A Walkthrough: The Powder Keg Trade

Been a long time since I was able to blog much. But in the words of Jack Nicholson from The Shining, I’m baaaack!

For the last past few weeks on Twitter I’ve been posting a lot about the #powderkeg trade. I’ve tried to explain what it is, why it works, when its most likely to work. But tweets aren’t always the best way to get a series of points across, and I’ve had a ton of questions about it. It’s not practical or possible to explain it each time someone asks about it, so I thought I’d walk through the finer points here.

First, let me go though what it is NOT (in no particular order):

  • The best trade ever. This isn’t a home-run type of trade. If you define it “right” it has small risk and generally good reward. By “good” I mean somewhere between 1 unit of risk for 2-3 units of reward. It’s a solid base hitter, though every now and then it cracks one out of the park.
  • One pattern to rule them all. This trade works best on non-trending days or later in the day when any drives from the opening of the session have exhausted their fuel.

That said, it has a lot of good things going for it (again, in no particular order):

  • It requires minimal tools, though as you’ll see I use a volume profile. VPs will help tremendously in defining the boundaries and quality of the setup. But truth be told this can be done without a profile.
  • It requires minimal preparation.
  • It requires no directional bias (it’ll be better if you suspend all bias, in fact). So in some ways, it’s the ultimate anti-revenge-trading tool (I’ll post about revenge trading another time).
  • No need to catch a falling knife or catch the top tick.
  • Works on pretty much any kind of short duration bar, ones that take 2-5 minutes on average to complete is best. The more bars there are the easier this pattern will be to identify. That said, many Renko bars will work against you here, they are designed to filter out exactly the kind of “chop” we’re after.
  • It’s the same pattern every time (but the quality – the ease with which its recognized – and outcome varies, of course).

Why it Works

Markets ultimately have one purpose:

quote

The theory behind this trade is simple. It works because it’s catching the end of a short-time-frame auction cycle… i.e. balance. Once a market achieves balance (supply/demand equilibrium, fair prices, etc.) on any time frame, its purpose has been fulfilled and it must start the cycle over again (see above). More about balance and other profiling concepts here. We want to be ready and waiting when it starts this cycle anew.

What to Look For

  • Find an area where price stalls, preferably away from a recent area of balance.
  • We want price to have left and returned to this “stall” (balance) area at least once on each side.
NQ - Powderkeg no profile

Example 1 – No Profile

 

NQ - Powderkeg with profile

Example 1 – with Profile

 

Now that we have the basic elements down let’s talk about a few characteristics which sweeten the quality of the setup:

  • The more times price exits and reenters the balance area the more powerful the break. At least one excursion-and-return on each side is needed to validate the setup.
  • The session VPOC’s included inside the balance area. Even better is when the VPOC’s in another location, you identify a new balance area, and before the balance breaks the VPOC moves into your forming balance area. This means volume’s being expended in this area and (probably) that stop loss orders are accumulating on either side of this balance area. These stops will serve to accelerate the move once it finally breaks the balance area.

 

Defining the Risk and Reward

There are multiple ways to do this, but ultimately your risk will be just over or under the center of your balance area. Preferably the highest-volume price in your balance area. Ideally it’s the session VPOC (point of control). You’ll want to define your reward at at least 100% of the size of your balance area. If for whatever reason it seems implausible that your target will be achieved, forget the setup and move on.

Example: if your balance area is 10 points across, your ideal 1st target will be 10 points on either side of the boundary of the balance area. Since you’re defining your risk as mas o menos the center of balance, if you enter at a break of the balance area that puts your risk:reward at ~1:2, assuming you only trade one contract or lot. It gets more a little more complex (but with a more favorable ratio) if you trade multiple lots or contracts because you can scale out along the way, booking profits and reducing your risk, while still having ammunition to take down further moves.

 

NQ - Powderkeg R-R

Example 1 – Reward Zones

 

Once the reward zones are defined, I like to use a trend line to split the balance area in half. There are many ways to split it in half, but I find this helps keep me focused and in the flow. Use whatever works for you.

I use a bottom or a top trend line depending on which way I think the keg will blow. It really doesn’t matter whether you draw the trend sloping bottom left to bottom right or vice versa as long as it splits the middle of the balance area. If price breaks back through the trend line, no matter which way you draw it, you’ll want to get ready to try in that direction. In this case, based on price action, order flow and internals I think this balance is most likely to break to the upside. So that’s how I draw it.

 

NQ - Powderkeg R-R Trend

Trend/Risk Line

Getting In

Now that our risk and reward is defined, how to you know when to get in? What you’re looking for is an impulsive directional bar. You HAVE to be paying attention here. This means any bar that starts to move unusually fast in a direction, compared to other bars nearby. Remember, you’re in a balance area, which is generally slow, lazy “chop.” So a bar that starts to hustle should grab your attention. Ideally, you’ll have your entry order(s) ready to go and all you have to do is place it and let price trade through and thereby assure a good fill. If you can’t get filled on your entry it’s probably because you hesitated and chose a bad price. The best prices are always ones that you can actually get filled. The best way to assure a fill is to make sure your order is one that gets traded through while price is on its way somewhere else.

This “trade-through” strategy is my preference, is entry option A pictured below, and will give the best risk and reward. A more conservative entry is to let the impulsive move happen and then wait for a back-test of the balance area to hold. This is option B. You still have to act decisively, or you’ll blow your R:R. Be quick or be dead, as I say. So shoot to kill.

 

NQ - Powderkeg ENTRY

Example 1 – Entry Options

One of two things will happen at this point, and neither are in your control. First, price will move toward your target and you get ready to book your profits, or price comes back at you and enters your stop zone (see above). If it does it’s OK. It happens. Look at the risk here… if you got long at the impulse through 4400 and your sell stop was at 4396, your target was around 4415… that was a 1:4 trade. You can afford to try again or flip the other direction even twice and still profit on the trade. But you have to honor your stop.

OK, so, how’d this one turn out? As you can see below, the impulsive bar I thought would be the magic one was a head fake. But that’s OK, because our stop was never touched again. Price re-entered the balance area, giving it even more power, and a few minutes later it launched out in our direction all the way to and past the previous day’s high. If you have enough units to scale out along the way, the max favorable excursion (MFE) would have been about 25 points, while the max adverse excursion (MAE) was just 9 ticks.

 

NQ - Powderkeg COMPLETE

Example 1 – Trade Complete

More Examples

Today gave more than its usual share of #powerkeg opportunities. Generally, there’s one or two a day. But today, thy cup overruneth,… so to speak.

 

NQ - Powderkeg EXAMPLES

More Examples – NQ

 

ES - Powderkeg EXAMPLES

More Examples – ES

Hope this was helpful, amigos. Until next time, trade ’em well…

Don’t be like Ron Burgundy

Unless you’ve been asleep at your DOM wheel no doubt you’ve noticed a substantial change in the equity market character since, really, the first week or so of December.

I’ll put it this way, many macro chickens are coming home to roost. We’re not just staring up the same sort of wall of worry that the bulls scaled in 2013 and 2014. The game has changed and the recent market price action is reflecting participants’ struggle to grasp the new rules.

I’ve written thousands of words on this topic over the last few weeks, analyzing this, that and the other macro circumstance. For the first time in a while I don’t think I really have to do that. The monthly and weekly time frame profiles show we’re back to a balanced state having done the needed repair work:

ES-Monthly

Dec – Jan Monthly

 

ES-Weekly

Dec – Jan Weekly

 

Yep. Pretty clear. So now work in this range is largely done it’s probably time to explore other prices. We have been in the 2050 region literally dozens of times over the past few weeks. And now the fairest price on both time frames is all the way down in the 2015-17 area. So….

In the SPOOs, bulls have but one mission – move that intermediate term fairest price back to the 2060s. On my current volume composite from October 15th 2014, the VPOC moved from 2060 all the way down to 2028 on Thursday. This is a big deal because it’s been up at 2060 since late November. If the bulls have any hope of new ATHs they must regain this ground sooner rather than later, achieve acceptance (widen/reaffirm the balance area there), and use that acceptance as a base for even higher prices.

ES-RTHpng

 

At this point I don’t think it’s of so much of technical importance that bulls have to move price up. We’ve been in this range for what seems like forever. What’s the harm of hanging out a while longer? Well, I think their mission instead is to generate the psychological confidence needed among retail equity buyers to act (stir the fear missing out) even in light of the macro backdrop perils and doubts. And there are plenty: details of the ECB’s monster bond-buying program still need clarification; there are well-founded questions about whether the ECB QE program’ll even work to reflate the Euro and EU economies; more than a few think it’ll just slam the door shut on a so-called liquidity trap.  I won’t even start on oil price-induced issues in Saudi Arabia, Russia, Iran, Venezuela, the turmoil in Yemen, Chinese random economic number generation, industrial metal and ore prices, blah deflation blah blah disinflation.

So I’m looking at the 2033-30 Alamo level, near the bottom of the LVA notch shown above as the proverbial line in the sand. If Monday we test the 2046 Alamo – or even 2056 area – and fail, bears can plausibly take price down to 2033-30 level very easily. If we don’t see a decisive buying response, we’re almost certainly looking at late longs from last week providing fuel for a descent to the 2020 area, then potential continuation to the 2013 LVA. Further and we’re potentially all the back to the bottom of the large volume balance area and wedge around 1985 or so.

The 2033 area and levels below should provide good R/R long opportunities for the bold and the quick. That said, in my view our likelihood of  trend down day(s) increases with every handle below 2030. Should the 1985-80 level break we could be in for a more substantial correction, the likes of which we haven’t had in 3 years or so. This would effectively signal no confidence in the ECB moves, and I’d need to re-calibrate my expectations if and when this happens. No need to get ahead of ourselves. This kind of down move/failure can easily take more than a day to play out.

On the upside, we still have the 2063 – 2075 area to test and repair. Chances for sellers to step in increases as we move up given the context and Friday’s close in my view. Since we’ve already had one test of the 2061 area, the best short opportunities should come in at the first test of the 2075 area. If bulls manage to reach and repair this region (shown on weekly profiles above) the next target is the 2086 gap area. This clearly puts new all time highs in sight with the 2100 level being the first obvious source of charismatic upside attraction.

WTI Crude Oil

Since we have so much volatility available in the ES recently I’ve stopped trading oil for a while. The SPOOs/ES is my main squeeze. My one true love. Oil is my sumthin’-sumthin’ on the side. I’m definitely watching though. I just don’t have a need to analyze and select targets.  Sorry if you were hoping to compare notes.

Anyway, suffice to say my view is that the bottom is not yet in. The fundamentals, put simply, stink. All reports confirm we’re drowning in oil, RBOB and there will need to be some substantial shift in the supply situation (with status quo demand) to bring this downside to a halt. Only the first hints and rumors of future supply reductions are beginning to surface, but in my view they don’t really matter just yet. The king of glut will probably take months or even quarters to resolve. That said, we’re seeing the kind of pool-pop-and-drop price action I’d expect out of healthy price discovery.

 

Trade ’em well this week, amigos…

 

Trading for Value, Part Four

Today, in part four of the Trading for Value series, we’re going to break it down and lay it out.

We’re going to spread some of the most important pieces out on the workbench and see how they all fit together. It’s going to be a bit technical. Maybe even a little dry by comparison to some of the other installments. But that’s because a lot of information is going to be packed in here. So grab some coffee (or an adult beverage depending on the time of day, of course) and read on.

What’s the “it” being broken down? Well, it’s this concept of the value candle. We’re going to walk through:

  • what they are/are not
  • some of the important visual patterns
  • how those patterns compare to things that might be more familiar

And then lastly we’ll examine several charts in several markets to show the kinds of instruments on which this kind of analysis yields the most and clearest insights. I’ll say right up front that this is not a Swiss Army Knife of an analysis tool. It does not work well on every instrument and trading situation. In fact, it’s pretty specialized and intended to be used on very short time frames. And as great as it is shaping up to be at aiding the trade in certain instruments, it’s only just ho-hum on others.

First, Some Context

Let’s do a little “level setting.” No, this is not a trading pun. It’s a bit of jargon we used to use before a big meeting at a certain monstrously huge software company where I worked. It means we need a little context before we get to the heart of the matter. An informational appetizer, if you will. The most important contextual assumption below is one that is so ingrained in my thinking I often forget to mention it. And that piece of context is that most all patterns are only worth your attention at prices or levels you have previously identified as important.

At other times (or prices), patterns of most all kinds should be considered noise. It’s only at or near real inflection points that action of any trading kind should be taken. And one of the most interesting things about real inflection points is that they are pretty predictable. The exact wrong approach in most any trading method is to act on a trigger or signal at just any old price. Some prices are way, way, way more important than others, and for the purposes of this discussion please pretend that the examples shown are in fact important prices. We could literally be here all week if I went through the entire process of price/level triage, and you’d never make it through to the end. I might not either.

For the sake of expediency I’m just going to pull some charts up from under the counter, ala Ron Popeil, so you can see the finished product.  Besides, level-finding and price triage will be the subject of a future series of posts. ;-}

Pogo Sticks

I am a very visual person and an aficionado of metaphors. So while these things are called value candles, almost every time I see them I think of a pogo stick. Why? Well, in a way, value candles look and function much like an actual pogo stick. Here is an enlarged value candle taken from an actual chart. Now tell me the resemblance is not striking:

Acme-Value-Candle---Pogo-Stick

 

There are really 3 fundamental components to the value candle/pogo stick:

  1. The handle/spine, which is actually the bar range. In this particular case, it’s an OHLC bar. It’s the central support, if you will, for the whole thing.
  2. The spring cylinder. In a real pogo stick, this houses the spring that gives the toy its rebounding energy. So it is with our value candle. It’s the 1-sigma value area of the bar and it’s where the bulk of the bar’s energy is stored.
  3. The foot pegs. In a real pogo stick, the pegs are attached to the internal spring. When compressed by human weight against something solid, they cause the rider to rebound into the air. In this metaphor, the pegs are actually the bar VPOC, or volume point-of-control. The point of control is simply the price at which the most volume is traded for that bar/profile/period, etc.

As we’ll see in a moment, the value candle VPOC very often displays the same rebounding characteristics. The more deeply it is compressed into the value area, the more likely price is to bounce the other direction very shortly thereafter.

Now one very interesting characteristic of this particular pogo stick is that it works both directions. Right side up or upside-down, the spring can be sprung.

Potato, Po-tah-toh

Before we go much further, I want to point out that the value candle concept is not something that we at Acme made up. In fact, it’s something we pared down. You see, the value candle is simply a volume profile, visually streamlined and reduced to its svelte, naked essence.

Let’s have a look to compare. Here is the same 5 minute bar of the same instrument from the same day and time, but “clothed” two different ways: on the right, in a single-bar volume profile; and on the left in a value candle.

Acme Value Candle vs Volume Profile

So you can see same essential/critical/most important information is displayed in both the value candle and the volume profile – the range, the value area and the VPOC. Though by comparison, the value candle is much less visually noisy.

And as we’re about to see, that increased focus on the essential information can render a rotation-in-the-making easier to spot.

On the Rebound

So what are the kinds of pogo patterns we’re looking for? Again, generally speaking, we’re looking for the body of the candle (actually the value area, or the range of most-accepted prices within 1 standard deviation of the VPOC) to be positioned toward the outer extreme of the bar range, and also for the VPOC to be positioned toward the outer range of the value area. The further toward the outer extreme the better. Remember, in this metaphor, the outer extreme is the top of the range if price is in an upward rotation, and the bottom of the range if price is in a downward rotation.

For the examples below, we’re going to use 3 minute candles. The choice of 3 minutes is pretty arbitrary to be honest. It’s just that for fast-moving instruments 5 minute candles may be too long. And for slower-moving instruments 1 minute is too short. So this is the happy medium I’ve chosen just so we can have a kind of apples-to-apples comparison.

Beyond that, each of the charts has 3 studies on it:

  • The Acme Volume Profile VPOC, which actually makes the value candles on the chart
  • 2 instances of the Acme Volume Profile Value Channel, with one value area set at 68.2% (1SD), and it’s the inner gray-shaded channel. The other is set at 95.5% (2SD), and it’s the blue upper and lower channel lines. These are on the chart simply for reference to the session’s value area context. See here for more on standard deviations, if you’re not sure what those really mean. Yes, pun intended that time. ;-}
  • One instance of the simple Acme Volume indicator. This shows relative per-bar volume at the bottom of the chart instead of in a new panel.

One last thing before we get to the annotated charts. I’ve cherry-picked some pretty clear examples. Better to start with an ideal and learn to recognize valid but less ideal examples than the other way ’round, methinks.

From Under the Counter

First up… West Texas Intermediate Crude (CL). This is a prime candidate for this kind of analysis as it has clean, volatile short term swings and is often driven by aggressive price discovery. This means key levels are frequently faded, and that’s exactly the behavior that value candles were conceived to reveal. In this example we have clear pogo stick patterns on a swing high and a swing low:

Acme Value Candles - CL2.14.2012

Next up… gold (GC). Here again we have a swing high and a swing low, though not on in the same session. Pretty similar patterns. A bit trickier to read by comparison, though.

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Acme Value Candles - GC High2.13.2012

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Acme Value Candles - GC Low2.16.2012

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Of all the indexes, by far the one that makes the cleanest pogo patterns is the Russell Small Cap Index (TF). Why? While I can’t be 100% sure, it seems to be the least arbitraged of the index futures. Again I need to highlight that this is speculation, and it has fairly light volume at around 125K contracts per day. So no matter what, it’s much, much easier to move around than, say, the ES (which we’ll see next).

Acme Value Candles - TF High Low2.15.2012

And with that, I’ve saved the worst for last. I think for an instrument like the ES, this really is not the best tool. There is so much volume in the ES with so many players acting on so many time frames with so many purposes all at the same time that it really can’t form clear pogo patterns on most rotations.

Value usually takes so much longer to play out in the ES than with many other instruments. Again, mostly this is because the ES is commonly used as both a position vehicle and a hedging vehicle. Meaning that institutions buy a basket of stocks and sell ES contracts against that basket to hedge the position, for example. Still other traders take outright positions on the S&P 500 with the ES contract. Both could be happening at the exact same time, and thus can tend to “confuse” the price action in the very short term.

These differences of volume and simultaneous intent in the participants cause each of these instruments to have a very different character. How so? Let’s look at a couple value candle examples in the ES:

Acme Value Candles - ES2.14.12

Conclusion

My hope is that this walk-through delivered some clarity on the value candle concept, why it works, what it’s useful for seeing and when it’s not so good too. Again, this is a new concept we’re developing, and so far it’s showing lots of promise. It’s in successful, daily use by a number of Acme traders, a couple of whom you’ve already met, and there are definitely more examples to come.

Have a great long weekend, amigos. Trade ’em well…

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[iconbox  title=”For Rancho Dinero Members” icon=”emblem-important.png”]The template used to make the charts shown above as been added to the Acme Chart Template Library.[/iconbox]
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Trading for Value, Part Three

In the last episode of our Trading for Value series, we saw a couple very interesting charts from our intrepid oil trader Danny. Not only does Danny trade oil, but he’s pretty damn funny too.

He was looking back over a chart from last week that marked a significant near-term turning point in the price of Light Sweet Crude (CL). He was sort of marveling at how clearly the turn was spotted with the Acme Volume Profile Pack studies (high praise, we know… but that’s the point of all this!), and made a joke that it was like the price was just swimming along and a Great White shark came right up underneath it. More to the point, he could actually see it coming:

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Acme Volume Profile VPOCThe Bait

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JawsThe Shark

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We’ve not heard the last from Danny. One of these days he will show up for an encore presentation, toting more interesting and creative thoughts on trading price and volume.

But today it’s all about Phil. Phil is a Rancho Dinero Pro Member, primarily an ES trader and he’s been using the exact same Acme Volume Profile VPOC study as Danny. Though in a completely different way. The point of this series, after all, is to show some fresh perspectives on using price and volume instead of or in addition to the kind of volume and TPO profiling many of you know so well.

So here’s Phil, ready to show and tell. These are his words and images, essentially verbatim. Without further delay, here is Phil to take it away:

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Anyone that uses profiling in their trading will know that the basic theory behind it is that of price discovery. Profiling is a great aid in helping determine levels of interest as it clears up much of the noise that may be missed by the just looking at the chart. In profiling theory price discovery rotates between balances which can usually be found by looking for the low volume nodes that surround a high volume node in a composite chart. That being said, something I have found to be of use is the application of this same idea down to the micro level.

One of the tools in the Acme suite, the AcmeVolumeProfileVPOC, allows you to see clearly where the majority of volume is being transacted per period in your charts. In my experience I have found that once you have determined your levels of interest (be it through a composite or simple support and resistance) you will want to have as much information as possible for you to make a decision whether to engage or not at those levels. In my trading I use a combination of divergence indicators to determine selling or buying pressure at this point and combine that with the AcmeVolumeProfileVPOC to see where the volume was done. Whether I am looking to fade a move or enter on a pullback, I want to see that a vpoc was created around this level and that the price action is showing clear rejection of the vpoc in the way of continuation or a counter move. Once this happens I look to enter in the desired direction on the retest of this vpoc which usually happens in the next or within few bars after. In some cases the retest is very quick so like anything in trading you have to be ready to jump on the opportunity when it presents itself.

In the example below I use a 5 minute chart to explain what I mean:

1)      Going into this past Friday, prior to the open I determined what levels I would be looking to engage in using a micro composite chart for the month of January along with a range profile for the previous swing that we are currently trading within. As you will see the micro composite for the month (ETH) showed that the highest participated price for the month was 1308, I therefore expected that 1308 would find buyers and sellers and looking at the previous move off of this price and the trend for the month, expected that buyers would be present.

2)      As you can see also from these charts, 1308 and its surrounding volume nodes were bought and rejected the price drop during globex into the RTH open.  In the 5 minute chart with the VPOC indicator you will also see that there was a vpoc on a wick of a clear reversal candle. This in my book means price got to that level and sellers were absorbed by enough buyers to be able to stall this move. As a result we knew saw a small bounce from this level into this open.

3)      Once the RTH session got on the way, we saw a retest of this vpoc at 1307.25 to the tick where buyers came in and a prepared trader could have bought at first sign of stalling or rejection (or however you determine whether or not to engage), with minimal risk (stop below the lows) for a possible bigger pullback of the globex drop to a previous area of resistance which in this case happened to be around 1313.50 where we saw congestion on the way down.

As you will see there are many other examples on this chart and as with anything in trading, it requires you be curious and try it out for yourself however I believe the vpoc tool will help you identify areas which are likely to be retested for a rejection and/or continuation with defined risk/reward parameters.

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ES 03-12 (30 Min)

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ES 03-12 (5 Min)

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Again, amigos, this well is proving to be deep, clear and mighty refreshing. We’ll be raising another bucket before you know it. And if you like what Phil had to say or you have questions, be sure to leave a comment. No doubt he’ll be around to appreciate and answer.

Until next time, trade ’em well…

Trading for Value, Part Two

In keeping with the “now for something completely different” theme, today we have a new post in a new series with a new instrument with a new strategy based on a new indicator by a new trader.

How’s that? Well, I’ve asked a couple of the Acme loyal to give some thoughts on how they Trade For Value™.

This particular trader and Rancho Dinero Pro Member is not new. In fact, he might be quite old. We’ve never met in person so I can’t say for certain. But in any case, I can say with certainly that he’s new to you and that he knows his stuff. He makes his living mostly from fossil fuels – namely trading the CL. As many of you know, the ES is my steed of choice. And so I thought it’d be interesting for everyone if we trotted out a horse of a different color.

The trader wished to remain anonymous, but let’s call him Danny. Why Danny? Well that was the male lead in Grease, of course. And this is about oil. So there you go. I can’t really believe I chose that name because in fact I can’t stand musicals of any kind. But there it is.

Danny has been working with me on a new concept I like to call value candles. Value candles are a new feature of the Acme Volume Profile VPOC study in the Acme Volume Profile Pack.

What’s a value candle? I’m glad you asked. Value Candles are per-bar volume profiles boiled down to their extreme visual essence. All you have to do to set up what’s shown below is create a chart, add the indicator and turn on the value area, as shown below:

Acme Volume Profile VPOC - Value Area On

… then adjust things to your liking.

The hypothesis we had was that, instead of letting the open and close form the body of the candle, what would new ways of seeing short-term price action could we discover if we use:

  • The per-bar value area range relative to the bar’s range
  • The VPOC’s position in relation to the value area range high and low
  •  The overall bar volume and range

… to form the basis of our interpretation of the price action?

Wordy there, I know. But the irony is visual vs literal. This way of seeing the price action could hardly be simpler, and it uses both price and volume in a new way.

So there’s the set-up. In some charts below, Danny walks us through a couple of swings on very short-term (1 minute) bars in the CL, and calling his actual trades as he goes. As you look over these charts, keep in mind what the factors above are telling you (and him) about what you’re seeing (and what he saw). Let go any pre-conceived notions you might have, and try to see the price action through the lens described above. Maybe it might inspire something new about how you trade your own instrument. You never know until you try, right?

Without further delay… let’s let Danny take it away.

Acme Value Candles 1 - CL

 

Acme Volume Value Candles 2 - CL

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We’ve really only tapped the well here, amigos, and it’s looking pretty deep. So look for more Trading for Value posts very soon. Watch this space and, of course, trade ’em well…

 

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.