[madspeculator]

Having discussed the shortcomings of the existing theory based on supply and demand, we move on to survey and critique the other theory: the theory based on value.

Theory based on value

In the early to mid 1980s, J. Peter Steidlmayer developed a revolutionary technique to visualize price action. He (and CBOT) named it Market Profile. Based on the observation that the profile had a bulge, he postulated a theory based on value (the term “value investing” – in the likes of Ben Graham and David Dodd – was in vogue during that time), and thus the auction market theory was born. The major tenants of this theory are:

1. There are different time-frame traders in the market.
2. Traders seek value; Price is all but an advertising mechanism in search of value.
3. Longer time-frame traders don’t interact directly with each other but through short time-frame traders.
4. Market moves only as a result of convection by a certain group of long time-frame traders.

This theory was born from empirical analysis based on the measuring tool – the profile graphic. This theory has five parameters: value, demand and supply of longer time-frame traders, and demand and supply of short time-frame traders.

Tools of measurement

Since the theory of value was born from the empirical analysis of the results from market profile, market profile became the primary tool of measurement. [Although the validity of construction of market profile might be a point for debate – should all the data points on a timeframe be given equal weight – such discussion is out of the scope of this post.].

As more information started decimating from the exchanges, volume profiles are being used to measure value.

Unfortunately, the market profile and the volume profile measures only one parameter of the theory – value. There exists no publicly available tool, as far as the author is aware of, that measures the other parameters of the theory, namely, demand and supply due to long time-frame and short time-frame traders. However, traders use tools developed to measure Wyckoffian parameters to predict the presence of the type (buyers vs. sellers) of long time-frame traders based on the location of such activity in relation to the value area of the profile and the resulting movement in price (initiating vs. responsive actions).

Side note: Although Steidlmayer advocated that value be measured only in “balanced” distributions, Dalton and others advocated the measurement of value even for skewed distributions. Steidlmayer emphasized that people should “find” the “hidden” value for skewed distributions by assuming that such skewed distributions eventually becomes a balanced distribution (interested readers are referred to his work on minus distribution, and more recent work on supply-based markets, and value-based markets).

Critique of the theory based on value

Of the two theories discussed in this article, the theory based on value rests on a very week footing.

This theory hinges on the concept of value, yet the very definition of value is questionable. Value, according to this theory, is defined as the first standard deviation from the Point of Control (PoC). Why the first standard deviation? No answer is provided.

If the definition of value according to this theory is indeed valid, the question arises as to why prices deviate from value. The answer provided is that perception of value amongst market participants change, thus changing value. This further raises another question: why do perceptions of market participants change so often – sometimes within a day or even when no substantial news comes out? No answer is provided to this question. Nor is there any plausible answer available in the larger financial or economic literature.

Further, an astute observer will observe that the so-called value changes based on the duration in which the profile is constructed. This points to the possibility that value is duration (time) dependent. The consequence of this observation, according to this theory, is that shorter time-frame traders have a different notion of value, compared to larger-time frame traders. Think about the consequence of the above statement for a moment. If an individual participant decides to change from being a short time-frame trader to being a long time-frame trader sometime during the day, her notion of value changes at that moment of decision. In other words, an individual’s perception of value changes because they change their trading time-frame. This definition of value clearly deviates from the standard economic definition of value (or equilibrium price) or individual’s utility value.

The next criticism is on measuring the so-called value using PoC as the starting point. Careful analysis of PoC suggests that PoC in a volume profile is formed around the area where a few large players transact large amount of trades. This would indicate that large players are responsible for defining value. Argument along the lines used above can be used to discount the use of PoC to calculate value. In the case of market profile, time determines PoC. Although Steidlmayer claims to have “removed time from the equation”, it is time that is being show in the horizontal axis of the market profile. Such a dependence of value on time, irrespective of the amount of transactions transacted at value, once again deviates from the standard economic definition of value.

So, is “value” in this theory really value in an economic sense? Or is it a misnomer for some other phenomenon?

Why is this question important? The only way for one to further or fully understand any concept is when words are not overloaded (using a well understood word to mean a different thing). This means that all phenomena should be properly identified and named. For example, if one calls a house a dog (for which a definition already exists), then the listener’s understanding of that conversation will be markedly different than if a house was called a house. If words are indeed overloaded, proper definition for the word should be provided.

Further, an overloaded word prevents us from determining if that word is really a principle component of the system or is a second order component of the system – is value a principle component or a second order component? As indicated earlier, in our field, where accuracy of measurement is a problem, measurement of second order components produces larger errors. The author contends that “value” according to this theory is indeed a misnomer (for a different phenomenon) and is a symptom (second-order component) of the trading operations of market makers (principle components being demand and supply of market makers). The proposed theory of market action identifies this misnamed phenomenon.

The lack of publicly available measuring tools to measure long-term and short-term traders’ demand and supply prevents us from validating tenants one, three, and four. Further, it appears to the author that tenant number three might be more applicable in “pit-trading” markets than in the present day electronic markets.

A theory or hypothesis should not be rejected solely based on the inability to measure all its parameters – in this case, long time-frame and short time-frame demand and supply schedules. People will invent new techniques to measure those variables at some point in time. However, a theory or hypothesis should be rejected if it is incongruent or its predictions contradict other well-established theories. Such is the case for the theory based on value. We will reject it.

It has to be noted that existence of tradable patterns does not support a theory. So, traders should heed caution that such tradable patterns might disappear. However, the local highest volume price (called PoC) has short-term significance as will be discussed in the proposed theory of Markets Action.

As a side note for those interested: Steidlmayer’s new work includes volume analysis. Further, he is now championing a new theory based on price-time measurements. I don’t think he considers PoC to be “value” anymore. In fact, he doesn’t use the words PoC or “value area” anymore, but uses the term “zero-line”. This of course is the mark of a true great trader – to understand one’s system and why it works (theory of markets), and when the theory behind one’s system is faulty, the system doesn’t work as expected (although the system might still provide tradable patterns); move on and search for a more applicable theory of markets to conduct your research, while still, may be, trading those tradable patterns until they fade away!

In the next – last and final – post, we will discuss the proposed theory of Market Action and present examples of new measuring tools.