Using live market data in the form of TPOs, the market profile adopted the normal distribution curve to identify the value area and create the Profile chart. The value area on a Profile chart identifies the price range that includes approximately 70 percent of the trades that occurred during a defined session. Since this is the area of prices where most of the activity occurred during the trading session, it is therefore the area where prices were most accepted by buyers and sellers. In other words, it is the price range where most traders felt comfortable to conduct their trades. Since this was the area of greatest activity during the session, it is also the area of the greatest liquidity during that session. It is the area where most of the market trading action takes place.
The Market Profile chart is the only chart that allows us to view market activity in terms of value. By definition, the market value for any given financial instrument is the price range or price area where the market has found buyers and sellers equal in strength. Identifying and understanding where value is in the market has many advantages. These advantages may not seem intuitive to most traders because they are not accustomed to looking at value in the market. First of all, being able to track and follow where value is in the market allows traders to identify areas of liquidity in the market. This information is invaluable to the short-term or intraday trader. Intraday traders typically trade using large position sizes and seek only a small profit for each of their trades. Consequently, market liquidity is essential for the success of this type of trading strategy. Short-term traders are most active within the value area. Identification of the value area also helps the long-term trader to identify price levels that may be advantageous for a buy or sell decision. As prices drift lower below the value area, they present buying opportunities for the long-term trader. When prices are below value, they are considered advantageous and thus attract the long-term buyer seeking an advantageous price in the market.
When prices rise significantly above a defined value area, they present the long-term sellers with an advantageous selling opportunity. Consequently, we often find that as prices drift too far above value, long-term sellers will be attracted to supply the market and prices will drop back to the value area. In monitoring how the market reacts to different price levels, traders gain a better understanding of how the market participants behave at various price levels. As prices move away from value to an unfair high price level, we can see whether this level will be accepted or rejected by the market. If the market rejects these prices at an unfair high, this rejection will appear on the Profile in the form of a single print selling tail. When the sellers aggressively step in to supply the market at an unfair high, the market tends to drop back and return to the value area.
On the other hand, if the market drops too far below value and reaches a price level that is at an unfair low, the buyers will promptly respond by stepping aggressively into the market and creating a buying tail. Once again, as the market rejects the unfair low, prices will move back up to the value area. If the market accepts these lower prices, selling will continue, dropping prices even lower. This will continue until prices reach an unfair low and buyers step into the market. When the market participants are uncertain about the future direction of the market, they tend to limit and cluster their activity to the value area.
The shape, size, and location of the value area within the day’s Profile structure convey to the Profile trader some important information about market activity. The more TPOs that line up at a price level, the greater the acceptance of that level. Value areas that have a large and balanced number of TPOs indicate a market that is in balance. A value area that has a long and skinny TPOs pattern with less than five TPO prints at any one price level is indicative of an imbalanced market.