(Chapter 6 and Chapter 7: Intermediate and Short-Term Auctions/Trading)
Part 1.
Rather than keep this to just intermediate term auctions, lets use the extremely important concepts of this chapter and relate it to all timeframes. I cannot overstate how good this stuff is – thanks to Jim Dalton & Co for writing this book.
Let’s review again these statements:
“Recognizing where you are in the auction process determines your risk/reward relationship.”
“The end of an auction offers the moment of greatest opportunity… risk & return are asymmetric at this point.”
“Auctions complete when the laggards from the last auction are met by the innovators from the new auction.”
Ok, this is Market Profile at its core. Through all timeframes (intraday or longer-term) – you need to understand how an auction ends. By understanding the signs of how an auction ENDS, you will know not only whether to enter a new order --- but also whether to stay with the flow of the current auction (either through holding on or re-entering on a pullback). Later we can discuss how a bracket ends and a new trend begins. For now, lets focus on the former --- when one auction ends.
The market is a series of 2-way auctions. The end of one auction leads to a new auction in the other direction. If you can figure this transition out, you are entering an order with big reward as you are in on the ground floor of a new auction. When you get it wrong, you will know quickly because of how you are ‘marking’ the end of the auction. Let’s get to it.
What is it that marks the end of an auction? (perhaps the most important concept in the book, imo).
“‘Excess’ marks the end of one auction and the beginning of another”
‘Excess’ can be seen in 2 primary ways:
1) A key Buying or Selling Tail
2) A key Gap
Excess occurs when a market makes a dramatic price high or low on low/moderate volume and opposing buyers or sellers react quickly and aggressively by auctioning price in the opposite direction. Sometimes this is in the form of a tail (a strong volume-based rejection) and other times in the form of an overnight gap (a gap that catches a market that got too long or short into the previous days close and has now ‘trapped’ those traders).
Be on the lookout for these two key signs of excess: the tail and the gap. This is so important in understanding the entire auction structure, IMO.
If the recent auction is downward and an auction low has been established with a buying tail, the investor who correctly recognizes the low and buys has a low risk/high reward (asymmetric) position. Why? His risk is that the 1-bar tail gives way (or less risk if you can fine-tune entries and re-enter if necessary). The reward for being right is an entire auction in the opposite direction.
In a pure sense, the absolute ideal location for entry is precisely on the price bar where an ‘excess low’ or an ‘excess high’ forms. This is the price bar where laggard meets innovator and this is where you would ideally like to be.
This is not just from Daltons chapter now, this is my own experience inspired from this (excellent) Dalton chapter.
Much of the time, the key ‘innovator-laggard intersection bar’ will be in the first 2 hours of the trading day. The most often will be the opening 30-minutes of the day, especially if the market has reversed down (from up auction to down auction). In general though, be on the lookout for a key buying or selling tail in the opening 2 hours – with particular emphasis on the first 1-2 30-min bars.
Regarding the opening 30-minute bar, I should also point out that any strong movement off the opening price can be considered similar to a ‘tail’ in and of itself. Range Expansion off opening price is an important concept. Though not really a big part of Daltons book, think about this as you study 30-min bar charts of morning reversals.
Another thing is that a tail in the morning session is best if it has also exceeded the previous days high or low. That is, a good buying tail will rinse below the previous days low and create something of a double tail --- a 30-min tail AND a tail on the daily chart. Likewise, a good selling tail should go above the previous day high and get ‘rejected’ by higher timeframe sellers --- and most of the time this will occur early in the session. The previous days high and low are very important ‘reference points’ in market profile.
The second form of ‘excess’ after the violation/tail is that of a gap. : “A gap at the end of an auction that occurs in the direction opposite the most recent trend signals a reorganization of beliefs. Market participants have changed their perception of value so dramatically that they simply begin trading at a completely different price level.”
2 things with gaps.
1) Gaps represent ‘overnight inventory’ --- traders who have entered positions overnight will generally be ‘weak-handed’. If price does not move in their favor quickly, they will panic out. This is part of the reason the first 30-min bar marks the high or low of the day more than any other single price bar.
2) Gaps are a bit tricky to enter on. You will need to understand the bigger auction structure or else a key auction-reversal gap will leave you in the dust. A good deal of the time, the market will gap and auction in the direction opposite the gap. Thus, you cannot just chase gaps and label them all ‘auction reversal’. You should just be aware of the key auction reversal gap if the structure of the recent auction also suggests it is losing momentum or is otherwise long in the tooth.
Remember, you will not be looking for tails or gaps in isolation. You will have a lot of context from your other indicators. Essentially, you will be watching the auction accelerate and then mature and then look for your tail/gap reversal signal. Market profile consists of many things that you have to synthesize into a composite answer. What did the histogram look like over the last ~3-4 days? Has the market been soaked of its buying/selling pressure and now poised to reverse? Or is buying/selling pressure still strong? Was volume getting stronger or is it getting weaker? Is the last auction long in the tooth? How did the market close yesterday relative to what it was ‘trying’ to do? In the context of the overnight move with the other indicators, what is the likely state of inventories across timeframes? When you put together these concepts, you get a good idea of where you are in the auction. When you combine it with the tail/gap indicator --- you are now ready to enter an order as you will have located your asymmetric location (the ‘innovators entry’). Even if you miss your ‘ideal’ entry, you still could get something similar to a ‘early adopter’ entry (1 step removed from innovator but still good location in the context of a bigger auction). So long as you understand the structure of the auction and are making
entries and exits within that framework --- you will be entering orders with the flow of the current auction.
I realize at this point that I am basically writing a rough draft of something that is no longer a pure book review. Oh well, will just wing it for a while. Eventually, this will get back to the original structure.
