'Markets In Profile': Detailed Book Review

[Frank]

This book by Jim Dalton is among the very best books ever written on understanding trading concepts, in my opinion. I read this book when it came out and have it all marked-up. As I have re-read it, I realize that I really should do a full outline of the book. This thread is for that purpose.

I will present what I think are the main concepts for each chapter. If you would like to contribute, please do. But one request, which you may or may not choose to comply with, lets try to keep the thread to just this book review and not with lots of posts that aren't related to actually reviewing the concepts directly from this book.

If you would like to contribute along, please re-read the Preface and the First 3 chapters and we will begin shortly.

[Frank]

Top Concepts From The Preface:

1. The objective of investing is to identify asymmetric opportunities.
2. ‘Excess’ occurs at the end of an auction
3. Trade location is the key to controlling risk and taking advantage of asymmetric opportunities
4. Successful investing incorporates both sides of the brain. Pattern-recognition is how you use the right-hemisphere.
5. [The traders] with superior results over the longer-term are those that are flexible and adaptive to changing conditions. Specific trade strategies come and go. But the underlying auction structure is recurring.

Discussion:
Since this is just the preface, it is introducing concepts which will be developed later in the book.

The theme of the entire book, in my view, is that of using the market profile to give you context on determining asymmetric trade location opportunities.

[Frank]

Chapter 1 “The Only Constant”:

Remember the lead-in from the Preface: The objective of investing is to identify asymmetric opportunities

1. Once the majority recognizes that change is occurring, all asymmetric opportunity is lost.
2. An easy way to categorize an ‘auction’ is to classify the participants as either; the leaders (innovators or ‘early adopters’) or the laggards (the ‘late majority’).
3. Auctions complete when the laggards from the last auction are met by the innovators from the new auction.
4. ‘This book challenges you to be an innovator’
5. People change markets, markets change people
6. The fundamentals of market activity are just as they have always been: price and volume move over time to facilitate trade in the pursuit of value. It really is that simple.

Discussion:
Chapter One begins as a general discussion about ‘change’ in the asset management business. The authors challenge the reader to be innovators and not followers. Examples of ‘followers’ (ERISA implementers, relative performance/MPT/Style-focus school to the ‘absolute return’ focus) are reviewed. Dalton is setting the reader up here for why the Market Profile is enduring.

While change is always occurring in and around the investment industry, it is the pure and unbiased information that comes from the order flow of the market itself that is ‘the only constant’ (Chapter Title). “Despite the astonishing rate of change in the investment world, the fundamentals of market activity are just as they have always been: price and volume move over time to facilitate trade in the pursuit of value. It really is that simple.” (pg 13)

The title of the chapter ‘The Only Constant’ --- appears at first to be that of the cliché – ‘the only constant is change itself’. But I believe what he actually means is ~’the order flow of the market itself is the only constant.’

The only way to be sure you are in with the ‘innovator camp’ and not a ‘laggard’ --- is to effectively analyze the order flow of the market itself. Don’t try to out-think the market, just learn to recognize the patterns that accompany whatever ‘change’ is currently occurring.

[Bearbull]

Excellent Effort Frank, keep it coming, as SoulTrader has illustrated the MP concepts can be blended with those of Wyckoff to provide that extra edge in trading
so any further explanation of MP can only lead to clearer understanding.

[Frank]

Chapter 2 ‘Information’

This chapter is mostly an explanation for why the Market Profile is a powerful tool for capturing the structure of the market.

There is a tremendous amount of conflicting information flowing into the marketplace at any given time. Processing this mix of dynamic news-flow in a real-time environment is extremely complex. But what compounds the complexity further is that many different timeframes are digesting the data concurrently. ‘Good news’ might seem bullish to a trader who is not already long the market. But to a big institution with an extensive inventory of long positions, ‘good news’ might lead to aggressive selling. Thus, the nature of the news might very well be inversely-related to the next directional move. Thus, the market is being moved around not so much by the intrinsic nature of the newsflow, its being moved by the NET order-flow of the different time-fames in the marketplace. The patterns in Market Profile reveal which timeframe is currently in control of the market.

The Market Profile histogram shows the structure of order flow for a given time-period and the ‘value’ area. It takes strong ‘bidding activity’ for price to move away from an established value area. Thus, a move away from a value area is monitored for bidding activity (volume) and acceptance/rejection. Market Profile will expose the dominant timeframe during this process to the seasoned eye before it is reflected in significant price movement. Strong downward movement indicates that the dominant timeframe (whichever that is at the time) views price as unfairly high and is seeking a new lower value area.

Bracketing behavior vs Trending behavior is introduced in this chapter. This is seemingly unrelated to the ‘Information’ title of the chapter. But the point is that current price movement needs to be monitored in the context of a higher-timeframe bracket or trend.

A ‘bracket’ implies moves away from value will be retraced. Trend implies new directional movement will prove self-feeding (higher prices attract more buying/lower prices attract more selling).

[Frank]

Chapter 3 ‘Timeframes’

Chapter 3 explores the concept of the distribution of ‘inventory’ among various classes of market participants.

Every market that is financial in nature involves the transfer of inventory from one price-conscious party to another. Each party can be classified with regard to how they think about inventory. A long-term investor is by definition ‘committed’ to their inventory of stocks. A short-term scalper trades in and out of the market while targeting zero inventory over any reasonable measure of time.

The current price of the market reflects the current preferences of inventory among timeframes. Future price movement depends directly on how the various timeframes ADJUST their inventories. Adjustments to inventories are in turn dependent on how long or short each timeframe is relative to their ‘normal’ inventory situation.

Market Profile is intended to structure order-flow to enable the user to ‘read’ the state of inventory and the changes to inventory through pattern-analysis.

Dalton has at this point created a multi-dimensional framework to work with:
On the one hand, you have many different timeframes of investors interacting and co-existing, creating a complex and dynamic puzzle.
On another dimension, Chapter 1 laid out a scale that ranges from ‘early innovator’ to ‘laggard’.

I think one way to think about this framework is structured like this:

‘Order-flow’ depends on your existing inventory as well as how attractive you view current price.

Since the ‘higher timeframe’ (longer-term investors) wield the most buying and selling power in the marketplace, it is their order-flow that is most highly correlated to net incremental inventory changes. Innovators are the ones to figure out when the higher timeframe is actively altering their net inventories and aligning themselves with this order-flow.

~”When the longest timeframe becomes active, it is not uncommon for all other timeframes to eventually join in, which can result in a major trend.”

‘Performance’ depends on how often you are in the ‘innovator/early adopter’ camp vs in the ‘laggard/late majority’ camp.

Note the link between the ‘innovator’ and the ‘higher timeframe’ player here. These concepts exist on different dimensions in that the ‘innovator’ may or may not be a higher timeframe player and a higher timeframe player may not be an innovator. Dalton writes that no matter what your timeframe, it is good trade location that is key – and the innovator is the one that figures out good location by examining the inventory/order-flow puzzle of the various timeframes --- and acts on this analysis in real-time.

[BrandonLG83]

Excellent review for a excellent book!

[Frank]

Chapter 4: Auctions and Indicators

Up to this point, Dalton has discussed the need to focus on order-flow in order to interpret news-flow/information and the interaction of various timeframes. Dalton has effectively said ‘Be an innovator by finding asymmetric trade location.’ Chapter 4 introduces some specific indicators that help point you to figuring out where you are in the acution process. Once you know where you are, you can then begin to recognize reward-risk and asymmetric location. This chapter begins the real meat of the book.

Market Profile is an analysis of the ‘structure’ of the market -- where ‘structure’ is different than price movement. For example, any down day that doesn’t have the proper ‘down-day structure’ is likely to have just weakened the short-side and may have just strengthened the case for the innovator to go long. And vice versa, any up day that doesn’t have the proper ‘up-day structure’ will have weakened the long-side by removing buying power and may have strengthened the case for the innovator to soon look to short.

An up day with the right ‘up-day structure’ means that while timeframes have begin to come into agreement, the ‘late-majority’ (laggards) have not yet climbed on board. Since the market is said to reverse when the laggards of the last auction meet the innovators of the new auction, the innovator should ‘stay-with’ his position a while longer as the structure suggests continuation.

One of the more important aspects to market profile is a careful analysis of what the market did the previous day – and also what the market did in the ‘overnight market’. All of the indicators of market profile relate to one of the following questions:

1. Whatever the market was ‘trying’ to do yesterday – how much conviction did it show in this attempt?
2. Were there signs of ‘higher timeframe’ participation?
3. Given the end-of-day profile structure, is there a recognizable pattern apparent which determines the likely state of inventories across the various timeframes?
4. Did the various timeframes come together and ‘agree’?
5. What was the relationship of time and price for the day?
6. Did yesterdays action ‘weaken’ the market by inefficiently removing buying power (short-squeeze)?
7. Was yesterdays action ‘constructive’ for the market by removing selling power from the market?
8. Should the market trade lower overnight or in the early morning, will encouraged short-sellers be ‘weak-handed’ and subject to a squeeze?
9. Should the market gap-up overnight or in the early morning, will encouraged momentum players be ‘weak-handed’ and subject to a ‘liquidating break’?

Indicators #1 & 2:
Profile Shape (Symmetric or Non-Symmetric) and ‘Range Extension’

Every auction that is financial in nature is a process that is in search of ‘value’. Competitive forces come together and interact until they are satisfied with the position of their inventory and then they slow-down or stop. This is how ‘value’ is determined. The shape of the distribution (profile) summarizes this activity in its histogram form.

There are 4 basic profile structures – with many variations of the primary 4:
1) Elongated Histogram (skinny and long, the histogram looks somewhat like a vertical line ‘|’)
2) Symmetric Histogram (squat or ‘fat and narrow’, the histogram looks like the capital letter ‘D’)
3) The ‘b’-shaped Histogram (the histogram looks like the lower-case letter ‘b’)
4) The ‘P’-shaped Histogram (the histogram looks like the upper-case letter ‘P’)


Let’s take the most extreme example as a starting point. If long-inventories are ‘low’ and short-sellers are weak and price is viewed as low by all timeframes, the market profile histogram will ‘elongate’ to the upside, forming a somewhat vertical line (‘|’). Price and time will have a ‘brief’ relationship where price is moving quickly over time in search of satisfying the markets needs (innovators aggressively increasing long-inventories and squeezing the laggards). The histogram that results at the end of the day will be thin. The high-to-low range of the day will expand, called range-extension.

What does an elongated (non-symmetric) histogram with big range extension tell you:
1. The late-majority is not on board yet --- you are likely still in the early adopter/early-majority zone of the ‘leader-laggard’ framework
2. Inventories are in the process of adjusting to the various new preferences of the respective timeframes and this process is not yet over.
3. This is a ‘new-business’ led auction. That is, new longs are being established – it is not just short-covering (shorts closing out their ‘old’ positions).

The opposite of an elongated histogram is a symmetric distribution. This is when the market is in balance and any attempt away from balance in quickly met with ‘responsive’ buying or selling to push the market price back to value. The time/price relationship will be extended as the market is in agreement on fair value. The histogram will be fat in the middle. Inventories are in-line with how the various timeframes prefer them. Range will not extend far beyond ‘normal’ and may be materially less than normal (narrow range). This is often the case when the market is waiting on forthcoming information such as a fed announcement.

The 3rd and 4th profiles are simple but important distinctions from the extreme cases above: the ‘b’ and the ‘P’… I am not going to go into these in depth yet as they are just introduced in this chapter.

Other indicators are introduced as well including:
Value Area Comparison: Is value being built higher or lower and is value overlapping with previous day or is todays value area noticeably different than the previous day?

Initial Balance: this is the first hour range. What happened during the first few 30-min bars?

Volume: volume drives acceptance of value. Value can assume to be beginning to migrate if bidding activity is strong.

Attempted Direction: Did the market open on one end of the range and make a clear attempt to move directionally?

[mister ed]

This is a great thread Frank - thank-you for your summaries.

[Frank]

Will be continuing shortly...

Reminder of the key 'Innovator-Laggard' Framework from Chapter 1: