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Balances: Three Day Rule

Donald L. Jones, Nov 11, 2007

CISCO Futures© 2007

The TPO-Value Area, as defined in the Meta-Profile, has come into wide use. This value calculation relies on a balanced market condition for it's validity (as does the much less used cleared-volume based Market Profile). Measurements of market condition such as the CISCO Bracket Screen and the Advice Engine show that markets are in balance only about half the time.

Little or no effort is made by most data providers to offer market condition information to their profile value subscribers. Consequently, the unfortunate fact is that calculated profile value areas are incorrect about half the time and the user has little way of knowing which are correct and which are not. Thus, trading decisions based on value are often made with flawed data.

This article illuminates the problem and proposes a solution for non-CISCO users, the Three Day Rule. This rule says that if one is to trust the profile value calculation the market condition must be balance (congesting). In the absence of a measured balance like the CISCO Bracket Screen or Advice Engine Tables, a good estimate can come from visually examining the last three days of profiles to form a rough Overlay. If this rough Overlay shows a cohesive group, a single distribution, you can trust the value area calculation. This is the Three Day Rule.


The Market Profile works of Peter Steidlmayer and the CBOT introduced the trading world to a manageable and logical way of finding the value of a future (and likely all auction market instruments) (references 1 and 2). The method is based on a bell-shaped (gaussian) distribution of volume over the price range of the trading day. It simply locates the central 70 percent of volume by price using cleared data from the CBOT. The count starts at the price with the peak volume (Point of Control). Work at CISCO found that TPO's are a valid surrogate for the volume, opening up the non-CBOT trading world to value analysis (reference 3). (For those unclear on profile nomenclature, an explanation is at: Introduction to Day trading).

In the original writings (ref 1, 2) it is clear that the value so found is for one (pit) day, or other trading period in 24 hour markets. In our studies we have found for most cases that the pit day time frame still has the bulk of trading in US based markets. Foreign exchange is an exception. There, a 24 hour market can be defined. But, pit hours or longer, value definition remains a day-local concept. For longer, multi-day periods, we developed the Overlay Demand Curve to find the collective value (value region) for the longer period (ref 4). Overlay Demand Curve Intro

The subject of this study goes to the heart of the definition of value. When is the 'value' calculated by the 70 percent formula valid? In references 1 and 2, validity appears to be essentially assumed for all cases. i.e. if you have a profile you can use the formula to get an answer--all you need is the middle price (Point of Control or POC) and then collect either TPO's or volume until you have added in 70 percent of the day's total.

The 70 percent formula can easily be shown to fail. Simply imagine a market in which price rises steadily, at the same rate, throughout a day. There will be the same number of TPOs at each price. Such a distribution has no POC with which to start the count. More to the point, what is 'value' in a trending market? Value comes from a consensus in a bell shaped distribution. There, some traders believe value is higher than the POC; an essentially equal number think value is lower than the POC. This stand-off explains the quasi-bell shaped curve of the profile in congesting markets. Moving markets generally do not have a bell shaped distribution. In the non-balance situation the snapshot calculated value is misleading at the least. At worst, it can lead to trading for the wrong reason.

So the the key is that valid value can only be found when the market is in a balanced (congesting) state. Consequently, a precondition for valid value determination is balance; so then we must define what balance means in market measureable terms. Single day pattern recognition will not help; a quasi-bell shaped profile can and does often occur as a one-day pause in a strong trend.

Guidance is found in the definition of balance in reference 4. In the studies that led up to that finding, these steps were followed:
1. It is understood that markets swing from balance to imbalance and back to balance, etc., as noted e.g., in reference 2, p34 and many other sources.
2. There is a point in the balance-imbalance cycle at which balance begins.
3. Volatility makes the start of balance very difficult to pinpoint in real time. There must be a look-back period available to find the start.
4. The required length of the look-back period varies with the state of the market. In an active market, normally three days are needed to confirm congestion. In a quiet market it can be as little as two days.

Congestion or balance, as defined here, is a minimum trading period of three or more days forming a single distribution containing the close, which produces a stable upper and lower limit. Prices moving above or below the limits are considered alerts for the potential start of a trend. A 'false breakout' is one in which the day ends back in balance. The balance limits can and will move a small amount from day to day as a balance continues. A true breakout will result in an end to congestion and the start of a trend.

Example 1 Discussion
In Example 1, find five days of profiles for emini SP from May 2 through May 8, where May 8 was the first day of a five day balance as detected by the CISCO Bracket Screen. Visually, this market was trending up until May 8. The trend was slow enough, with enough day-to-day overlap, so that the first day of price reversal netted out a balance.

Given that May 8 started a 5 day balance; when in the preceding days could a trader have spotted a nascent balance? The two day Overlay of May 7 and 8 below the 5 days of profiles, shows a double distribution--not a balance. In this case, two days is not enough.

Stepping down to the Overlay of the last three days, May 4, 7 and 8; this set meets the definition of balance. This is a fairly common case. A market making the transition from trend to balance usually does so in a relatively smooth way. Even so, the last one or two days are often not enough to point out an incipient balance. Combining three days often does confirm that a balance state is beginning, as was found here.

Example 2 Discussion
This example is distinguished by the latest day in the balanced 5 Day Overlay being a strong trend day. Normally, the breakout day from a balance is the more violent, in this case, day 5 (Jan 25) shows a trend ending blowoff. Again, the 2 Day Overlay is not in balance, but the 3 Day is.

Incorporating the Three Day Rule in a Trading Setup
These two examples illustrate the Balances Three Day Rule. Are there cases where the latest two days of a new 5 Day balance show balance? Of course! But there are many, many cases where the latest two days show balance but the market is not going into a five day balance. The odds are far better if the last three days form a balance. A trader who has access to the CISCO Advice Engine gets a list of all balances before each market day.

The trader without access to the Advice Engine table can estimate whether or not there is enough balance to trust the value calculation by posting the last three completed day's profiles on a single price axis and eyeballing for balance. While this may be a bit of a chore, it is far, far better than making trades on the basis of bad data. 
References
     1. CBOT Market Profile Manual 1985
     2. CBOT Market Profile Manual 1991
     3. Determining the TPO Value Area, Don Jones, 
        Market Logic School Alumni Letter, Apr 13, 1987
        and
        Estimating Market Profile Value Area for Intraday Trading, D.L. Jones
        Stocks and Commodities, Sep 1987
     4. Overlay Dectection of Long Term Market Condition, D.L. Jones
        The Profile Report, Vol 2, Oct 1988
        and
        Locating Value with Auction Market Data, D.L. Jones
        Stocks and Commodities, Jul 1989


Example 1


THis example shows five days of profiles that resulted in a balance at the 
close of the fifth day.


              The CISCO five day Market Profile* display

Mini S&P 500 (CME-IOM) JUN 07   First date:  5  2  7   Last date:  5  8  7

         2              3              4              7              8
151650                                           B                           
151600                             C             BCG                         
151550                             CDE           BCDEFGJKLM                  
151500                             CDE           BCDEFGHIJKLMN               
151450                             CDEP          BCDEFGHIJKLMNP              
151400                             CDEP          BCDEFHIJMNP                 
151350                             BCDEFP        BCDIMNP       KLMNO         
151300                             BCDEFP        D             KLMNO         
151250                             BCEFGP                      IKLMNO        
151200                             BCEFGJMNP                   HIJKLMNO      
151150                             BCGIJMNP                    HIJKLM        
151100                             BGIJMN                      BHIJKLM       
151050                             BGHIJKLMN                   BHIJK         
151000                             BGHIJKLMN                   BH            
150950                             BGHIJKLMN                   BH            
150900               DELMNP        BGHIJKLN                    BCDEFGH       
150850               DEGLMNP       GHJKLN                      BCDEFGH       
150800               DEFGJKLMNP    GH                          BCDEFGH       
150750               DEFGIJKLNP    GH                          BCDEFG        
150700               DEFGHIJKLN    H                           CDEFG         
150650               CDEFGHIJKLN                               CD            
150600               CDFGHIJL                                  C             
150550               BCDGHIJ                                                 
150500               BCDGHIJ                                                 
150450 KL            BCDGHI                                                  
150400 IJKL          BCD                                                     
150350 IJKLM         BCD                                                     
150300 DEHIJKLM      BC                                                      
150250 DEGHIJKMN     BC                                                      
150200 DEFGHIMNP                                                             
150150 DEFGHMNP                                                              
150100 DEFGHMNP                                                              
150050 DFGNP                                                                 
150000 CDN                                                                   
149950 CD                                                                    
149900 CD                                                                    
149850 C                                                                     
149800 C                                                                     
149750 BC                                                                    
149700 BC                                                                    
149650 BC                                                                    
149600 B                                                                     
149550 B                                                                     
149500 B                                                                     
149450 B                                                                     
149400 B                                                                     
149350 B                                                                     
149300 B                                                                     


2 Day Overlay of May 7 and 8
Observe that this display has two distributions. The one centered at
151450 is the dominant. Two days' distributions do not show balance.
You do know from the 5 Day display that the lower distribution, centered
at 150800 is from the latest day, May 8, and is the earlier part of the
day, TPOs B into H. So this is a rejected area for the day. You might use
this information in your trade setup. That is up to you.

    2 151650    1  +
    4 151600    1  +
    6 151550    3  +++
    8 151500   12  ++++++++++++
   10 151450   14  ++++++++++++++ POC(2)
   12 151400   11  +++++++++++
   14 151350   10  ++++++++++
   16 151300    6  ++++++
   18 151250    5  +++++
   20 151200    7  +++++++   Close
   22 151150    6  ++++++
   24 151100    6  ++++++
   26 151050    5  +++++
   28 151000    2  ++
   30 150950    2  ++
   32 150900    2  ++
   34 150850    7  +++++++
   36 150800    7  +++++++ POC(1)
   38 150750    6  ++++++
   40 150700    5  +++++
   42 150650    2  ++
   44 150600    1  +



3 Day Overlay of May 4, 7 and 8
This three day Overlay is a single distribution. By the Overlay
rules, this is a balance. While a 'Value Area' could be calculated,
the data could be used in the formula, the Value Area is not defined
for a multi-day period. A 'Value Region' is more apropo and would
be 151550 - 150700, the region between the limits.

Now that there is a congestion, price above 151550 is an alert for 
start of an up trend, below 150700 is an alert for down trend

    2 151650    1  +
    4 151600    2  ++
    6 151550    5  +++++        Upper Limit
    8 151500   15  +++++++++++++++
   10 151450   18  ++++++++++++++++++ POC
   12 151400   15  +++++++++++++++
   14 151350   15  +++++++++++++++
   16 151300   12  ++++++++++++
   18 151250   11  +++++++++++
   20 151200   14  ++++++++++++++  Close
   22 151150   13  +++++++++++++
   24 151100   12  ++++++++++++
   26 151050   13  +++++++++++++
   28 151000   11  +++++++++++
   30 150950   11  +++++++++++
   32 150900   10  ++++++++++
   34 150850   13  +++++++++++++
   36 150800    9  +++++++++
   38 150750    8  ++++++++
   40 150700    6  ++++++        Lower Limit
   42 150650    2  ++
   44 150600    1  +


5 Day Overlay of May 2, 3, 4, 7 and 8
This is the original 5 Day Overlay posted daily on the CISCO
Bracket Screen. The limits are 151550 - 150050, considerably wider
than the three days 151550 - 150700, as would be expected.
Both upper limits are the same. A breakout alert on the downside
at 150700 could be understood to be confirmed at a price 150050.

    2 151650    1  +
    4 151600    2  ++
    6 151550    5  +++++      Upper Limit
    8 151500   15  +++++++++++++++
   10 151450   18  ++++++++++++++++++
   12 151400   15  +++++++++++++++
   14 151350   15  +++++++++++++++
   16 151300   12  ++++++++++++
   18 151250   11  +++++++++++
   20 151200   14  ++++++++++++++
   22 151150   13  +++++++++++++
   24 151100   12  ++++++++++++
   26 151050   13  +++++++++++++
   28 151000   11  +++++++++++
   30 150950   11  +++++++++++
   32 150900   13  +++++++++++++
   34 150850   19  +++++++++++++++++++ POC
   36 150800   18  ++++++++++++++++++
   38 150750   17  +++++++++++++++++
   40 150700   15  +++++++++++++++
   42 150650   12  ++++++++++++
   44 150600    9  +++++++++
   46 150550    7  +++++++
   48 150500    7  +++++++
   50 150450    8  ++++++++
   52 150400    7  +++++++
   54 150350    7  +++++++
   56 150300    9  +++++++++
   58 150250   11  +++++++++++
   60 150200    8  ++++++++
   62 150150    8  ++++++++
   64 150100    8  ++++++++
   66 150050    5  +++++    Lower Limit
   68 150000    2  ++
   70 149950    2  ++
   72 149900    2  ++
   74 149850    1  +
   76 149800    1  +
   78 149750    1  +
   80 149700    2  ++
   82 149650    2  ++
   84 149600    1  +
   86 149550    1  +
   88 149500    1  +
   90 149450    1  +
   92 149400    1  +
   94 149350    1  +
   96 149300    1  +




Example 2


This example shows five days of profiles that resulted in a balance at the 
close of the fifth day.


              The CISCO five day Market Profile* display

Mini S&P 500 (CME-IOM) MAR 07   First date:  1 19  7   Last date:  1 25  7
       BAL            BAL            BAL                           BAL
        19             22             23             24             25
144650                                           NP                          
144600                                           NP            B             
144550                                           LMNP          B             
144500                                           LMNP          B             
144450                                           LMN           BC            
144400                                           JLM           BC            
144350                                           JKLM          BCD           
144300                                           JKL           CD            
144250                                           JK            CDE           
144200                                           EJK           CDEF          
144150                                           EFHJ          DEF           
144100                                           EFGHIJ        DEF           
144050                                           DEFGHIJ       DF            
144000                                           DEFGHIJ       DFG           
143950                                           DEGIJ         FG            
143900 D                                         BD            FG            
143850 DE            B                           BCD           GH            
143800 DEKLM         B             IJ            BCD           GHIJ          
143750 DEKLMNP       B             HIJK          BCD           GHIJ          
143700 DEFGKLMNP     B             HIJK          BCD           GHIJ          
143650 DFGIJKLMNP    BC            HIJK          BC            GHIJ          
143600 CDFGIJKLMN    BC            HKP           B             J             
143550 BCDFGHIJK     BC            HKLMP         B             J             
143500 BCDFGHIJ      C             EFGHKLMNP                   J             
143450 BCDGHIJ       C             EFGHLMN                     J             
143400 BCDGH         C             EFGLMN                      J             
143350 BCDGH         C             EFGLMN                      J             
143300 BCH           C             ELN                         J             
143250 B             C             BCEL                        JK            
143200               CL            BCDEL                       JKL           
143150               CDLNP         BCDEL                       KLM           
143100               CDKLMNP       BCDE                        KLMN          
143050               CDEFKLMNP     BCDE                        KLMN          
143000               CDEFJKLMNP    BCD                         KLMNP         
142950               DEFGIJKMNP    BC                          KLMNP         
142900               DEFGHIJMN     B                           MNP           
142850               DEFGHIJM      B                           MNP           
142800               EFGHIJM       B                           M             
142750               EGHIJ                                     M             
142700               GHI                                                     

VALUE AREA, VOLUMES & OPEN/CLOSE STATISTICS AVAILABLE
ONLY FROM CBOT LIQUIDITY DATA REPORTS


2 Day Overlay of Jan 24 and 25
This two day Overlay, the last two days of a 5 day balance,
does not fit the definition of a balance; there are three
distributions. Referring to the 5 day display above, note that 
Jan 25 was a rather extreme activity day; a rather strong downtrend.


    1 144650    1  +
    3 144600    2  ++
    5 144550    5  +++++
    7 144500    5  +++++
    9 144450    5  +++++
   11 144400    5  +++++
   13 144350    5  +++++
   15 144300    5  +++++
   17 144250    5  +++++
   19 144200    7  +++++++
   21 144150    6  ++++++
   23 144100    7  +++++++
   25 144050    8  ++++++++
   27 144000    9  +++++++++ POC (1)
   29 143950    7  +++++++
   31 143900    3  +++
   33 143850    4  ++++
   35 143800    7  +++++++
   37 143750    7  +++++++ POC (2)
   39 143700    7  +++++++
   41 143650    6  ++++++
   43 143600    2  ++
   45 143550    2  ++
   47 143500    1  +
   49 143450    1  +
   51 143400    1  +
   53 143350    1  +
   55 143300    1  +
   57 143250    2  ++
   59 143200    3  +++
   61 143150    3  +++
   63 143100    3  +++
   65 143050    4  ++++
   67 143000    5  +++++
   69 142950    5  +++++  Close
   71 142900    3  +++
   73 142850    3  +++
   77 142750    1  +


3 Day Overlay of Jan  23, 25 and 25
In spite of the violence of the latest day, the 3 day
Overlay shows balance, supporting the Three Day Rule.
Are these just lightly coupled profiles showing a specious
balance? No, in spite of the strong activity of the latest
day, Jan 25, the next two days, Jan 26 and Jan 29 continued
in 5 day balance.

    1 144650    1  +
    3 144600    2  ++
    5 144550    5  +++++
    7 144500    5  +++++
    9 144450    5  +++++
   11 144400    5  +++++
   13 144350    5  +++++
   15 144300    5  +++++
   17 144250    5  +++++
   19 144200    7  +++++++
   21 144150    6  ++++++
   23 144100    7  +++++++
   25 144050    8  ++++++++
   27 144000    9  +++++++++
   29 143950    7  +++++++
   31 143900    3  +++
   33 143850    4  ++++
   35 143800    8  ++++++++
   37 143750   11  +++++++++++
   39 143700   11  +++++++++++
   41 143650   10  ++++++++++
   43 143600    5  +++++
   45 143550    5  +++++
   47 143500   10  ++++++++++
   49 143450    9  +++++++++
   51 143400    7  +++++++
   53 143350    7  +++++++
   55 143300    4  ++++
   57 143250    4  ++++
   59 143200    7  +++++++
   61 143150    8  ++++++++
   63 143100    7  +++++++
   65 143050    8  ++++++++
   67 143000    8  ++++++++
   69 142950    7  +++++++
   71 142900    4  ++++
   73 142850    4  ++++
   75 142800    2  ++
   77 142750    1  +