foreground (in addition to the Page 2 mark) and the lull is about over. The background has absorbed the counter activity, which was not much more than a stall. The next line shows that the up vertical dominance is return­ ing on the 8th in the foreground, so the inefficiency of the back­ ground will be enhanced, thus giving it more life and the trader more opportunity. The price at this change is 6637, which is above the Page 2 output mark; it will serve as the vertical base for further development. The focus for the trader will now shift to the foreground, as it is its continued progression that is important for the trade. The vertical is actively growing, with the horizontal giving a mostly locked performance. The background responds to this by con­ tinuing to show good vertical direction, locking at 21 in the hori­ zontal after only one horizontal change, which occurred at 18. Note that after the Page 2 mark at 6623 the vertical/horizontal relationship in the foreground moves to four times the horizon­ tal, and that of the background changes from being a little less than half the horizontal to being more than one and one half times greater. As a trader, then, you'd be continuing to watch for the interruption of this new surge of dominance and the onset of the inevitable lull. Our last example deals with finding some of the more uncom­ mon efficiencies in the market. Most of those we have found and worked with to date have been the more common varieties that come in the more horizontal periods of price movement. We have found that efficiencies can be fragmented and found in the more vertical periods, and they are very good at referencing abrupt changes or continuation in the vertical movement. We've come up with two ways to illustrate this, and the software to automate

120 CHAPTER ELEVEN

Contract: TYZ6

Date

Time

Samples 88

Price

%Chg: 1.03%

Bands B-Horz Holds Page2

Vert-2 Horz-2 20

11/05/96 22:00

11009

45Up

34

30

11105196 23:30

11012

45Up

34

32

20

11106/96

1:00

11013

47Up

34

34

20

11/06/96

2:30

1 l 01O

47Up

34

34

20

11106/96

5:00

11009

48Up

34

34

20

11106/96

7:30

11002

48Up

34

34

20

11/06/96

9:00

11000

48Up

34

34

20

11/06/96 10:30

11004

49Up

34

34

20

11106196 12:00

11003

49Up

34

34

20

11/06/96 13:30

10931

49Up

34

34

20

11106/96 15: 30

11000

50Up

34

34

22

11106/96 18:00

10931

50Up

34

34

24

11/06/96 19:30

10925

51Up

34

11106/96 22:30

10923

51Up

35

2 5

11/07/96

0:00

10922

51 Up

35

3 12 12

11/07/96

1:30

10925

51Up

35

12

11/07/96

3:00

10926

52Up

35

12

6

11/07/96

4:30

10923

52Up

35

12

9

10929

1 3

11/07/96

7:30

10922

52Up

35

12

11

11107196

9:00

10924

52Up

35

12

14

11107/96 10:30

10922

52Up

36

12

17

11/07/96 12:30

10931

52Up

38

17

17

11107/96 14:00

11007

52Up

38

25

17

11107/96 15:30

1 l 01O

52Up

38

27

17

11 107/96 18:00

11010

53Up

38

28

17

11107/96 19:30

11010

53Up

38

28

17

Table XI-3. Database Controller Output, Dec. Ten-Year Note, 1996

it is currently under development. We'll analyze one of these manually. There is a little more to it than what we are going to set out here; however, we'll be able to demonstrate what we're after. The procedures within the data base controller allow us to set up a way to isolate fragmented efficiency in the vertical. Looking at the data base controller display in Table XI-3 (the TenYear Notes), consider the foreground columns (the two right-most columns). A change in the horizontal on the 7th by three (from 11 to 14 ) comes just after the low price that occurred at the 7: 30

LOOKING TO THE FUTURE--DATA ARRANGEMENT

121

listing of 1 0922 on the 7th. Another such change occurs in the following sequence at the 1 0:30 listing at the price of 10922. Notice that the vertical foreground then starts increasing, and the horizontal remains locked, giving a one dimensional vertical op­ portunity that is occurring near the low of the previous move. The price low on the display of the data base controller is 1 0922; however, since the change listings are predetermined in the setup, I want to point out that the actual price low for this study zone was 10916. In all of the above examples, we have shown you a more tra­ ditional exercise, in that knowledge, skill, and work were all ap­ plied in a very laborious, time-consuming way. Applying this methodology to the markets would limit one's productivity in a physical way. It is important to note that it is not at all necessary to go through this type of exercise with each trade you make in the future. It is only necessary to provide the computer with the knowledge-based requirements of trade opportunities, and it will deliver the set-up and monitor the conditions for you. An ex­ ample of this sort of screening in a business context could be that an ore producer would like to open a new mine, one that had a certain ore content per ton that could be profitably developed. Mine properties then would be screened until the requirements were met, and those selected would begin operations. The varied components in the markets today give us a collec­ tive dominance, where a great many traders are not really desir­ ous of directional movement; for example, in structured trades that are looking elsewhere for the payoff. In this environment, it's important to be able to find directional movement as well as measure it against a background, rather than just considering it in and of itself. Early on in my trading career we could determine who was right or wrong, as the traders who bought or sold were desirous of opposite things. Not so today. To deal with this situation, we can ask our data base for a background of such and such with a foreground of some particu­ lar nature; for example, all the commodities that are at least 75%

122 CHAPTER ELEVEN

efficient on the background and 60% efficient in the near term, and that have just traversed a market output (Page 2 mark). To give another example from business, we can be like a corpora­ tion that wants to buy smaller companies. The CEO tells the staff that the corporation's interest will be limited to companies with a certain amount of gross in industries that have exhibited x amount of growth during the past three years . Once they buy any com­ pany, it has to move up to at least being number two within a certain amount of time, or they dump it. Now traders can specify their trade parameters and justify their activity the same way. Using an objective data base in today's computer world al­ lows traders to expand far beyond their subjective self. The ad­ vantage goes to a machine-readable data base versus one that requires a visual or physical presence. There are lots of for-in­ stances, and I don't want to overdo it, but one example would be where you sense that there is an opportunity in cocoa and the move materializes over a period of six to nine months, producing a ten thousand dollar move per contract. The market moved as you expected and you made about 60% of that as per your con­ tract size. The results are very good; however, having identified the opportunity, instead of just one entity (you) handling a trade, it is entirely possible to have several trading programs of differ­ ent natures trading into the same opportunity. Let's just assume you had five programs and they each made three thousand dol­ lars per contract. You have made fifteen thousand dollars out of a ten thousand dollar opportunity - a great improvement over a very excellent one-entity program. Or say you are interested in stocks, and you have several thou­ sand in your data base that you have been following. You can ask for all those satisfying certain background/foreground conditions, route them to various computers according to their characteris­ tics, each of which has a trading program that fits its chosen sce­ nario, and make them meet certain conditions in order to stay with the trade. All the programs of one type would then be com­ peting versus the same standard, and those with inferior develop-

LOOKING TO THE FUTURE--DATA ARRANGEMENT

123

mental qualities could be watched more intently or just elimi­ nated. In closing this chapter I'd like to relate another one of my ranching experiences. The horse stock we had at the ranch al­ ways came from a person or family that had a horse that they boarded with us. As their interest waned and the feed bill rose, usually they traded the horse for the bill. I have spent many a hot, dusty summer day on horses that just were not suited for the pur­ pose, and I know what it feels like. Using an outdated or inferior trading approach is as bad as using a family pet when a work horse is required. Since that time, I've always made the invest­ ment in productivity whenever it's reasonable, and I still recom­ mend the same.

124 CHAPTER ELEVEN

CHAPTER TWELVE

Price...The Market Messenger

Up to this point, throughout most of the discussion, there have been very few references to price. The reference instead was to market activity, its free expression, its output, its dimensions, and its disciplines. Price is the medium chosen to illustrate change, and by its very nature is one-dimensional vertical, which tends to create a reactive atmosphere. Long thought of as a controlling element, price has been treated as all encompassing, without be­ ing defined. Price offers only a limited view, as it changes only in relationship to itself, and the depth of information it conveys is highly varied. It intensifies the one-dimensional approach that all involved in markets seem to take. To most, it's the only choice, and it has never been questioned as the matrix of activity. For people with this view, price has evolved into being the market data base. It organizes background and illustrates change in what appears to be an objective setting. In this way, it seem­ ingly provides a medium through which introduced trading dis­ ciplines indicate opportunity, and these, coupled with financial discipline, offer a major means of control. Price change is equated to market conditions, to being right or wrong financially, and a host of other things. The fact that it is always changing makes it a hard message to read or interpret.

125

126 CHAPTER TWELVE

As a message, it is ill-suited for the roles it has been used in. Its value in this total background is highly subjective, due to the amount of interpretation called for. A price change related to itself has a very limited objective information content, especially when we're interested in market expression and condition. Used as it has been, it substitutes for market objectivity by defining the related but external trader and financial disciplines to augment each other, creating two dimensions. It has aspired to objectivity as a goal, when in fact the whole process is substantially subjec­ tive. In reality, market conditions and change are defined by the market's dimensional makeup. Price data needs to be directly related to this to be in step with the proper representation. As the medium of expression, price will always change, but it is not the expression itself; that is the misinterpretation here. W hen price is used as a message, rather than being regarded as a messenger, it creates the need for strong subjective skills in interpreting what most consider to be objective output.

CHAPTER 13

Where Do We Go From Here?

There are going to be two conclusions reached as a result of this book - yours and mine. I hope that I've presented a back­ ground that has been beneficial in helping you come to your own conclusions as a trader. I firmly believe that a trader's develop­ ment does not come from theory, but from practice and observa­ tion. As knowledge and experience grow, one moves toward sim­ plicity. If one is fortunate enough to have started on the right path, coming to a final focus opens up opportunity as never be­ fore. The bottom line is that Market Profile best serves as a data base. As such, it fills a basic need that is not currently being met. It provides a dynamic two-dimensional method of data entry and collection that gives the market freedom to objectively display itself. It gives one the ability to learn from observation, and thus provides the necessary foundation for a trader's development. The path to the future has been laid out. With the cost of infor­ mation and computing equipment within reach of the average person, and with the availability of computerized market analy­ sis algorithms, the burden of following the market falls on the machine rather than the individual, making trading practical for a vastly increased population, in a way that would have been impossible ten years ago. 127

128 CHAPTER THIRTEEN

I also think there's a path to the future for our industry. I feel that at this juncture, drawing on the experience I've gained over 35 years, I can see areas of change in the industry that are as important to it as the changes I have been through were to me as an individual. With all the money and talent that has been put into this in­ dustry, plus the growth in the power of the computer over the past few years, it would seem to be a small accomplishment rather than a large one only to have distilled the trading process down essentially to arbitrage, i.e. relationships between various prod­ ucts, rather than the contrast of things within themselves. A great deal more has been done by some individuals and companies in a subjective way, which I think supports the idea that more can be done objectively. The shortfall is due to the unfortunate representations of mar­ ket data being used, to the representation of opportunity as one dimensional, and to lots of faulty ideas and concepts about mar­ kets in general; to the "it's not possible," "one can't do it," and, even more importantly, to the lack of openness to new ways of doing things. This even extends to trying to find ideas or new directions. In recent times there have been no indirect benefits to the industry like those that formerly came from the large compa­ nies or exchanges doing new things. Sort of reminds me of an old feeling: it's quiet out there. That is the condition in which one does not know what type of problem one faces. I feel that as an industry we have become a great deal more cynical internally, and it is very hard to shake this overall effect. It's rather ironic that we are doing this to our own future-what some might call imploding. Anything new or different has been viewed totally in dollar terms, with a short time span in which to produce results. The attitude is, "I tried it, but did not make any money, so it's no good," or "It used to work, but not any more," or, if it's a new product, "Who's going to use it?" Or the biggest cynicism of all, "Once everyone has it, it will soon be self defeat-

WHERE Do WE Go FROM HERE?

129

ing." This mind-set is a major barrier to effort and a self-confi­ dent spirit. All this is taking place at this very moment against a backdrop of utter failure in a true business sense - customer failure. I think it's pretty clear that what we have today is inadequate for our growth and role in the future. Given the mere assumption, if one is not willing to concede the fact, that the market's database is being misrepresented in important ways, it is logical to expect some type of exploration of new ideas. Has education or under­ standing ever produced an attitude of self-destruction in other industries? If people use basic business principles and under­ standing, does it become self-defeating, or does it grow the in­ dustry? Is it a very big step to apply logic to a dynamic data base, instead of one that is one-dimensional? Being proactive means that we can learn from our experiences, and use them as a base to go forward. It also will attract new people to the industry, and the industry will therefore grow. As a long-time member of the CBOT, I have always viewed our suc­ cess to be, not the number of contracts traded, but the number of new faces that showed up to compete. During my active floor years, there was almost always a new star or stars who showed us new and better ways to go. The older stars did not necessarily fade, but adjusted to the new situation, as it was the new situation that let the new succeed. Is there a lesson here? I would like to point out that while we are all strong support­ ers of our industry, and we are on the same ideological path, there are two sides of that road. The left-hand side represents doing things the same old way. At present, I see our industry growing just because we have a presence in the marketplace; if that is the case, it could ideally be growing at a far greater rate. If the rate is low, we have to ask what are we offering. If it's not much, the business that was automatically ours will soon be done in a dif­ ferent way somewhere else. Is our infrastructure functional for the times and opportunities? Are we presenting real opportuni­ ties? I am not of the opinion that our industry is meeting these

130 CHAPTER THIRTEEN

needs, or that it cares to. It all starts with direct communication from us to our customers. Is what we are doing being correctly presented? If not, then this would be the left-hand side of the road. In this light, let's look at our most prominent industry descrip­ tion, that the market is a zero sum game. Do we deserve it? W hy does it seem to persist? As an industry, do we really care? Per­ sonally, I hate it. I never equate the market to a game, because I don't know its rules or its time frame. Everybody who uses the market has a different time frame and different objectives. I have always thought and experienced the market to be dynamic. The role efficiency plays never allows the market to revert to zero, but only to shift between conditions of itself. Growth is non-static, and I feel that anything growing is never zero, that the market serves and that it's a growing type of ser­ vice. Any business that doesn't grow isn't going to make it any­ where. To say that there's a loser for every winner does not make sense in a growing environment. It's like musical chairs - as long as the music is playing, there is no loser. Music is growth, and we should not let it stop playing. When the music stops playing, someone always drops out, but that person does not necessarily lose. For instance, in some of their studies the Federal Reserve have come to the conclusion that there are too many banks. This means that some banks will be gone in the future. They can be merged, bought out, etc., and the banking industry can effectively grow to serve our needs. The right-hand side of the road would be a path that would lead people toward their goals. It need not detail every step, but must allow for discovery and growth. In simpler terms, it means pointing out what we are, what we are doing, and what we offer, and making certain it's the best we can do. These simple steps have not really been understood by our industry. There is an un­ der-utilization of the asset base we now have. Putting all the various talents in the industry in a closer working relationship to the market would unleash a much greater level of growth.

WHERE Do WE Go FROM HERE?

131

We need to get beyond our current stalemated position, and, in doing so, explain the advantage to being associated with the opportunities we offer. It would be fair to say that in the past the professional trader had a distinct advantage. Access to informa­ tion, time devoted, experience, location, all allowed one to over­ come most basic handicaps. Those outside of this framework were at a distinct disadvantage. Today, advanced forms of communi­ cations are delivering information in a cost-effective manner and without geographical bias. Computer processing power has ar­ rived and can be effectively used by all types of participants. No market is isolated from world events. With markets moving glo­ bally to an around-the-clock environment, we will soon have a new and level playing field. Computers will be in place to com­ pensate for the missing time factor, as all traders will have some type of time gap to handle. Computers will begin to do some processing even for the floor local. They will eventually do more and more of this, and do it better than the floor local used to do it. Everyone will have to be better prepared for whatever role they intend to play. All this means that the industry is poised for change, and we need to be ready for it. As the "zero sum game" idea implies, it is those who use the markets who are thought to be the losers today, but it will be those who do not use them who will be the losers of tomorrow. In a recent article, R.C. Longworth, a senior writer for the Chicago Tribune, cites a study by the Institute for Policy Stud­ ies in Washington, DC. The study states, among other things, that 51 out of the 100 largest economies in the world are not governments, but corporations. Longworth asks a very good ques­ tion: W here will control lie now, as this trend accelerates in the global atmosphere? If I were to give my answer, it would be in the markets, and not with government. Even now, it has been the markets that have really transformed the landscape, not the Fed­ eral Reserve and their counterparts around the world. The oppor­ tunity for our industry today is unparalleled versus any time in our past. We need to center our efforts on knowledge, education,

132 CHAPTER THIRTEEN

and openness to new approaches. We can do a lot better, and must discover the fact that we have to. Consumption is the main driving force in all societies, whether it is due to the wealthy wasting resources, or to the poor overpopulating, or just to natural/abnormal growth disparities. Market opportunities have been and are being created. We can and must do a better job than we have been doing to service this basic need. If we avoid the risk of having our industry implode as a result of our inability to innovate, we face the complementary risk that the opportunity could engulf our inadequate infrastruc­ ture, and we would stand a good chance of getting lost in the process. It's hard to justify how you missed out on success when it's past you. That is a position that we do not want to be in. The future is in our hands, and we collectively need to be a concerned leadership.

Index

Symbols 3-1-3 89, 90 3-2-1 89, 90

B background 1, 6, 10, 21,25, 2628, 36, 47,48, 73, 88,91, 97, 108, 111, 125 background efficiency scan 108 beginning traders 10 bell curve 4, 6, 7, 32, 37, 65, 75, 89 Berkeley 75 big traders 6 blueprint of development 90 Boyle, Mike 65, 89 British Pound, example using software 107-111 business principles 9

c Canadian Dollar, example 107-111 capital flow 33 capturing Market Data 61 CBOT (Chicago Board of Trade) viii, 3, 10, 129 Chicago Tribune 131 chronological time 4, 37, 61, 81, 89 Cocoa, example using software 93, 94, 122 collective dominance 121 Commodity Trader Identification Codes 65 computer processing power 131 computer productivity 18 consensus 77, 44, 59, 112 control 44 cn codes 2,3

133

134 INDEX

D D-mark, example- data base controller 116 Data arrangement 69, 74 data base 1, 74 data base controller 113, 113-121 data entry system 4, 5, 65 data organization and representation 5- 7 day profile 34, 83 development 62 development as a trader 8 dimensional measurement 107 dimensional movement 56 discipline 6 discipline of the bell curve 76, 78 distribution theory 34 dominance 6, 46, 48, 50, 70, 84, 86, 91, 96, 111 dynamic efficiency 36, 78, 105

E early experience 10 efficiency 3, 5, 13-15, 21, 26-28, 33, 35, 38, 39-48, 57, 100, 116 Emory, William Uhlman 58

F fair price area 39, 41, 59 Federal Reserve 130 financial control 1, 6, 10, 23, 47, 106 first standard deviation 32, 36, 65, 76, 86, 89, 92 Five year note, example data base controller 115 foreground 13, 47, 48, 109, 118, 119 four steps of market activity 90-91 fragment 55 fundamental analysis 8

G Graham and Dodd 8 Griffin, Bill, Sr. 51 growth 130

INDEX

H horizontal 36, 39, 43 horizontal and vertical axes 61

I industrial indifference 23 inefficiency 14, 16, 33, 57 Institute for Policy Studies 131 internal controls 22 investing 8

J Jirout, Bob 65

K key to objectivity 37 Kirby iii Kummel, Gordon 71

L large trader 6 LIFFE exchange 88 liquidity 6, 45,46, 49, 56, 83, 111 Liquidity Data Bank 66 Longworth,

R.C. 131

lull 6, 49, 87, 91, 96, 113, 119

M market activity 11 market behavior IO market cycle 40, 43 market data base 125 market development time 77 market discipline 13, 16-17, 21-24, 52, 76, 78, 80, 86, 91 market efficiency 5 market organization 42 market output 41 , 57, 77 Market Profile v, 4, 5, 7, 28-32, 88, 127 Market Profile, dynamics of 93

135

136 INDEX

Market Profile, updating understanding of 79-91 market time 62, 90 market's development 62 market's process 40 market's purpose 5 mean 32, 75 measurement 5 Measuring dimension 56 minus development 87, 91 mode 32, 76, 82 money management 10, 23 mutual funds 1

N neutral day 86 non trend 81 non-efficiency 39 non-trend day 86 normal days 81 normal variation day 81

o objectifying the market 70, 103 objective trading parameters 80 opportunity 8

p Page 2 mark 115 phonemes 104 Pollack, Bill 71 prediction 9, 10 price 125 Price discovery 41 price plus time equals volume 66 profile, formula for 66 purpose of the market 33-38

Q Quaker Oats 87

INDEX 137

R Randomness 45 randomness 6 range extension 82 Rosenthal, Les v

s saying 9 sayings 9 scalper 11 scalper-spreader 11 scan indicator 108 Security Analysis 8 SFE 88 Silver, example 107-111 small trader 6 Snapple 87 software,Page 2 71 software, studies 99-101 speculation 8 standard deviation 76 stops 11

T Ten-Year Notes, example-data base controller 120 The Bell Curve 75 third standard deviation 83 Trade facilitation 86 trade facilitation 33, III trader discipline 11, 22 trader's development 127 trading plan 7 trading programs 72 trading system 38 trapped money 97 Trend 81 trend day 97 two dimensionality 55 two-dimensional data organization 75 two-dimensional display 61 two-dimensionality 61

138 INDEX

two-phased market 34

u u.c. Berkeley 8

v value 5 vertical 5 vertical background 59 vertical dominance 119 vertical extremes 77 vertical market phase 6, 58 vertical reference 41, 58 vertical/horizontal relationship 56, 116, 119 volatility 74 volume data 3

z zero sum game 131