Volume Profile, often hailed as the trader’s secret weapon, is a graphical representation of trading activity over a specified time period. Unlike traditional price-based charts, Volume Profile focuses on the volume of trades at each price level, offering a unique perspective on market dynamics.
Throughout this post, we’re going to be using the Futures Market as our main asset to break down our concepts. These tools can be used on other assets as well.
Setting the stage for inflection points exploration
Inflection points, the pivotal junctures where trends may reverse or accelerate, are a vital component of Volume Profile analysis. By understanding and effectively utilizing these points, traders can make informed decisions that have the potential to yield substantial profits.
You even wonder how to identify large opposing swings in the market?
Are you ever in a position and it’s going well just to see the whole move reversed in lightning-speed fashion? Confused even by what had happened and why?
This is exactly what we’re going to delve into.
Definition and Purpose
At its core, Volume Profile is a tool used to visualize trading volume at different price levels within a specified time frame. The purpose is simple yet profound: to identify areas of high and low trading activity. These areas, often represented as histograms on a chart, reveal critical support and resistance levels.
Volume Profile constructs these histograms by taking the total traded volume at each price level and plotting it as a bar. This results in a bell-shaped curve, referred to as the Volume Profile, which highlights price levels where significant trading activity has occurred.
To navigate the world of Volume Profile effectively, it’s crucial to grasp essential terminology:
- Point of Control (POC): The price level at which the most significant volume has traded.
- Value Area: The price range encompassing a specific percentage of the total volume, often 70% or 80%.
- Virgin or Naked Point of Control: A POC that has not been revisited in subsequent trading sessions.
- Value Area High/Low: The top and the bottom levels of the value area.
- Low volume nodes: Levels in the volume profile that have low volume traded (indented)
- High Volume nodes: Levels on the volume profile that have high volume traded (extended)
- Initial Balance (IB): The range within which the majority of trading occurred during the first hour of the trading session.
If you want to learn the bare bones of Volume Profile and How it’s used, before you dive into the intricacies of inflection point trading take into consideration the following resources:
The role of Volume Profile in market analysis
Volume Profile is an indispensable tool for market analysis, offering insights that extend far beyond traditional technical indicators. Its key roles include:
- Identification of areas of balance and imbalance that allow us to understand smart money concepts and market direction.
- Identification of Support and Resistance: Volume Profile helps traders pinpoint precise support and resistance levels, increasing the accuracy of entry and exit decisions.
- Confirmation of Breakouts: Volume Profile can confirm the validity of price breakouts. A breakout with high volume is more likely to be sustained than one with low volume.
- Revealing Price Gaps: Gaps in the Volume Profile indicate areas where price has moved rapidly, potentially serving as future support or resistance zones.
Defining inflection points
Inflection points are critical junctures on a price chart where the trend may change direction or accelerate. They are the focal points of Volume Profile analysis, often associated with key price levels that attract significant trading activity.
Types of inflection points
Distribution Ledges: These are the ending points of a balance, not to be confused with value area highs and lows. Rather these are areas that enclose a balanced area, stalling price from exiting, moving into imbalance. These are areas where large traders or strong handed traders are known to appear.
Point of Control (POC): The POC is a crucial inflection point, indicating the price level where the most significant volume has traded. It often acts as a magnet for price. We’re going to be focused on VPOC (virgin points of control) because these areas are of higher probability for rejections to happen.
Value Area High and Low: The boundaries of the Value Area are also inflection points. Breakouts above or below these levels can signal potential trend changes.Again, as mentioned above, virgin areas are a better indication of where the turning point in the market can happen.
The theory of inflection points, why do they happen?
The first thing that we need to understand is where do these inflection points come from? They’re created by strong-handed traders who enter into a position or start exiting positions. A strong-handed trader gets into an area where they want to reverse price, where they think that they can influence price movement. These general areas are going to be areas where the volume goes from heavy to light on a profile.
This means the first expected inflection point to consider is the ledge of a larger distribution on a volume profile. A larger profile is a cumulative profile.
In this case, we use a 50-day cumulative profile so we can see the volume stacked up over a 50-day period.
Below we’ve encapsulated the large distributions that are obvious and visible in the red boxes and the ledges where there are key drop-offs in volume with blue lines.
These are the first areas where we would expect to see inflection points in the market.
Price inside of balance is expected to stay in balance, meaning selling tops and buying bottoms. Price outside of balance is expected to hold outside of balance.
The second aspect of inflection points using a volume profile comes from individual sessions.
This is where we bring out our virgin levels. These are levels that traded on a session but haven’t been traded again.
There are 3 virgin levels we should note:
- VPOC (virgin point of control): The largest volume of a session trades at this level. Traders can go further and note where the POC of the week, month, quarter sits, see if any of these levels are “Virgin” levels which will provide a large inflection point in the market.
- VVAL (virgin value area low): A value area low that was created during a session and wasn’t traded again.
- VVAH (virgin value area high): A value area high that was created during a session and wasn’t traded again.
These areas are worth noting, especially if they haven’t been traded in a very long time and if they are clustered together in a key region.
Let’s do a case study on the above inflection points.
- The red box encompasses the area of interest.
- The purple line is the VPOC from the session most to the left.
- The grey line is the VVAH from the session most to the left.
- The third arrow on the right is the large volume profile ledge that was created from the 50-day cumulative profile.
Notice that we have a general area where we expect prices to reject. Between 4361 to 4370. This is a wide area of about 9 points or so, which can be used on a wide stop. However, better yet a trader should confirm that the region will hold and where it’ll hold. Using something like order and volume as confirmation is a good start.
What does this actually look like on a chart? The move that created these naked levels was the overnight session from September 25th, 2023. The retest of the area happens on the overnight session of September 28th, 2023, and the following morning session, of September 29th, 2023. Both sessions trade into the resistance and fail.
In the image below, the area where the resistance should be met is circled by the red box. You have a few good opportunities to short within the block on lower risk before we exit and run to the downside.
Volume Profile Shapes & Inflection
Volume profiles can have different shapes and the creation of these shapes can give traders insight on what had happened in the session and the expected next move of the market.
There are 2 specific shapes that are generalized turning point triggers or inflection points in the market.
- P-shaped profile: This profile has limited volume throughout the move to the upside, which is thin shot to the upside. At the top of the profile, you have consolidation and large volume creating the distribution at the top of the “P”. This would suggest that traders are exhausted on the move higher, longs are getting stuck at tops, because they cannot move any higher. This allows sellers to step in at the highs and present a pullback.
- b-shaped profile: This profile is generally created by a downside move. There is limited volume on the move down until a consolidation forms at lows. This creates the distribution at the end of a down move. These moves are generally created by sellers weakening into lows allowing buyers to step in and reverse price.
Case Study of Volume Profile Shapes:
Below we have both a “P” shape (top, in red box) and a “b” shape (at lows, green box) these indicate price reversals.
Ideally price hasn’t started running already before the shape fully forms.
The thing to understand is that trading is not a perfect science when these moves come about, so you have to use other confirmation. Now, keep in mind the reversal of the moves is VERY high probability, as long as the session closes with price in the distribution of each shape.
Entries & Exits on Inflection Points & Volume Profiles
Execution of the trade makes or breaks the trade, with all the analysis in the world if the execution isn’t good, there won’t be a good trade.
That means you have to understand what entries & exits look like.
When you come into an area: distribution ledge, VPOC, VVAL, VVAH, you want to use these areas as confluence and enter around this region with stops above or below, depending on which direction the expected rotation is going to go.
Overall the entry should be around a key region, starting off basing entries at large distribution block ledges found on the cumulative volume profile (50-day). You can use confluence of other levels as confirmation.
Exits are either to profit or to stop.
That means you have to understand the expectation of the move, is it going to be worth the risk to reward planned?
You would want to exit at another level of inflection, generally a large distribution area, another ledge that is extended away.
In conclusion, Volume Profile is a powerful tool that adds depth to technical analysis. By understanding its basics, recognizing inflection points, and integrating it with other indicators, traders can make more informed decisions. Whether you’re a day trader, swing trader, or long-term investor, Volume Profile has the potential to enhance your trading strategy. As you delve further into this analysis method, remember that practice and continuous learning are key to mastering it. So, embrace the world of Volume Profile, and may your trading journey be filled with insightful inflection points and profitable opportunities.