j. peter steidlmayer 141 west jackson a journey through trading discoveries 1996

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141 West JacksonA Journey throug Trading Discoveries

rJ. Peter Steidlmayer

Steidlmayer Software, Inc.Chicago Illinois



Copyright 99 Peter SteidlmayeA Rghts Reseved.

Repoduction or taslaton of any pat of ths wok beyond thatpemitted by Section 0 or 08 of the Uted States Copyrght Actwithout the permsson of the copyight owne is unlawfu. Thispubicato s desiged to provide accuate and authortatve for-maton egard to the subject matte coveed. It s sod wth theundestandng that the publshe s ot engaged in ederng lega,accountg o other pofessonal sevce. If ega advce o otheexpert assistace s equed the services of a competent pofes-sona person should be sought. Fm a Dearatio of Priipesjoity adopted by a Committee of the Ameria Bar Assoiatioad a Committee of Pubishers

Prted by: Ltho At Printng 0 SE Cay St

Potland Oego9

Maret Poie s a egstered tadea of the Chicago Boad ofTade.

ibrary of ogess aaog ar Nmbe 3

Frst Edto

Printed in the Uted States of Ameca



To Kb-whoe ene of ode wa complete and wondefull

nfectou.



Preface

I as een an neresng orney Oer e pas eenyears I ae seen Marke Prole eole rom an oeceopu wc requred a ar amon o sece npu owa we ae oday a Marke Prole dgal daaase aelps o oecy e marke. Oer a same me orzonmarkes ae ecome more neaonal nerconneced and

comple. Te callenge o e nddual rader as ecomemore danng. Te nuence o eernal markes and odayscapal ows wold a e marke ndersandng o e mossuccessl ne rader o e pas. To deal w e aa-lance o e normaon age and reman oece and ere-ore n conrol as a rader reqres new ools.

Wen readng s ook approac as yo wold anymenal eercse. Look o gan knowledge and consder owyo could apply e conceps presened o your radng Donsee as a owo ook a conans e Holy Gral. Te wayMr Sedlmayer oers s nsgs ogs and oseraonsas plc doman s surely seless and eemplary. He s asonary wo as coneyed a leme o ogs and deas on

markes no one allencompassng manscrp WesJackson.

Seen B HawknsSBH Captal Management

Decembe



Acknwedgments

In s oo ere are any uses o o e sngular an plural n escrng evelopens Soees s I soees weor us epenng on e way I jus naurally el aou wa ookplace a a parcular oen. I ve een orunae o ave a loo elp rougou s proec nclung especally e ull suppor o all ose assocae w e as well as ose wo eleve n e I woul e proper o acknowlege eac person

wo was nvolve nvually u e conruons cae roe wole Marke Prole couny an a nclues aloseveryone I ve eal w. I woul le o sngle ou e personos responsle or e esence o Marke Prole: e orerCaran o e CBOT Les Rosenal Leaersp unle sew-arsp calls or avng a sense o recon an ore por

anly a clear percepon o ow o le ngs procee. To all oyou wo parcpae I le o epress y ans or a very unourney an or your eors n elpng o ae wa I eel s alasng conruon o e nusry

I s always cul o n a clear way o epressng racally new eas. An epressng ysel s no y srong pon nany case I le o parcularly an y eors Cyna Brown

an Ron Mesc or er ruly rllan ransoraon or peraps I soul say ransuaon o y roug anuscrp no spresen polse or.

1



Backgrund

en I grauae ro college an rs sare rang yaer ase e wy I woul wan o ge no a usness werealos everyone loses My answer was a ere wouln euc copeon

Despe y ravao I new I woul nee o overcoe orale osacles on e pa o y goal Mos poranly I real

ze I was worng agans a acgroun were e accepe pracces were no ang oer people successul Because o yeperence n scool I was conen a I coul learn ow olearn. I also new was poran o eep e learnng processseparae ro ang oney To e wa oers regare assuccess weer was eae nancal gans or e goo

opnon o oers was no real success ecause g no avea real ounaon Te ounaon or eng successul was n elearnng e real enon o success was proveen n yaly o uncon proveen n y perorance as copareo e acgroun o wa I was eore I el a os peoplen ae e e o lea an n ae a coen oeep leang once ey egan o ae soe oney Te pa I

was gong o ae was one were I woul queson everyng I

One acor n y ecson o ecoe a raer was y eperence ouse e Ccago Boar o Trae (CBOT) n ryng o geno oer usnesses I a wa I oug were a lo o gooeas u I a a ar e convncng people n power o go

along w e In oer wors I go e ol "ell son wen


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x

you ave a lo of eperence coe ac an see e aue was errly frusrae coul see a woul e a long eefore I go e opporuny o use y capales n e usness

worl I egan loong a e CBOT ares as a place werey eas coul ac wane o ecoe an ourg raer raeran a roer a spreaer or a scalper ecause fel a was eges ecelon one coul aceve: a a lless poenal If couln succee as a raer I was wllng o leave e nusryan ry soeng else

Te pa evenually evelope for yself was raer unoroo a e e an ecause of y preference for areconrols over fnancal conrols (eas Ill eplan laer) an ynssence on e nee for e nusry o cange s sll veryconroversal However n vew o e lac of success of e curren eoologes logc woul say a cange s necessary

Over e years as I wore o ecoe a successful raer I

ep reurnng o y faers queson wonerng wy so anyasprng raers fal I ave coe o eleve a conssenly successful rang requres a grasp of e unerlyng processes arve e are a leas on an nuve level Successful rangas o eerge fro an unersanng of e acgroun of eare My goal as een o ae a unersanng eplc

an o ae e processes ojecvely easurale Te ool veevolve an use n s eneavor s e aaase an areanalyss syse calle Mare Profle Ts oo s e resul



Cntents

Caper OneWa Tis Book is Abou

Caper TwoGeing Sared

Caper TreeMarke Discipine, Background, and Eciency

Caper ourLooking for e Purpose of e Marke

Caper veEciency and is Roe in Marke Organizaion

Caper SHow e Marke Denes Isef

Caper Seven

Capuring Marke Daa

Caper EgTe Imporance of wo-Dimensiona Expression

Caper neTe Be Curve

l



xii

Caper TenUpdating ur Understanding of Market Proe

Caper ElevenLooking to the Future--Data Arrangement

Caper Twelve

Price...The Market Messenger

Caper TreenWhere Do We Go rom Here?

Index



CHAPTER ONE

What This Bk is Abut

Sues o e cooes arkes conssenly sow a85% o all raers lose I ve egun rang socks n e las coupleo years an neresngly you easure e resuls o sock

uual uns versus a sanar ne e success rao s slar: approaely 85% o all sock uns ale o ea e S&Plas year. Te "rang acvy n a sock un s sock pckng.I s que revealng a wle os cooy raers are ecncally orene an os sock pckers rely largely on unaenals er rang resuls are que slar.

y o suc verse approaces lea o equally supar per

orances? a s e coon enonaor? Te answer aI nally gave ysel an wc I sll eleve s correc as oo w unersanng parcularly n ers o arke ackgroun. Te progras o o ypes o raers see o eclpseackgroun n e case o e ecncal raer w nancal conrols an n e case o e unaenally ase raer w a

ele n projeconsA raer us ry o unersan a arke n e presen raeran aepng o prec e uure. I nk a wa ollows ns ook wll go a long way owars solvng s prole Tecru o wy people are losng s a ey are usng e wrongaaase one a acually ns e necessary nsgs ro



CHAR

PRCE C 2 C 2% C4 C 4 %

58-5 50 7 34 33 6658-14 387 247 63.8 40 36.2583 54 381 641 23 35.958 12 530 6 59.9 6 1 4 40158 2632 630 6l 002 3858 10 3288 202 63.6 16 36458 523 3348 63 1 8 1 36588 366 266 58.6 530 4l4587 3232 804 558 428 44.2

586 2781 0 68.7 87 31.3585 2n 3 64 78 36584 20 350 66 66 33583 2635 1 7 1 4 65.1 2 34.9582 3626 2454 67.7 lIn 32358 5543 3462 625 208 37.558 6434 38 62 2445 38573 384 2360 63 48 387

5730 536 313 622 43 378572 352 2627 66.5 1325 33.55728 3674 244 66.4 233 3365727 2206 37 59.7 88 4035726 2582 68 65.1 0 345725 2078 1288 62 70 385724 137 6 672 68 32.85723 040 622 5.8 4 1 8 402

5722 1 586 638 333 362572 63 404 63.2 235 3685720 77 582 56 395 40457 1 473 258 54.5 25 45.5578 87 76 874 II 26

Table -1. ond ade voume by caegories ct. 6 8

evelopng an us locs e ro learnng aou e ares.

Inernal are sascs reveal a successul raers woare osly concenrae aong e proessonals are usng a eren sraegy an unsuccessul ones. Tale 1 gves volue



Top 1/3

Middle 1/3Bottom /3

WHAT K 3

CTI, 2 CTI4

594 (629)

645 (629)642 (629)

406 (37)

35 5 (37)35 8 (37)

Tabe 2 rade percentages summarzed by categores

statistics for trading in bonds on October 6 98 1 . It was issued

by the Chicago Board of Trade in an attempt to help the tradingpublic by providing information on the various types of marketparticipants. At that time the volume data was broken down intosegments of CTI codes (Commodity Trader Identification codessuch as commercial trader local local off floor, and other); CTIand CTI2 are the local and professional trader categories whileCTI4 represents all others (CTI3 was not used).

The total percentage of trades for the local and professionaltraders is 62.9%, with the remainder going to the others If bothcategories of traders were trading the same way, then thepercentage columns would read 629% and 37. % all the waydown the table. Clearly, this is not the case. To get a better idea ofwhat's going on lets average the percent of trades for each

category in the top, middle, and bottom third of the table Theresult is summarized in Tabe 2.

Note that in the top third of the range the CTI4 traders areseveral percentage points above their 37 1 % average, while inthe middle and bottom third they are several percentage pointsbelow it The implication is that the market is extracting a premium from this type of trader for the potential opportunities pre-sented The CTI and CTI2 traders have the reverse effect; theyare not paying the premium because they are trading the eicientpart of the market that the trades are going to emanate from The



4 CHAR

impication is to move your trades to this part of the range aswe. The esson here is that successfu traders have an understanding of the market that produces a different strategy than that

used by unsuccessfu traders.A great dea has been eaed about markets since 982 when

the origina version of the Market Proe data management andanaysis system was first formaized. The initia effort was basedon the notion that the be curve, a fundamenta organizing principe in statistica anaysis, woud have some important reation

ship to market behavior. Whie not perfect, the first version wassuccessfu enough to inspire an ongoing uest to understand moreProgress was incrementa and reativey sow, as earning camefrom observation and experience, contributed to by many peopein an open process of exporation, discussion, and discovery.

Many of the key formats used in organizing the data werefortunate discoveries that proved to have important ramifications

far beyond what we intended when we rst deveoped them. Whenwe went back to try to understand why the formats worked sowe, we were ed to the operating principes of the market Theorigina formats, which were based on an intuitive understanding of trading, had in them the seeds of the forma knowedge wewere seeking. It took 5 years of working with Market Profie to

deveop a the insights Towards the end, progress was greatyacceerated by using a computer to do the processing, aowingus to work out and verify our ideas on many more markets thanwe coud have deat with otherwise. In fact, bringing the computer into the word of trading has acceerated the ow of infor-mation and hence the evoution of the markets and of tradingmethods in genera. With new types of data rangement, the com

puter aows uicker forward movement Change enabes the success of peope just entering the markets, as a new techniue aways offers opportunity to the new person

Our most important innovation was the data entry system itsef. Its key advantages were that it aowed us to get away fromusing chronoogica time as a basis for organizing our data, and



WHAT K T 5

forced a twodimensional data representation giving us a verti-cal base for data processing This system got the eort of dataorganization off on the right foot and gave us a solid basis for

going forwardOver time the data entry system evolved from daily profiles

into profiles organized around market events and finally to adatabase of smallest meaningful data units The system accom-plished the graphic capture and display of the market in a two-dimensional setting that reflects the underlying market processes

This is a clear prereuisite for obtaining objective measurementsthat define the state of the market and thus the opportunities thatmay be present Markets measured means markets defined Defining your opportunities in terms of market measurements is asclose as you need to be

The culmination of our studies was the discovery that themarket is a dynamic selforganizing system that is based on effi

ciency The market is always trying to make order out of disorder It has a welldefined underlying process that can be under-stood and recognized and that process has a natural progressionthat can be seen and measured It has reference points whichwhen identified represent important information and it producesa final output or resultant which accomplishes the market s pur-

pose The process is cyclic it reaches closure and then starts overagainFinding the markets purpose was our most significant break

through and it is the central theme of this book Our explanationof the market s fundamental process reconciles the notion of market efficency with the ability of skillful traders to make money(In an efficient market price moves immediately to reflect value

Thus the cost of information outweighs the prot potential fromhaving it) The idea of efficiency has a long association withmarkets mostly conceived as a barrier to successful trading andit has been a revelation for us to note its importance as a dynamicresource for traders

The various stages of the development of Market Profie

through the years reflect our increasing understanding as well as



6 CHAR N

actual changes in the markets Throughout the process, we fol-lowed a consistent theme As our understanding developed, webegan to notice a correspondence between the disciplines im-

posed on traders by the market and the notions we derived bystudying the bell curve and its expression in Market Profile Atrst these were subconscious revelations that led us to choosegood data representations later, as theory and practice began tomerge, we were able to objectify our intuitive understanding

Along the way to our nal results, we had several important

contributory insights which we ll discuss as we follow the pathof Market Profile For example, the material on liuidity and itsrelationship to randomness has very practical applications in trading The strategies of big traders are always interesting and note-worthy, and provide us a viewpoint that should in principle beadopted by all traders We' ll look at the concept of background,which substitutes for financial controls for large traders, and how

it should be used by small tradersAs we consider the notions of horizontal and vertical market

phases, we ll introduce the terms domnance (the force that drivesthe vertical phase) and lull (the pause that usually follows a ver-tical move, and is hard to handle) These terms will allow us toformalize and discuss important phenomena that people usually

take for granted as a background, without consciously studyingand measuring them In particular, we'll investigate the essentially twodimensional nature of the market

The puose of this book is to enhance your market under-standing Your future success is your responsibility; there is noautomatic, "foolproo' formula As you develop yourself as atrader, take particular note of the lessons of principlethose that

have come from the market itself, and those coming from yourown experiences These will provide the basis of integratingmarket data into your own trading program



CHAPTER Two

Getting Started

In the course of this book were going to examine the under-lying ideas behind Market Profile as it was when we first for-malized it as we developed it and in its present form as we bringit to a nal phase of understanding. Unlike most books about

trading or the markets we are not going to prescribe a specifictrading plan nor will we give how to details This book is likea cookbook that explains the principles of cooking rather thangiving specific recipes One always needs a deeper understand-ing than recipes or formulas can give to achieve anything real.It s my hope that this book will provide the reader with a strong

background and understanding of markets and stimulate the de-sire to take advantage of the opportunity thus presented to pursuethe issue of markets further

I have been trading for over 35 years From the beginning ofmy trading career I have organized data around the bell curveloosely at first and more formally from the early 1 980s on. Ifeel that Ive finally come to a full and complete understanding

of the merits and subtleties of this approach. Data organizationis fundamental to my theory of the market and it can also serveas a knowledge base for you whether you plan to trade as a ca-reer or just want to understand trading as part of your financialeducation.

7



8 CHAR wo

Like most of you, when I started trading I had uestions relating to my ability to understand what I was going to do Howwould I know whether to buy or sell How woud I recognize an

opportunity, and how ong would it remain an opportunity herewere three stages in my development as a trader. he first was anexploratory, or educationa, phase. I became interested in trading whie at Vc Berkeey, ater reading an article about it inFortune. I began to focus on trading as a career after a course oninvestments he text in that course, Graham and Dodd's Secu

riy Analysis explored fundamental analysis. he methods de-scribed in the book appeared ogical and made a lot of sense tome. he book emphasized that mistakes or good decisions couldbe isolated and understood against a background of principles.his was my first exposure tofinancial contls, the use of ob-jective parameters like profits per share, cash ow, etc to controinvestment decisions. ignificantly, these controls were interna,

in that they emanated from the company itsef.I aso became aware that there was a profound difference be

tween specuation and investing, and that because so litte wasunderstood about markets and specuation, almost al commodity traders ended up losing I read extensivey in "Howo books,books about great stock traders, and whatever else I could find

that reated to the markets, trying to nd the best way to get startedI asked myself what I was going to bring to the table What was itthat was going to put me into the successful group here wasn'tmuch material avaiabe on winning commodities traders, and,with my lack of experience, I wasn't in a position to readiy accept or reject the available knowledge and teachings that werebasic to the trading industry

I decided to try to use as my guideines the business principlesof other industries , ones where most participants were generallysuccessful, and see if they couldn't be applied to trading. I realize now that I was fortunate that information about winning traders was so sparse, since I might have tried to emulate them andwould not have had the ability, at that stage of my development,



I ARTE 9

to do so Even at the time I felt that by studying business principles that worked I would be able to carry on within myself atwhatever level of ability I had rather than asking myself to be

greater than I wasAnother source of potential wisdom was the many "sayings

about trading that were passed along by experienced traders A"saying is a truism coming from the practical experience of thosewho have dealt with the market For example "The market takesno prisoners means that there is no middle ground between be

ing right and being wrong. uch sayings were never explainedand were usually uite general and unspecific but they repre-sented insights that had helped people trade well over a periodtime

Both the business principles and the sayings turned out to befruitful areas and worth exploring further They contrasted directly with the "take it on faith attitude and lack of real under

standing I found in most books on trading. In many of thesebooks everything seemed to revolve around financial managementthat you could always predetermine where to get outbut could not determine anything else You took whatever camefirst if your goal was hit you had a profit; if your stop was hityou had a loss. Further with no particular knowledge or skills

one was supposed to be able to dely mange a winning trade toits maximum potential It seemed to me that this type of programdid indeed make commodity trading a gamble just as most conservative investment books said it was. Most commodity industry approaches seemed to y in the face of commonsense busi-ness practices that were applied every day in other industries.You would not dream of running a business you understood with

the practices these books recommended.Most of the academic works I encountered dealt with eco

nomics or investments not with trading but I nevertheless founda lot of principles to think about. My basic conclusion was thatunderstanding had to be the key to success and that understanding was a present tense process Predictions especially those



0 CHAER wo

that can be characterized as more or less baseless assumptions,cannot be used as a continual foundation for a business In trad-ing, people think that they can use money management to com

pensate for any assumptions they make. This is an illusion Yousole the problem by understanding the background, projectingforward from a sound base, and seeing a contrast to the present,not by looking at the excitement of the moment Predictions aredreams, and dreams are hard to ealuate.

Reading gae me a certain amount of preparation, but I real

ized that the only way to really find out anything about tradingwas to gie it a try. ome experience would help clarify mattersand perhaps gie me a path to follow. I was not ery successfulat first, but I managed neer to lose more than I had In retrospect, this is about adeuate as far as financial controls are con-ceed, as I always managed to stay about where I started. Mostof the disappointments came when things were going well and

then tued against me. Aer a couple of years, I started to getthe feeling that I could in fact succeed, and decided to go to Chi-cago. This began the second stage of my deelopment as a trader,what I call the early experience phase

When I started in Chicago, I knew that I had to hae a reasonto make a trade other than some baseless prediction, and a mar-

ketderied reason to exit outside of a simple profit or loss As aCBOT member, and a floor trader, I was able to le by watch-ing markets and traders at work. Being able to study and contrastsuccessful and unsuccessful traders was ery instructie. Therewas denitely a base of successful knowledge on the oor, andan inaluable opportunity to watch great traders in action. (This ,by the way, is a problem for the young exchanges today, and for

screenbased exchanges, where there s no opportunity for begin-ning traders to le by example) Along with watching traders, Ilearned to look for market behaiors the actiity leel, tone, andso on, of markets that were moing up, down, or sideways Icould tell the basic opportunity leel by how many traders werein the pit. I would ask myself why there were 1 00 people trading



EN TART 11

co, compared to 300 in the bean pit, and how that aected theway the market was acting This gave me a chance to understandthe different types of market activity

In my first week of being a CBOT member, I had two realinsights that tested my resolve Many of the successful traders atthe exchange were scalpers or scalperspreaders, trying to buythe bid or sell the offer The way they illustrated their techniueto young traders was to mark a price on one side of a trading cardwith a pencil, showing a hypothetical buy at, say, $ 1 23 1/8 Then

they would ip the card to the other side, where there would bethree potential exit prices $ 1 23 1/4 (a prot), $ 1 23 1/8 (scratch),or $ 1 23 (a loss), whichever came rst They were most helpfulto me and other young members Their advice was never to besmarter than the market The market was always right, i e , takeyour loss if price went against you

I understood the principle that trader discipline was impor

tant, but I felt that this type of trading again reduced the marketto a gamble in terms of whatever event came first, and I ues-tioned its merits I did not understand the reasoning as it relatedto taking the loss in the prescribed manner How could a finan-cial loss by itself make you right or wrong I did not think thatanyone could be so good as to never have an euity loss at some

time during a trade, so I decided not to use that as a determinantMy rst need was to find a way other than stops to exit a badtrade I reasoned that the market had only three ways to moveup, down, or sideways I figured that if I thought the market wasgoing to go up, and it didn't, it should at least move sideways This gave me a 66% chance of not losing, a big improvementover the 50/50 chance associated with using a financial stop If I

thought the market was moving opposite the way I was set, Iwould get out immediately, but if the market was moving sideways I would tend to stay in, even if it was going against me tosome extent In addition, I was not at all skilled at or desirous ofcompeting for the scalping type of trades in the pits, and viewed

giving up the edge for the right to the idea as a sound practice for



12 CHAR wo

me. In other words if I thought grains were going up I wouldpay the seller's price go for the idea and either sink or swim onthe results.

My second insight came after a lunch with two respected traders who had more of a nonscalp mentality and whose tradingstyle was more in line with what I was doing Both were eryinterested in helping young traders from a personal as well as amarket perspectie. At the end of the lunch markets were discussed. My iews and trade positions were opposite theirs in terms

of the next probable moes in the markets. This was uite upset-ting to me because when I put my trades on I really felt that I wasright. That night I decided just to coer the positions in the moing and chalk it up to experienceI clearly had a lot more tole. The next morning when I got to the trading oor I decidedto wait for an hour or so and gie the market a chance to go myway instead of immediately coering on the opening. The mar-

ket moed sharply my way and later that day both members cameoer separately to ask what I thought now! This experience en-couraged me to keep the general principle of what I was doing inplace and confirmed my notion that the best idea for me wouldalways be my own a principle I think holds true for all traders.

This attitude was reinforced a couple of years later. I was short

co oer the April Stks and All Psitins report. I was fairlybearish on the market and it was close to the typical seasonalend of the price moement for old crop co. Thinking that therewould be no surprises I did not stay for the release of the reportbut instead went to a Cubs game that aernoon ome other trad-ers came out to the game later and told me the report was extremely bullish. I felt that this was big trouble for me and that

the market was likely to go limit up the next day. I was just hop-ing it would not start there.

I went down to the oor early the next moing and ran into acouple of large co brokers. I asked them what they thought ofthe report and they said the market would likely be unchangedor at most only a little bit higher. I was immediately relieed and



N SA 13

my anxiety started to dissipate But, aer a little more thought, Irealized that what they had said could not be right. I felt that theyand their customers were all short, and that they were trying to

talk the market down The more I thought about it, the more Iknew that my feeling was right The market opened reasonablywell versus my worst expectations, but well above the generalopening call given by the pit brokers, and I covered aggressivelyright on the open I was hoping that they had decided to wait andsee, and that they would be covering later in the day if they needed

to. The market closed very strong that day.To develop myself further as I gained experience trading, Istarted a program of working with what I now call mket dscplne I studied all my trades each day against the backdrop ofwhat took place in the marketwhat I did, why I did it, why wasI right or wrong. I began to look at the market in two phases : abackground phase, and a foreground phase Market discipline

consisted of studying the relationship between background andforeground: the ntel contst of the mket wthn tse

Market discipline has many connotations Practically speaking, it's the school of hard knocks It means that the market willpunish those who try to ght it. In this sense, it 's a discipline thatthe market can and does impose on its participants You learn by

doing, by asking uestions of yourself, by not repeating yourmistakes, by taking responsibility for your actions and not complaining about whatifs, what went wrong, etc. You are in a continual learning mode The problem with using financial controlsis that background is never given any considerationit is alwaystaken care of by the financial control. This prevents people whouse financial controls from learning Market discipline is not a

wellwrapped pretty package; learning from ones experience isnever a neat and tidy process, but it is essential

In a more elevated and reective sense, market discipline isthe market' s efficiency. Aer all, according to academic theory,efficiency is the reason one is supposed not to be able to makemoney trading. As a trader you are trading an inefciency or a



4 CHAER wo

potential ineciency that the market is trying to rectify in con-crete terms a vertical move or potential vertical move Usually atrader has paid a premium in terms of trade location for the infor-

mation that an inefciency eists The important thing to note isthat an episode of ineciency has a life and is not static It is this"life that gives the trader an opportunity to succeed The reasoninefficiency can develop is due to market uncertainty which al-lows it to epand or contract on itself In retrospect, it shouldhave been obvious to me and others that no static theory could

account for an uncertain process Ineciency is the ultimate con-trast of the market within itself, because that is when the fore-ground is most different from the background Both backgroundand foreground must be epressed in terms of efficiency, in orderto evaluate opportunity (For eample,inefficiencies are gener-ally absorbed into an eicient background if they are not powerful enough to change the background) It makes sense, then that

to succeed one must understand efficiency, or market disciplinework with it and make it central to ones trading approach Aswe shall see, efciency is a dynamic phenomenon that is totallyinteal to the market.

This brings me to the third stage of my development as a tradera stage I have been in for a very long time now It is one of

continual eposure to and absorption of market discipline ac-companied by a constant desire to improve myself. Market discipline is not a road map, it's a compass You find the directionand keep going in a process of discovery

There are two major advantages that I have had over others intrying to pursue education as it relates to markets The first wasbeing on the oor and getting eposure to a lot of good traders I

met new young traders who approached the markets in a freshway in growth situations the new are always closer to the beat,so to speak I also met many fine traders who were satisfiedtrying to stay the same and over time I realized that was not theway to go as those who continued to update seemed to do better.Evolution theory tells us that the most specialized organism is



NG TARTE 15

the most successful in a constant enironment, but can't suriethrough a change The trader who keeps leaing might not bethe most successful in any gien situation, but can keep going

and adapting as conditions change But in either case, the knowledge of markets as expressed by these arious indiiduals was ina subjectie code Hardly a trader could explain the what or thewhy, but the knowledge itself was definitely there

Most oor traders lea their skills through their experienceof the practical side of trading, where participants are brought

together in the discoery process, whether its the open outcrymethodology, specialist, screen based, or something else Oddly,nothing has eer been directly written about this. Most peoplewho are leaing to trade fantasize about being just like so andso, the great trader If you hae the opportunity to discuss tradingwith a successful trader, try to elicit the principle behind what isbeing done Remember, if someone is good oer a period of time,

there is something being done rightI was trading in the bean pit once on an extremely olatile

day, and I had bought some beans at 786 The market moed upto around 792 Then, it paused and backed up to the 790 1 2leel All this was tang place uickly, oer a period of just afew minutes In the pit there were probably 40 to 50 participat

ing scalpers and traders in addition to all the brokers Most ofthem were ery actiely bidding, oering, and competing for anyorder that cae into the pit When the price reached the 790 area,I decided that I'd like to hit the next bid that cae into the mar-ket, and I didn't mind hitting a local who was bidding the bidprice or slightly under As I watched for my chance, to my amaze-ment not one local had both hands up and they all were only

bidding erbally, which meant that they were only reuired totake one contract I sensed that my of knowledge of this situationwas not isolated, as the behaior of the whole group indicatedthat they had read the market the same way, and they were allwaiting to hit the next bid I dumped the market a cent and a halflower; it bounced back about a 1 2 cent and then broke 1 0 cents



16 CHA w

The thing that surprised me was that we all came from differentapproaches, and we all traded dierently, but we all knew thatthe situation was not faorable for an actie bid.

In looking back on this experience oer the years, I learned tomake the same trade oer and oer again The important cluethat we all picked up on in the pit was that there was a ery uickmoe from 92 back to 90. This indicated a large degree of ineiciency in the market, which became an outer boundary from whichthe market was going to moe ertically. In later years, when-

eer the market was in a position where it was ending a erticalmoement that I wanted to trade against, I always waited for auick ertical moe in the direction I was looking to go in beforeI would make the trade

This example illustrates that the market does in fact commu-nicate with those attuned to some sort of market discipline. Trading based on eents like uick moes, totally dead markets, and

so on represents implicit knowledge that has neer gotten out.Most people approaching markets want rigid definitions, whenin fact its best to hae a general principle defined in relatieterms. The intuitie feeling of those attuned to market disciplineis lled with relatiity

What is the underlying order in the seemingly chaotic open

outcry system that allows it to work so well What informationis produced, when and how does it become aailable to participants or to those wanting to participate, and how do they use itThis would, if understood, be the basis from which to go forward, because it proides an organic understanding It is an in-tuitie part of successful trading that has neer been articulatedImportantly, one could note that with prediction and financial

controls dominating traders thought processes, there was probably no demand for it.

The second adantage I had in coming to grips with the orderof the market was the isual output of Market Prole I couldbegin to trace the outline of market discipline in the data units ofthe aggregated profiles I was also able to separate my trading



ENG SARE 17

results from my efforts to attain a higher plane of knowledgeOver a very long time, I was able to correlate more and more ofmy practical trading experience with the visual order created by

the prole, thereby getting what I would now describe as a con-vergence of the two. Each small piece of understanding contrib-uted greatly to unlocking the next problem, until now I feel thatIve gone as far as I can, that Ive reached my goal of objectify-ing the market. his goal i s different from most people' s; it s nota trade parameter were running through a database and

backtesting with financial controls to see if it produces a profit orloss. Instead, we have built a framework from which uestionscan be asked and the whole spectrum of opportunities can beidentified and routed to the proper trading programs.

For example, a friend called me last week and pointed out atrade setup It was good, but the trade took a lot of skill in execution in terms of finding it, getting it on, and managing it. In look-

ing at the background in which the trade opportunity had developed, there were many opportunities earlier in the week in whichthe same trade could have been made under less demanding cir-cumstances Most experienced traders will tell you that the setups for good or losing trades look identical when looked at in thecontext of shortterm market activity. It s the longerterm back

ground that can distinguish between them and allow a market-oriented approach to replace reliance on good financial management. Most associate not having nancial controls with total recklessness and lack of discipline. An objectified data base, whichprovides information related to the background, gives much better control than any financial control. Upgraded opportunities arethe result.

While I feel that Ive reached my goal of objective marketunderstanding, I do not think that all my ways of implementingmy insights are by any means ideal But the basic fundamentalprinciples are there and will not change. It is these principlesthat will propel the industry forward as better ways to implementare continually found. I see basic industry growth coming from



18 CHAR wo

expansion into other arenas. I think that commodity trading willexpand into the area of investments, and that stock investmentwill expand into stock trading. Logic and reasoning in the present

tense, something we're all capable of, will begin to replace thefantasy and fiction of predicting the future. The result will be abusiness that operates on the basis of inteal controls, the keyingredient for a successful business in the long term.

I have always looked to the future and tried to place myselfsomewhere in it. And I think your interest in this book signifies

that you do the same. What does the future hold I am certainthat it is going to be something very different. I really do nothave the ability to stray too far from my base, so I 'm going to justlook at the areas that I'm currently involved in. Coming from aranching/farming background, I have always been resource oriented Trading has been natural extension of that interest. Froma historic view of economics we've had an abnormal situation in

recent years where political and economic policy has been run tofavor the financial marketsand they have certainly benefited.In addition there have been other fundamental changes in theeconomies of the world that are supporting increasing marketuse. I feel that there is going to be a more obligatory participation in the future; markets are going to be needed as never be

fore. And these circumstances will arrive sooner rather than later.We're all concerned about our future as we move toward aglobal society. The increasing speed of computer productivity isrunning at a far greater pace than human productivity. If computers and our skills move along at the same rate, we' ll be neededas people. Thus, the emphasis by the government on education.But the trend over the last four to five years is disturbing. Tech-

nology is leaping ahead at a tremendous rate. For example, medical technology has gone to a level that we really can't even afford. We haven't kept pace, and have been left behind as a society. If we take a look at computer productivity and the growth ofprocessing power, we're nding hat the gap is beginning to widen.Is here a path that we can get on now that assures that we have a



ING SAR 19

future Ths s a ueston that all of us should be askng our-selves. Ive come to the concluson that tradng oers a tremendous opportunty far beyond anythng else n todays envron-

ment n that t gves a person the self relance that seems to becalled for n the new envronment. It s a skll that f learned andmastered wll take you a long way.

Another reason tradng s mportant s because of the ncreas-ng mportance of resource producton and dstrbuton As edu-caton and captal spread throughout the word, were gong to

fnd that consumpton becomes more decentralzed, ncreasngthe economc base of markets, and ths wll produce a lot of market growth I thnk well come to a day n the U f we do notgrow at a faster pace when other economc areas wll bd resources away from us. Ths wll be a drastc change. I m gongto stay as close to my base of expertse as possble, because ac-tvty s gong to be hgh, and there are gong to be lots of oppor-

tuntes for people who understand markets and tradng to explot.

Ill close ths chapter wth a sayng whose truth weve allexperenced: f you really need a break or somethng favorableto happen, t wont. Beng n a poston of ndfference n rela-ton to luck s far better, because then youll probably get t Prepa-

raton and skll are the foundaton for a sold program for yourself A personal busness plan n whch you prepare to takecare of yourself wll never let you down



0 CHAER w



CHAPER THREE

Market Discipline, Backgrund, andEfficiency

The three topics listed in the chapter title, market discipline,background, and eiciency, are the most important and least un-derstood concepts in the trading community We'e all had someexposure to the idea of efficiency, but we' e been conditioned to

think of it as the Achilles' heel of our trading, when in fact aproper understanding of it is the key to unlocking the mystery ofthe markets. Background has always been present by defaultwe're going to talk about how it changes and how monitoringbackground is one of the most important factors in trading decisions Market discipline was introduced in the preious chapter

here we' ll expand on the idea and show its close relationship tothe other two.The major point of this chapter, and indeed of this book, is the

central role that efficiency plays in the market. The market is aselforganizing system that brings flareups of inefficiency backto efficiency. From a practical standpoint, eiciency is the market discipline that ultimately determines either a profit or loss on

your trade.The benefit from working with market discipline is that you

get closer to the market, to the point where you're really in tunewith it. Market discipline proides a basis of market study thatleads you in the right direction and allows you to learn from yourmistakes. The idea of market discipline is probably aguely fa

2



MAK DIPLN BAOUN AN N 3

year of tradng, I realzed what some of my many character awswere, and I decided to rectfy them, so I could improve my trad-ing results Ater sx months of hard work I had made absolutely

no progress and not much more money, ether) I then decided toaccept my faults and neutralize them by working with situationswhere they did not come into play By featurng the thngs I coulddo well, and accepting my shortcomngs, I had exponential gainsI call ths industral indifference feature what you do best and beaggressve

The other discipline is the financial one that has engulfed theindustry the emphasis on money management The very factthat t is endorsed by all segments of the industry including le-ga, regulatory, management, and the printed literature) meansthat it should not be a trader focus It should be present to anatural degree, and one defintely needs to be aware of it, butanything beyond that is inappropriate Fnancial disciplne tends

to creep forward, engulfng more of what you do, and in generalinterferes wth the clear logical thnking needed to trade It makesmanaging your trades an allforeground program, as financialcontrols take the place of background Every opportunity is treatedthe same way, when in fact no two are alike Overemphass onfnancial controls is a sign of a lack of understandng and self-

confidence, and leads to a false sense of securityThe same s true n any area of busness As an example, ayoung and growing busness has a banking relatonship at theoutset wherein the bank believes n the company and its management The relationshp often does not fit all the banks risk poli-cies (whch are ther fnancial controls) as set out by the loancommittee As time goes on, and the business gets on ts feet, the

bank becomes stricter about its rules Making a new businesssatsfy all the reuirements shows little or no interest or confidence by the bank, and forces the management of the business tofocus on satisfying the bank nearterm instead of on growing thebusness and ts industry



24 CAE EE

As individuals we all are different and will not necessarilyt a particular style of trading. Market disciplines are the mostnatural and immediate form of control available It does not make

sense to focus on trader or financial controls which are artificialand external I realize that some need more financial controlsjust as some need to overcome themselves I just want to pointout that these types of problems are out there in all industries andare exteal to the businesses themselves.

Working with market disciplines or market control does not

imply that we now have control over the markets ; they are uncertain. It means that we can gain control in a business sense Wehave an understanding of what we are trying to do and we havean understanding of what the market is doing We can get objective answers to our uestions. For example a car maker mightask what is the condition of the car market today and what is ourmarket share in the compact market How is our new model

moving compared to last year's model and to our chiefcompetitor's Has our new advertising the past month shownany benefit A trader would ask where is the soybean marketnow Has there been any change in its condition in the past weekIf so what What type of opportunity is it What is the best wayto trade it How can we tell if we are right or wrong These

types of uestions need to be answered in order to be successfuland this book will provide the basis for doing so. uccessfultraders have always done this subjectively so it is not an impos-sible goal. Objectivity which can only come from a completeunderstanding of what we' re doing and what were working withwill allow more traders to achieve the same goal.

We as traders need to understand not just the workings of the

market (which is what I mainly focused on at the beginning) butwhat it does what it does it for and how it does it; what it meansto call the market a selforganizing system and what the organizing principles are. We need this foundation in order to gain acomplete understanding of market discipline.



MARK DIPLIE, AKRO A IIY 25

Understanding the markets purpose is the key to unlockingall this This basic insight eluded me for a long time My ap-proach has always been from the ground up trying to merge prac

tical results into theory rather than starting with a theory andtrying to fit my observations into it I think the fact that I made apersistent effort was more important than any one particular ideaIt was my varied experiences in using the developing profile sys-tem that revealed the most I could always seem to find new approaches to keep the discovery process going The constant

changes taking place in the market really brought focus to thesituation It forced me to continually do things differently andfinding the same answers over again in dierent ways brought adegree of condence that I was on the right path

Lets take a look at some specifics From my beginnings as atrader I have always tried to work with a consistent and recur-ring aspect of market activity This ties the trade opportunity to

the market and to my knowledge base and the trade potential istherefore much easier to manage on its way to maturity Forinstance when I first got to Chicago the markets were very active and the pits were generally full. I had a really hard time reading the market activity when the pits were not full Being moreof a position trader I began to notice that most of my profits

would dwindle or disappear ater the pit emptied out I saw thatthe pit emptied because the good traders could sense a lesseningof directional activity through the order ow and that it filledagain when there was a new opportunity The market would al-ways go the opposite way as the pit filled back up Aer a shorttime I realized that I should exit my trades when the pit started toempty out in order to hold on to my profit

As with the last trading situation I described I have takenadvantage of this same situation over and over again during my35 years of trading Obviously my ability now ater years of experience to recognize the market conditions that precede the tradeis the key to finding it again The essential ingredient is themarkets background which is one of high efficiency With this



6 CHAR HR

background, any inefficiency that causes the market to move ineither direction is eventually absorbed into the background ofefficiency. Also, with this background, the market tends to move

in the opposite direction from the one it had been moving in whenreaching efficiency. Efficient markets are trading markets wherethe inefciencies run out of gas before they can change the background, causing the market to move in the opposite direction whena vertical move ends

Another experience taught me to recognize another type of

background. When I started out I traded al the commodities thatwere offered by the exchange, rather than just one. I noticed oneday when I was standing in the corn pit that there was a loud roarcoming from the soybean pit, and that runners were scurrying tothe brokers. The oor was totay focused on the attempt to movethe market higher The price at the time was about 2.52 a bushe.About 45 minutes later, I noticed that the prce wasnt any higher

than it had been when al the activity started It seemed to methat all the kings horses and a the kings men coud not makethe market go higher. I also thought it woud be difficult for it tomount another charge of eual magnitude, and that I ought to goover there and sell the market. And, in fact, the sae worked outwe.

Once again this is a trade that I ve made over and over again.The issue here is that the market was at an efficient price. Generaly speaking when the market is in a state of efficiency, it isgoing to move vertically out of it at some point due to some reaor perceived change When the market has made a good attemptto move verticay in one direction, and fais, going for the opposite direction is one of the easier trades to make, because prices

wil either move in that directon or at worst stay the sameIn todays markets I have noted that this condition oen comes

about when the market is focusing on a government report Thereare two possible market conditions prior to the report. In onesituation everybody is generaly getting flat, and the market hasreached some state of efficiency. If the report comes out and it's



MAK DIIPI, AKO A IIY 27

deemed to be bullish and the market barely opens higher andthen starts breaking, then it s the same situation as the bean tradeal over again

f the day before an important report that everyone's ookingforward to is an active directional day, it can make the reportredundant, because in this case the market has not reached efficiency prior to the report. When a report is issued in an efficientmarket the market will go one of two ways if there s no ray ona bullish report, it gives the other direction all the momentum. f

the market is inefficient and moving directionally prior to a report, generally the condition will prevail regardless of the reportThis is again illustrative of the importance of understanding thebackground

Theres something in common among the trades mentionedhere and the bean trade example in the first chapter They allilustrate what mean by opportunities that come internaly from

the market The ideas for the trades did not come from anythingthat had read nor did they come from any particuar study, norfrom technica analysis nor from fundamental analysis nor fromthe person standing next to me nor from a news letter, nor froma news ash nor from a suawk box that detaied what commer-cial was buying or seing They were rea trading situations that

developed from within the market and they were recognizableas characteristic of some type of opportunity. Right now amonly trying to make the point that there is a great difference between interna and exteal approaches to trading. This in itselfis not startling news, as most traders like to have good loor support from their brokers But mere closeness to the floor does nothave any vaue in and of itself. The closeness must come from

your own program and that calls for your program to be alignedclosely with the workings of the market

Over the years have tried to take these kinds of practicalobservations and transate them into theory But in my case prac-tical success did not transate immediately or automatically to acorrect theory. n academic circles accepted market theory had



8 CHAER HREE

cast the market as being statically efficient, and hence impliedthat traders could not succeed in that environment. (The idea be-ing that a trader succeeds by taking advantage of a situation where

price has moved away from value If price immediately changesto reect value, there's no opportunity) I had seen a great dealof success in the markets and this focused me in the oppositedirection, away from the idea of efficient markets I started tolook elsewhere for the answers, but progress was slow I felt itwas necessary to understand the puose of the market, and that

did not seem to be expressed anywhere by anyone. I spent a gooddeal of time trying to find it, as you will see later onI mentioned earlier that one potential source of wisdom I con

sidered were the many "sayings about the markets and trading.These sayings tended to be very practical in application, yet al-ways seemed to defy logical explanation when I attempted to pindown just how they worked. Looking at the market within the

context of accepted market theory and of practical sayings, itwould be fair to say that the general workings of the marketswere unkown and unexplored upporting this claim is the factthat even the practical everyday traders used external disciplinesto control their tradinga situation that is still very much thecase today

My insights arose in large part out of working with the Market Profile notation as it evolved over time Many readers will befamiliar with at least the basics of Market Prole for those whoare not, lets take a uick look at it.

In its raw form, data about a market is just an unstructuredstream of numbers, recording the various times and price pointsat which buying and selling takes place the sort of information

recorded on a ticker tape. In an effort to gain a visual overview ofprice activity, traders came up with the bar chart, in which a vertical bar records the range of prices for some fixed time intervalMany traders use daily bar charts; for our purposes, that timeinterval is too coarse A popular intraday time interval, whichbecame the foundation for Market Profile, is 30 minutes.



MAK DIIPLI AKRO A FFIIY 9

Figure III-. xplded prfie ch fr ec. und, v. 6 6

The problem with a bar chart is that it captures only onedimension of market activity the vertical Because the horizontalinterval is fixed, there is no variance allowed in the display Theprofile chart is, as we shall see, much more twodimensional, inthat it allows for horizontal variance

The easiest way to understand a prole chart is to start witheach 30 minute time period shown as a separate column, similarto a bar in a bar chart In Figure III , the price data for the DecLIFFE Bund for November 6, 1 996 is displayed in this fashion(The asterisks are inserted by the Market Profile sotware, andneed not concern us here) In Market Profile, each half hour ofthe day is assigned its own letter The LIFFE Bund begins trad

ing during "1 period, so "1 is the letmost column for November 6. The next half hour is called "m, and so on through thealphabet the halfhour following "z is A.

Now we're ready to create a daily profile chart (The result isshown in Figure 2) The starting point is 1 period its rangeis from 100.31 to 10040, and "ls are placed in the correspond



3 CHAER HREE

Fgure Daly prfile cart fr Dec. LFFE Bund, ov 6 6

ing rows (price levels) forming a column just like the column of"ls in Figure III The next period s "m whch ranges from100.35 to 10047. Its range overlaps that of " period between10035 and 1 00.4 1 When the "ms are added to the daily profilethe ones between 1 00.35 and 004 1 go to the right of the "ls

making the developing profle two letters wide at that point The"ms between 1 0042 and 1 00.47 are the first letters in their pricerange so they go in the leftmost column where we placed theoriginal "ls If you look at just the "ls and "ms in the Nov 6profile in Figure 2 you can see ths pattern in place.

Now we go through the rest of the halfhour periods in thesame way assgning each letter to its proper row (price level)

and to the first empty location starting with the original " col-umn The effect is as if we collapsed the halfhour columns ofFigure 1 by suashing them over to the left as far as possblewith the "1 column as a starting pont

Notice the dierence in the information conveyed by Figure1 and Figure II2 In Figure II2 the width of the profile



MARKE DIIPLIE, AKRO A IIEY 31

3 3

Figure 3 he e ll Curve

gives a clear indication of the horizontal movement of the market. If the market spends its time in a small range the result willbe a short wide profile in which the horizontal aspect predominates A fastmoving directional market will create a long nar-row profile in which the vertical clearly predominates (For ex-

ample periods "z through "E in the last profile in Figure III2 .)This brings out the vertical dimensionality of the market in con-trast to through y periods on that day

One feature of this chart deserves some comment When wefirst began working with profiles we started a new profile eachday This had some justification since the global 24 hour marketof today was in its infancy and each day on the loor had a dis

tinctive beginning middle and end phase. As we move throughthis book developing our ideas we' ll also show the corresponding evolution of the profile notation.

The other aspect of profiles that should be brought out at thispoint is their tendency to fall into a patte resembling a bell-shaped curve The bell curve which is at the heart of much of



3 CHAER HREE

statistical theory arises in situations where we re studying a uan-tity whose value is inuenced by a number of contributing fac-tors over a large population For eample if we were to measure

the height of all the men in the country and make a bar chart ofthe result the chart would form a bellshaped curve since heightis inuenced by a host of genetic and environmental factors Of-ten the situation in the marke is the same as many small inu-ences on each of a multitude of traders act to form each personsopinion of a good place to buy or sell

Figure 3 shows a typical bell curve with some of its moreimportant features highlighted If we think of this curve as a barchart of heights (where each bar is only one piel wide) then thecenter value the highest point on the curve represents the singlemost common height This value is called the ode For a bal-anced curve such as this one it is also the ean or averageheight If we go to the le and right of the mean far enough to

enclose approimately 67% of the data this distance is called therst standard deviation It s shown as a dark area in the center ofthe bell curve in our diagram and marked with the number " 1 If we go out further from the mean far enough to enclose approimately 95% of the data we get the second standard devia-tion; adding the third standard deviation encompasses approimately 99% of the data In statistics the size of the standard de-viation is used as a measure of variability; we ve found it usefulin a similar vein when applied to profiles

Look back at the prole for Nov 6 shown in Figure 2 Ifyou tu the book on its side so that the let column of the prolebecomes the bottom the resemblance to a bell curve is clearThis profile is particularly close to the classic shape with its mode

almost eactly in the middle and the volume distributed evenlyabove and below the center in the characters tic shape Well eplore the implications of this resemblance and what it meanswhen the market departs from it as we develop our theory of themarket



CHAPER FOUR

Lking fr the Purpse f the Market

As I began to work with proles and develop my theory myfirst pronouncement was that the purpose of the market was tofacilitate trade i.e to try to do the most business possible. Read-ing the market from my background as a trader I was not yetaware that trading activity within a constricted range is a sign ofeciency or that the fast action on the extremes of vertical movesreveals a high degree of inefficiency. What I did notice in a prac-tical sense was that the market would not go where it could nottrade. When it tended to hold and accept an area that area provednot to be an extreme. If the market was moving directionally

then I would assess the amount of activity as being increasing ordecreasing if it was increasing I'd stay in or go with it if de-creasing I would get out or go against it

The important point is that I was using information comingfrom the market. But although the theory of trade facilitationwas useful in practice it was a long way from capturing the purpose of the market Looking back this theory was more descriptive than analytical in nature but it did succeed in giving a goodreading on continuation of directional change.

As time went on I refined the concept of vertical movementas it relates to trade facilitation to declare that the purpose of themarket was to distribute. This was the channeling of trade facilitation (capital ow) into a medium of expression (markets). Ac



34 CHAER OR

tually this was farther from the true purpose of the market thanmy original theory in that distribution (a onedimensional vertical move that stands out from the background) is an expresson

of the degree of ineiciency What was revealing was that distributon was part of a seuence of events prior to a vertcal dstrbution the market had to have a base of horzontalness in orderfor the distribution to be seen. In other words an underlyingorder of events was there which could be recognized and so potentially lead to some form of control.

Moving from trade facilitation to dstribution as the underly-ing purpose of the market advanced our understandng by pnpointing the area where the distribution started. I noticed that thebackground prior to the start of a distribution was always morehorizontal and this led to the key insight of a twophased mar-ket Also in the early days a vertical move usually started in thefat or horizontal part of the day profile. In short the distribu

ton theory advanced the necessary understanding of vertcalmovement for practical use but it did not truly dentify the purpose of the market.

Throughout my early career I wrestled wth the issue ofwhether or not the market was efficient From a practical standpoint I did not think it was efficient or if it was t was only

ecient for short periods of time; it was not statically efficient.Further in my trading I was not interested in the phase when themarket was more horizontal and thus potentially ecient. I startedto ake noice however when evidence showed that a lack ofactivity which created a horizonal prole usually preceded agood vertical move

What really brough his phenomenon into focus was the num-

ber of misplayed opportunities hat started with a horizontal mar-ket. It has always been a good trading practice to go with something until its no longer there and not o trade for what isn'there I mosly adhered to this pracice and as a result I wouldsometimes be fooled by what I called a false expecations gapNothing at all would be going on so expectations visvis the



OOKI OR RPO OF MARK 35

day would be extremely low This condton would usually havepersisted for a week or so, to the pont where I was conceedabout my ability to find any wellpayng opportunty. Most of

the thngs I did would just sort of die on the vine At this point,more often than not, I would start o the day trading what I thoughtwas a good opportunity. The market would mmedately go myway, and I would uckly get out, having been condtoned to doso by the uiet market It would never fal that the market mademy small expectatons look foolsh.

At this pont, I was totally unaware that efficency was thesetup for change. From a practical vewpoint, market efficiencywas not n the vertical prce acton, which s what I was lookingfor, but in the horzontal, offerng very little opportunity for tradng prot I tended to avod horzontal price action as dull, a marketwth nothing going on, and tred not to trade under those cond-tions As tme went on, the fact that the market had what ap

peared to be two phases, dead and then vertcal, began to regsterin a theoretical way. I began to reassess my earlier rejection ofthe generally accepted theory of effciency, as it seemed that Ihad recognzed efficency n my practical tradng. It was denitely a market condition, but not a constant one The marketwas not statically efficient, so ts other phase had to be noneffi

cency. The market appeared to spend most of its tme bengnoneffcent (vertcal), and shorter amounts of tme being ecient (horzontal) The efficient perods were the most dffcultto trade.

It took a longer time to notce that the market was alwaystrying to get to effciency that effcency, in fact, was alwayspresent n the market to some degreeand, conversely, that the

nefficiences also were never entirely absent. The varyng ratoof these two factors is what makes the market dynamic. Bengdynamc means that the market is always somewhere between99% effcient and 99% inefficent And, most importantly, tryingto get to efficiency s the markets goal or purpose. This whole



36 CHAER OR

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Fie V. year ond futures for late Jne and early July 1996

fundamental concept can be suarized in two words as dynamiceciency

To illustrate the market's process of moving from inefficiencyto efficiency, consider the chart in Fgure IV , which shows 30year Bond futures for early July, 996. In this example, we canfollow the life cycle of an ineffcency, and see how t eventuallygets snuffed out by horizontal actvity, preparing the way for anew inefficiency to happen The second profle from the left, forJune 28, shows inefciency predomnating, as the market madea strong vertical move. The market then begins to trade more orless sideways. We refer to the fat part of a profile, where most ofthe volume is concentrated, as the first standard deviation Look-

ing at the profiles for the 28th and 30th, the frst standard deviations are in the upper part of the daily range, while on the 2ndand 3rd they are at the bottom It appears, then, that the lfe of theineffciency has been taken out by the consistent average activityof these four days In viewing the background, you can see achange, and a completon, so you know that whether you have a



OOK OR RPO O MARK 37

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profit or loss in the rade, the life of he nefficiency that causedthe market to move s over On July 5, he next cycle began wiha sharp decline

Another way o look at the process is o reorganize the profiles getting away from using chronological time beyond he day

imeframe The idea is o start a new profle when the markeshfts into nefficiency, ie, disribung, and to combine all hehalfhour perods as he market works its way to efficiency Inths way a roughly bellshaped profle should emerge from themass of daa, culminang wth a new vertcal move Figure IV2shows the profiles from the chart above regrouped according tothis scheme

I knew ha dscoverng the market's purpose was he key toobjecivty I had been rying to find it for many years throughmy work wth Marke Profile Many people would assume thatthe highes possible goal of data arrangemen would be a radngsysem in whch money would come out forever I do not believeha such a sysem s possible or even necessarily the best thng



38 CHAR OR

Having a trading system as your goal would mean working for alimited purpose A deep understanding of the market's dynamicfunctionality leads to control over your interaction with it Build

ing an objective data base where any uestion can be asked oranswered is far superior to having a set of trading rules

On realizing that the purpose of the market was to move towards efficiency, I felt that most of what I had done prior to thispoint could be understood as a subjective reading of efficiencysubjective because I had yet to gain a full and complete understanding of the market. During the discovery process, insightsgained from working with Market Profile had begun to revealclues that seemed to dovetail with everyday experience In theearly stages of Market Profile the fact that the market was constantly trying to shit into the horizontal phase of activity was thekey ingredient in all our trade parameter classifications. Tradingexperience reinforced this even further, and the ultimate conclu

sion was that the market was always to trying nd efficiencythrough a dynamic process.



CHAPER FE

Efficiency and its Re in MarketOrganizatin

Eiciency tus out to be very important for two reasons First,it creates the most readable vertical reference in the market Itgenerates a fair price, which is the base from which the marketcan evaluate any change Even as the market moves vertically it

will constantly try to find eiciency, and therefore bits and piecesof horizontal development can be found throughout the verticalmovement These represent a reference from which further vertical movement is evaluated by the market participants. Then, ashorizontal trading becomes more predominant, a more concentrated appearance of eiciency becomes evident.

econd, an aperiodic cycle of activity repeats itself as the mar-ket moves itself into the future Nonefficiency continually flaresup and is processed out again and again The market shows acontinuous selforganizing capability that is based upon bring-ing a data mass to efficiency Each completion leads to the nextone as efficiency reasserts itself as a natural result of the tradingprocess The market processes each small episode of ineiency

that is part of a larger move; then, when the move is complete, itbrings the entire largescale data mass to efficiency Eiciencyrepresents more of a certainty, while the vertical moves are anexpression of uncertainty The net eect is a self organizing system that is in control of market activity and only needs to beunderstood

3



40 CHAE VE

Let's take a coser look at the seforganizing process inherentin the arket The initial vertica market movement can be thoughtof as gathering or attracting those who want to becoe involved

In this way the market begins by searching for a vertical rangefrom which to apply or define efficiency and then begins to process out the accompanying inefciency. Thus the market' s process has two distinct stages with the vertical occurring first. Theentire process is dynaic and not necessarily easiy readabe thedata mass that is brought to efficiency is aways going to be ir

reguar. For exaple too few or too many participants may beattracted in the initia phase Too few leads to further gatheringie more vertica moveent) too any eans soe need to beprocessed out producing extended horizonta or opposite vertical activity

Fundamentaly one says that the market has or has not pricedout the users Market observers in the edia provide the ex

cuses for price oves that we're al familiar with: profit taking soe news event a stateent by an authority and so on.Experience has shown that where there is a directiona stiuusand nothing happens the opposite direction generay ensuesshowing that you already have too many participants in the market. In either situation the arket is always moving towards ef

ficiency The ipulse towards eciency is an unrelenting forcethat is always present always active aways trying to get contro. It aways accopishes soe part of its goa so when it isnot present to any arge degree the suggestion is that the arketis not done vertically. This is what aows readabiitythis iswhat the intuitive trader picks up. For instance ost oor traders will tel you they try to make the hardest trade rather than the

easiest trade if it's easier to sell it's usualy the wrong way togo and vice versa.

Let's look ore specifically at the arket cycle. The arketfirst tries to establish one vertical reference point a point that isvery hard to read in the present tense due in part to the volatienature of the market at this stage with its many ups and downs



FFII A I O I MAK AIZAIO 1

Then it proceeds to find the other outer parameter, ie, the sec-ond vertical reference point, again hard to read in the momentVerical activity is uite irregular in the data mass volatility can

not be neatly cataloged), and the where and how of these references cant be easiy established Its only necessary to know thatthey will happen This is the gathering process, the first stage,and is highly unstable and difficult to read

To some etent during, but mostly aer, this process, the moveto efficiency will begin to develop The fair price area, or effi-

ciency, is what I call market output, the result of the selforganizing system This represents the real "close of the market processthat is, the result that summarizes that phase of activity Itis necessary for the market to find this in order to start the wholeprocess over again

It is important to note that the outer boundaries and the amountof data processed during this cycle will vary dramatically It is

the output of efficiency that is the constant The cycle from inefficiency to efficiency is a great reference at any stage of its de-velopment, whether the beginning , middle, or end Like the developing ears in a crop of corn, it represents a direct output thatcan be measured in stages Price discovery, long thought of inrelation to a fair price, has an entirely new meaning in this con

tet: its defined by where the market is in its process You mayhave a fair price generated during the gathering phase, whichwould be one of the vertical etremes, or a fair price during thehorionta phase, which woud represent the consensus fair valueAlso note that in the process of gathering the market will try toinvolve those on the edge of development, because its easier todo the job once than to do it twice This eplains the volatile

nature of the market in establishing vertical reference points andthe difficulty in using them

A practical eample of a gathering process similar to that ofthe market comes from my personal eperience. As a young man,I had to gather cattle every year on the family ranch aer schoolwas out at the end of May The first thing I did was ride my horse



4 CAR VE

to the outer reaches of the ranch boundaries, trying to push theoutlying cows and calves closer to the middle of the ranch Ifsome of the cattle were on the adjoining ranch, I d have to move

further out in the gathering process While I was doing this I waslooking at the condition of the cattle If I saw four or five cowswith only two calves, or four or ve calves without cows, I knewconditions were not perfect Tis did not give me a reading onthe entire herd, only an indication, the answer to which might beover the next hill I 'd be getting some insights as to the overall

condition of the cattle It would be hard to rely on is smallamount of information or make a decision based on it, but still itcould be very significant

As we moved more towards the interior of the ranch, or towards the natural location of the coal, and I gathered more ofthe herd, my information would become better and more reliable Finally, in getting the whole herd into the corral pasture, we

would definitely know what the condition of the herd was Wecould see how many cattle we had versus what we turned out,what the co

j. peter steidlmayer 141 west jackson a journey through trading discoveries 1996

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