Monday, July 30, 2012

Trading stocks and bonds with Market Profile

I don't advise any trader to limit themselves to any one idea or method.  However, Market Profile seems to be one of those tools that enables traders to best filter out the noise, and is perhaps the best tool to view the long end of the US Govt bond market (for our purpose here, ZN 10-year futures), as well as the S&P Index eMini contract (ES).  For this reason, I will mostly be talking about the US Govt Bond Market and Stocks (hereafter referred to as "the market" or just "the mkt") in terms of Market Profile as I attempt to blog about my trading in real time.

In order to effectively use Market Profile, and hence, the concept of Bell Curves, we first must agree on a few concepts.  The Mode (like from statistics) is just another term for the current center of value.  When the market is not trending, the mode will suck in the market with "gravity."  High amounts of both trading Time and Volume will occur at this center of value.  The farther away from the center of value during non-trending activity, the stronger should be the force of gravity, and hence the bigger should be our positions with an expectation of a return to the center of Value.  There are different models that use Market Profile to determine the center of value, as well as the extended value zones, in order to determine the best times to initiate / exit a trade. 

The million dollar question is, "how do we determine when the market has transitioned from non-trending to trending, and how do we know when the center of value has shifted?"  The answer to these 2 questions are the most difficult in trading, and correspondingly, the most profitable opportunities.  We will attempt to answer these questions thru observation and example as we post our interpretation of the market, as well as our trades so the audience can follow along.

So, lets dive right in and look at what the market has done over the past couple days.

Friday and today (Monday July 30), the bond market is in what we call "value seeking" mode.  This means that, while surely there is a center of value somewhere, the market has not been kind enough to inform we observers what that level is in the market...not yet anyway  For this reason, there is only minimal edge in having a position from a Market Profile point of view.  Below is a screenshot of the Sept 10-year US Treasury Future, Market Profile chart (5 days, 30 minute periods) with volume at price overlapping time at price.  Below the market profile image is the corresponding 5 day intraday price graph, just so we have a common frame of reference.

ZN Market Profile

ZN Tick

While we can (and will) talk about what happened on Friday July 27, and Today, Monday July 30, you should know the story as it would be told by any participant.  Namely, on Friday morning around 9:00 AM in NY, several large macro hedge funds sold the bond market in size, while simultaneously buying stock index futures, also in large size.  This was in reaction to a Medley Global Advisors report, stating that the political landscape within European Central Banks had shifted in favor of using the ECB to purchase peripheral govt debt to reduce interest costs for struggling nations.  Then, just after 1:00 PM NY time, the head of the ECB publicly announced that he and the ECB  would "do anything necessary to save the EUR."  Thus, the Medley report was proved "true"and the market went haywire for about another hour (1pm -2pm).  While the stock market held onto its 1pm announcement gains, the bond market returned to pre-1pm levels after about an hour.  This is all that happened on Friday.  There were no new announcements over the weekend, and Monday proved to be a slow grind higher, back to the level where the "Medley sellers" initiated their position.  This is where the market now sits as i write this blog post Monday afternoon.

All this movement around political announcements extends the time frame for which Market Profile must be expanded, in order to properly observe what is taking place in the market.  Or, in other words, these announcements, and the markets reaction to the announcements, do not change the dynamics of the market as viewed thru the lens of market profile.  Yes, stocks rose sharply, and bonds sold off sharply because of these announcements.  However, in the long run (lets talk 1 week here for the long run, which is an eternity in the capital markets), market profile will still enable us to talk about the auction process of the market, and come up with a clear prism thru which to view the market.

So, lets see what Market Profile would say about what happened on Friday.  The bond market started off with an initial center of value around 135-00 (134-29+ during the overnight session) with the most recent volatility being 7 ticks both above and below this center of value (we are talking about Thursday afternoon, moving into Friday morning).  (That takes us to about 6:00 AM Friday)  The next event to attempt to move price was the Medley report.  An attempt to sell the market moved price away from the most recent center of value.  Important to note that this selling attempt was initiated BELOW the center of value (134-17 is where the large selling volume occurred, and you could have seen this in real-time if you were watching the futures market).  The selling volume was larger than 10% of the ADV, which tends to be enough to move the bond market for a while.

Note, the ADV of the US Govt bond market is about 450bln 10-Year duration equivalents.  This means that 25 bln 10-year equivalents is usually enough to cause the market to escape the gravity of the center of value, at least for the day.

So our market profile tells us that a large seller has attempted to sell the market at 134-17 from below the center of value. We are still just watching at this point.  We then observe the head of the ECB concur with the Medley report (no surprise here..Medley is almost never wrong in the short term).  The bond market goes home Friday in the low half of the range at 134-07 (again, not surprising given the way the selling worked out.   The market has not spent enough time at any one price area to determine a new center of value.  Also, the selling was initiated from below the center of value (previous days value was 135-00...and the overnight value was 134-29+).  So, we are left wondering, did the sellers create enough of an oversupply condition to transition the market from non-trending to trending?  We would need to see the market spend a significant amount of time in the lower 3rd of the selling days distribution.  So, now lets go over the numbers.  The ZN seller sold most of the product at 134-17.  The local low with any volume was 133-28.  This is approx 21 ticks. So, 1/3 of 21 ticks is 7 ticks.  If this seller was going to successfully create a trending market, we would expect to see the market stay below 134-03 (133-28 plus 7 ticks = 134-03) for the next 8 trading hours.  We count trading hours starting at 2:00 AM NY time (about 7am London time) thru 5pm NY time.  Tokyo trading is generally irrelevant for this determination as very little volume trades there.  Unfortunately for the sellers, the market ends up settling around 134-07, which is already 4 ticks above our determination of where the market would need to stay below in order to create an oversupply condition.  8 hours later (10am in NY) the market is still trading at 134-07 (after dipping briefly to 134-02).  This is not looking so good for the sellers.  While their position is still "in the money," we would have expected the market to stay in the lower 1/3 of the trading distribution after their selling.  This would indicate the beginning of a new trend.  This has not happened.  This indicates that the probability that the sellers will ultimately (within a week) be unsuccessful is greater than 60%.  Fast forward another 6 hours to the end of the NY trading session at 5pm NY time, and indeed, the market has traded all the back up to where the large sellers initiated their position, and will go out at 134-18.  This leaves us with a very interesting question...have these 10year bond sellers closed out their position, will they attempt to sell the market again, or do they still need to cover their short?  If they closed out their position, then we can expect the market to settle in to a new center of value relatively soon.  If they have not closed out their position, then that means they still need to.  That would create a massive short covering rally, as todays buyers are currently in control (having initiated their long positions around 134-08). 

So, lets see what our options are.
a)  Friday Sellers holding and Monday buyers holding (buyers in control with mkt around 134-18)
b)  Friday Sellers have already short covered and mkt has not been bought by new buyers

Under scenario a, the most likely outcome is a massive short covering rally
Under scenario b,  the market will gravitate to some new center of value

Given the price action of the past 2 days, both scenarios seem to indicate the bond market moving to higher prices.  However, we do not like the concept of buying high without an under supply condition.  The market moving to higher prices in these scenarios results from short covering, and short covering is difficult to predict.  That said, short covering is exactly what we are predicting.

So, as I transition from teacher to trader, I will look to buy a dip in the ZN bond market overnight, but I will be small.  I will also look for an opportunity to sell ES stock futures overnight.  The reasons are not identical but similar.  Stocks (ES) traded up 30 points on Friday, but only went sideways today, while bonds rallied.  As stocks tend to be the last bastion of hope, and the potential for Fridays buyers of stocks to have been the offer into today's strength while they bought back their bonds (hypothetically), the net pressure in stocks is now towards lower prices.  Just to have a position, I sold 1 unit of ES contracts at 1382 today.  I was looking for a chance to buy a dip in bonds, but a dip did not materialize.  Perhaps overnight.

I'll update overnight if i make any trades.

Good luck trading

1 comment:

  1. can't wait to hear more about your trading...keep it up govt trader!!