Trading for Value, Part One

And now for something completely different.

I’ve posted a lot over the last few months about patterns and contexts where price and volume disagree. Today I am starting a series on what I (and probably others) call value trading. Basically, it’s the flip side of the auction coin. It’s about when price and volume work together – agree – to tell you what might happen next.

This way of looking at price and volume that is not suited for all instruments on all timeframes. As the series progresses, a plethora of examples will appear. But for now, suffice to say I think that value trading tends to make the most sense for instruments that have inherently mean-reverting tendencies.

In this case, I don’t really mean mean-reverting in the strictest mathematical sense. As in a magical attraction and desire to return to some average. What I mean is mean-reverting in the sense of returning to value. And what is value?

Value, in this vocabulary, is a statistically-defined range of previously accepted prices.

This is also known in TPO and volume profiling terminology as areas of balance. Now, lots of folks try to trade for value using moving averages of various lengths. There are really a few drawbacks in this approach, in my opinion:

  1. A moving average equals only one price at any time. Thus I think it creates an expectation of precision in the minds traders which doesn’t exist in reality. Trading is an inherently imprecise game on all but nano-second time scales. To compensate for this cognitive dissonance, or because averages were the only tools they had, I’ve seen folks create “ribbons” of multiple moving averages to represent zones of prices. Good start, but there is another way, as we’ll see.
  2. Moving averages lag. It’s a mathematical fact – what a moving average is telling you is what happened in the past. There are lots of variations on the formula which give recent prices greater influence on the current output. But at the end of it all what is happening now takes additional time to be meaningfully represented in the average.
  3. Averages are self-referential. What I mean is that a moving average of price is only measuring itself. And price action can deceive you. As I’ve said before, price is what the market says, but volume is what the market does. So “deceptive” prices calculated into averages still contain some deception, even if smoothed by time.

So what if you could use volume as a kind of real-time, non-lagging “test” for the veracity of price action? What if the range of statistically-defined, previously accepted prices could be overlaid on a chart? What if – at least for some instruments with value-reverting tendencies – you could use this tendency and these statistically defined ranges to trade against? What if you had a chart that distilled most of the most important principles of volume profiling (namely identifying unfair prices)?

Well, if you’re still reading then I’m going to guess you’re interested in some answers. I don’t know that I have the answers, but I do have some example charts to show you that illustrate the points above.

The Basic Setup

  • The ES on 15 minute bars, RTH session. The ES might be the king of the mean/value-reverters, so we’ll start there first. The only reason 15 minute bars are shown is because you can fit a lot of time on a reasonable sized chart, and there is less noise. We really only care about the “edges” in this example, and fewer bars show that better.
  • There are two instances of the Acme Volume Value Channel on the chart. The first one – the gray channel – shows only the traditional session value area, which is 1 standard deviation of volume clustered around the VPOC. The second one  – the outer white lines – is also the Acme Volume Value Channel, but instead set to show 2 standard deviations.
  • The chart is from January 3rd 2012, to January 25th. This is 17 trading days.

Now on the chart I’ve circled all the instances where price touched or breached the 2nd standard deviation and then reverted to the same day’s value area or the previous day’s value area in the same session (or immediately after the open of the subsequent session).

ES 2sd Value Chart

The Big Picture

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ES 2sd Value Chart - 2

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ES 2sd Value Chart - 3

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Closeups of the Big Picture

Conclusion

This type of value reversion happened 22 times in 17 days, under pretty sane/normal market conditions. It’s not a coincidence. It’s the market doing its job, re-testing previously accepted prices to see if buyers or sellers are still interested.

What I like most about this chart is its simplicity and consistency, both visual and conceptual. We are leaning on volume to help us gauge the “truthiness” of price (yes, I am a big Colbert fan). And I think one of the ways to become and remain successful in the markets is finding at least 2 – maybe even 3 legs – to stand on. How long can you stand on one leg? In this metaphor, that one leg would be price averages. You need two to cover any real distance. 3 legs might be even better but let’s keep it clean, amigos. This is a family blog. ;-}

In the simple example above we would have theoretically had a little better than one quality entry per day had we used that and only that to read the auction. Not bad, huh? There will be more examples to come that illustrate this approach to analyzing price action.

So as they say… watch this space.

6 replies
  1. Derek
    Derek says:

    Interesting thoughts, El Duque. Your comments on price echo something Dalton frequently warns traders about: price is an advertising mechanism.

    Btw, if you haven’t seen it yet, I recently watched a video presentation by J. Peter Steidlmayer on volume strips: http://goo.gl/0CvaD

    First, I won’t even pretend I understood everything Pete discussed. Second, it was fascinating to see his take on how markets have changed, specifically in regard to mean-reversion tendencies. Some of the concepts he touched on: new orders, being close to volume, low-risk price discovery, and concave value areas. It’s been on the CME website for a few months, so you may have already checked it out. If not and you’re open to listening to Pete talk about trading stuff for 90min, well, there ya go! 🙂

    As always, thanks for sharing your ideas and your work – it’s all much appreciated.

    Take care –

    Derek

    Reply
    • El Duque
      El Duque says:

      You probably figured out that the concept of “volume strips” is really just volume profiling… interesting that the inventor of MP has switched, no? Really, I think that it’s just a reflection of how the tenor of the markets have changed over the years. The advent and pervasiveness of electronic trading has introduced new degrees of precision to intraday trading not really present when MP was invented and futures were dominated by the pits. Thus a more precise measure is necessary, over short time frames at least. TPOs are still an amazing analysis tool over time frames greater than 1 day, IMO.

      Reply
      • Derek
        Derek says:

        Right, from what I understood he was basically talking about dynamically created VPOCs. And the way he described his bracketing entries, it sounded a bit like micro-sized, dynamic VAs. I’d read a couple years ago that he had moved to a more volume-based approach, but I guess at the time I assumed he was still working with daily profiles. Looks like I was wrong. Not a first 🙂

        As for TPO’s, I agree. For starters, the areas of acceptance and rejection they describe do exist; the market really did generate that information. Secondly, I read somewhere how (I’m paraphrasing) it’s a simple fact that humans like to categorize things by time. 😀 And that’s what TPOs do. I think it’s one thing to know that a 5min bar didn’t actually create a market condition, but if 95% of the retail trading world is trading it as though it did, that seems like useful information.

        Take care –

        Derek

  2. Josh
    Josh says:

    El Duque,

    Note how many times the circled area on the 2nd standard deviation line actually touched the line many bars before you circled it. It’s like you’re finding the extreme, and clrcling it, but in fact, it touched the line many bars before. I appreciate reading your thoughts, but it’s as simple as this: when the market is in balance, trade to revert to the mean. When it’s not, don’t fight the flow. You need no value areas or standard deviation lines to tell you this.

    Reply
    • El Duque
      El Duque says:

      Appreciated, but I think you missed a couple important things. First it’s only trade-able if price is at a level you’d previously determined is important – just touching or breaching the line is not enough. Second, you’re exactly inverse on the question of balanced markets – at least in VP or MP terms. Balanced markets are slow and choppy, in MP/VP terms because they occur when buyers and sellers are in agreement over price. So there’s no reason for aggressive action. More importantly, balance areas are traded to, not from. Areas far from balance areas are considered attractive prices and where buyers or sellers get aggressive.

      These charts show when price is very far – mathematically – away from balance (accepted prices) and at important prices – ones where buyers or sellers have shown up in the past. Basically – the center of balance IS the mean… or in this case the most-agreed prices (called the POC or VPOC). You trade swings back to those prices, not away from those prices.

      If your strategy works for you… that’s great. But it’s important to understand what you’re looking at. Without some familiarity with one or another profiling style, it can seem pretty counter-intuitive.

      Reply
  3. Tony Muller
    Tony Muller says:

    This is a good list for beginners to know the different strategy to become a successful trader. It’s definitely worth looking further into it. I will recommend this source to others as well, thanks for the info!

    Reply

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