Futures trading is one of the most popular and liquid traded assets in the world. However, a lot of traders get confused as to what’s really important when trading futures, where to start, what to learn, and how to trade profitably. Futures are leveraged assets where the wins can be substantial but the losses can also be amplified so it is really important to understand what a good futures trader needs to take it to that next step of profitability. Introducing the volume profile. The volume profile is the main tool that futures traders need to understand on a deep level and use on a daily basis. Throughout this article, there will be a full explanation of the volume profile, how to use this tool, and create a trading strategy from that.
1. What is the volume profile?
2. Distribution theory
3. Creating a trading plan and levels
The volume profile is a simple trading tool that can be found on any software. Throughout this post, we are going to focus on the use of a platform called Sierra Chart for futures. You can learn more about Sierra Chart on their website and here on our Youtube Channel. The examples used in this article will be based on the S&P500 E-mini futures. The ES or commonly known as the “SPOOS”. If you want a really good understanding of the futures market, check out this full futures trading article, the Ultimate Guide.
1. What is the Volume Profile?
The volume profile is a vertical volume tool that will appear on the left-hand side or the right-hand side of your chart. What this tool represents is the volume traded at each individual level on the market you’re looking at.
The volume profile can be created from multiple cumulative days and sessions, making one large profile on either side of the screen or split up into different sessions. The futures market trades the regular trading hours (RTH from 9:30 AM EST to 5:00 PM EST) and the extended trading hours (ETH from 6:00 PM EST to 9:29:59 AM EST). Meaning the profiles can be split up into different sessions. Just the image below. Where we show the RTH in a yellow box and the ETH in a green box. The cumulative 20-day total volume profile is on the most right-hand side of the chart.
As you noticed, in the image above there are a lot of numbers and boxes, below is a quick explanation of what these areas are and what are the most important aspects of the volume profile.
1. The blue area on each session profile: The value area.
a. The value area is 70% of the daily traded volume on each profile.
b. This is “balance” in price where the price would want to hold.
c. Volume attracts price, so large areas of volume become “balance” for price
d. The value area is enclosed by the value area high and the value area low.
e. These value area highs and lows extend and can act as support/resistance levels.
2. The yellow line in the volume profile: The point of control (POC).
a. The POC is the largest level of volume traded in a single session.
b. Most contracts trade at the POC that is why it extends so far on the profile.
c. The longer the volume profile level extension the more volume trades. The smaller the less volume trades.
d. The long areas of volume are called high volume nodes.
e. The small areas of volume are called low volume nodes.
f. The POC is an area where a lot of chop happens in price, because price wants to stay in that area.
g. Trades use the POC as a magnet, rather than an area to initiate trades.
3. The red lines: Ledges in the profile.
a. A ledge is created when a high volume node drops off into an immediate low volume node, creating a volume profile shelf.
b. These ledges are really strong support and resistance levels.
4. The blue box: A distribution.
a. This is an area where you have multiple high volume nodes that come together to create a market belly.
b. This is a large area of volume traded, where price can find “balance”
c. Price would get attracted to these areas and look to trade from one end to the other.
d. The distribution is enclosed by a ledge on either side.
e. Price moves from distribution to distribution.
2. Distribution Theory
Distribution theory or commonly referred to as auction theory is how the market moves based on balance and imbalance. There are laws associated with the theory that will be discussed. Overall the theory states that the market will stay in balance as long as we stay in large areas of volume (distribution), otherwise an escape of the balance, the price becomes imbalanced and will run through either end.
When price moves into balance that is considered “fair value”, outside of balance, price is considered “unfair value”.
Distributions are bellies on the volume profile which can be seen either as value areas on the individual session chart or the cumulative volume profile.
Here are the “laws” of Distribution Theory:
1. Price inside of balance is expected to maintain within balance and reject the ledges of balance (either value area levels or distribution ledge) until proven otherwise.
2. If the price accepts into balance, it is likely to revert to the other side of that balance. Meaning if the price is imbalanced and we move back through the value area high or low, the expected move is through the balance to the other end. Into the other value area high or low.
3. Price within balance is considered “choppy”, there will be less fluid movements within balance. This is because a balance is a larger area of volume and price is attracted to most of those points within the balance. Unable to use ledges or low-volume areas as areas of movement/rejection.
4. If the price is accepted outside of balance, there is a high chance that the price becomes imbalanced. When price moves through a distribution ledge or value area high/low, the price can revert back but the general consensus is that the ledge will now hold as a barrier for the price to continue into imbalance.
5. The target of the imbalance break and move through balance is a prior balance area. The first target would be that session’s POC. Usually, on volume profile charts that your software has, you can allow for the “naked” POC areas to extend until they are traded again. A naked POC is a POC that hasn’t been traded since it was formed.
6. As the price gets into a new POC level (usually a target after moving into “imbalance”) there is a strong reaction to the level. This means traders should look to avoid initiating positions at the POC, but rather target the POC from an existing position. The aggressive reaction of the POC usually disrupts Law 1. Where the expected move is the other end of the balance.
7. Price is known to retest the ledges of balance, whether it’s a value area high/low or a ledge that was created. This is going to create not only a ledge in the profile but really strong support and resistance to the playoffs.
3. Creating a Trading Plan & Level Identification
Now that we’ve understood distribution theory and what we’re looking at based on how markets move we can break it down further. A market will move from distribution to distribution and look to stay in high-volume areas. This can identify the direction in the market as well.
First and foremost we can identify large distributions, then levels of support and resistance (based on ledges), which can then lead to trading plans. Very similar to the ones we post in our trading room on a daily basis.
Take a look below how our plan worked out. The key “long area confirmed” was the 4000 area where we have the pink arrow.
The first green arrow is 3987-88 where we identified our first long opportunity in the plan above, which turned into the low of the day… From that area, we went up to 4072. This is all based on distributions and the volume profile. The red areas arrows are targets to the upside and expected resistance, look how well price bounced off those levels, even if it was temporary it is a reaction that confirms the levels. Then the green arrows are the pullback levels after we break and retest the key areas.
To create a plan we have to understand the following:
1. Where are the large distributions on a 20-day profile?
2. Are we within any of these large distributions?
3. Where did the prior price close & where are the overnight traders going to close?
4. What are all of our key levels based on ledge profiles?
Then we can start getting into the plan. The plan involves a pivot area, above which we are looking for the longs, then below we are going to be looking for shorts. Now naturally there are possibilities of fades on any of the levels. The general guidelines of a plan is to break down your sentiment based on the distributions and levels drawn.
In the image above we have:
- Green large boxes: these are the largest distributions based on the 20-day profile. Price would want to stay within these areas as “balance”. An escape of these areas would push price into the next large distribution block above.
- Blue smaller boxes: these are intermediate distribution blocks that are within the larger distributions. They act the same way and the ledges are used in the same way. As support/resistance levels.
- The levels from the ledges are drawn in gray small lines that extend throughout the whole chart.
From this each day we can develop a plan. For example over the last few days, we finally got close above a distribution block (the first bottom large green box) and price moved above 4050 into the close. This suggested that the longs were in control. The fact that we moved OUTSIDE of balance and became imbalanced. We would target the coming balance areas. In this case, it’s to the upside. Meaning we are bullish biased. Then we are looking to play our levels as support to get buy side moves.
With that information we can identify the pivot of the session, this is usually the level (ledge) that cuts apart different distributions and breaks up longs from shorts. Which can be the start of the bottom of the second green box. In this case 3987-88. Anything above we look for the long side continuation. Break and retest. Under we can look for the shorts.
All in all these plans are given in our futures trading room each morning and guided analysis throughout the day. There is a lot of value in distribution theory and a lot taught in our community. Always remember, large volumes want to attract price. If you can identify ledges, you will have good levels. And not all ledges are good areas! Find where the large distributions form.
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The information contained in this post is solely for educational purposes and does not constitute investment advice. The risk of trading in securities markets can be substantial. You should carefully consider if engaging in such activity is suitable for your own financial situation. TRADEPRO AcademyTM is not responsible for any liabilities arising as a result of your market involvement or individual trade activities.