Thursday, December 23, 2010

12/23/2010 Spotting a long trade with the volume ladder

Hello Trader,

Its been a boring holiday trading week so I had plenty of time to prepare this blog post. I have been using the volume ladder more often in my trading to spot entry and exit points. This post will describe my method by outlining a long signal from yesterday's trading. I haven't been trading the market much because of the low volume and practically nonexistent volatility. In fact on a side note, I would be buying puts to hedge any long exposure you might have because protection is dirt cheap right now. The VIX had traded as low as 15.50 this week!

Getting back on topic now... In order to learn how the volume ladder works I read the thread at BigMike's Trading Blog, and watched the seminars. Then every night I looked at the swing lows and highs and examined the volume ladder during those time frames. What I found was exactly as described in auction theory books such as James Dalton's Markets in Profile.

For those that haven't read the book or aren't familiar here's a brief (and rather crude) example. First you need to see Price acting as an advertising mechanism and the merchandise on sale are ES contracts. Now imagine an ES contract as a reposed Ferrari at auction. When the car comes up for bid they start at 50k. At first, everyone's hands go up because it would be a steal! As the auctioneer keeps blurting out higher and higher prices, fewer hands remain in the air. The auctioneer, talking faster and faster edges the price up to 150k, and there are only ten hands remaining. 200k he says frantically, 3 hands. 250k! He shouts as his face turns red. Down to 2 bidders. 275k! He screams. SOLD!

That last guy got the car. But what if the auction didn't end there? If it kept going what do you think would happen to the price? Furthermore, lets say there were a million Ferrari's up for auction. If this was the case (as it is) then the cars would sell for the highest price people are willing to pay for them given the laws of supply and demand. In other words, there would be a balance.

The market works in a similar fashion. If it is not trending it is trying to find a balance. Part of our job as traders is to find that last guy willing to buy or sell, and take the other side of his position. The theory being that price will return to the balance where the most contracts where traded and likely to the opposite end of the range (where the most hands are going to be up).

Looking at the volume ladder will show this theory in action. First observe the tick chart on the far right corner of the image above. You can see that buyer's responded to lower prices at the support zone (zones are provided my around 2:23 PM EST. An aggressive trader would try to fade the extreme but a move conservative trader would likely enter on a pull back. Let's assume the latter. You can see in the bottom panel of both charts that cumulative delta continues to improve as price pulls back to the moving average. At first price seems to find support at 1250.75, but how do we know to take a long?

Let's look now at the volume ladder on the left. 1250.75 is the dash blue line. The fist test attracted 162 contracts, which you can see in the bottom left box on the ladder. The second test only 100 contacts were sold at the bid, AND a huge block of buyers stepped in. They picked up 2,169 contracts at the ask. That's your first clue. The third test only a mere 110 contracts sold at the bid. You can begin to see selling drying up. Price responds by moving higher and the cumulative delta continues to improve leading into the fourth and final test of our level. On this last test of 1250.75 you can see that ONLY 3 contracts traded! Flashback to our Ferrari auction.. The guy that sold those last 3 contracts is the winner of the action.

Now can you see how to spot when selling is drying up? Fewer and fewer contacts trade at that price (fewer hands going up) until the selling (or buying) just shuts off. The entry on this trade could have been 1251 with the first target at the Volume Point Of Control, where the most trades took place. That level I marked with a white arrow is 1252.50. As you can see the contract did trade back to that level, in fact slightly higher. This quick scalp could have netted you six ticks or $150.00 on two contacts. Not bad for 15 minutes of work!

In the future I'd like to do more of these posts. I have found market profile and auction theory to be a huge help in my trading. I will continue to use the blog to document my learning and share setups and ideas with everyone else. Thanks for reading, I appreciate any comments and I love to connect with fellow traders so feel free to email or Skype me. I hope everyone has a safe and Merry Christmas and a Prosperous new year. Take care


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