Market profile is one of the most advanced charting technique which is used by technical traders to predict future price movements. It has received enough traction since last few years in the algorithmic trading ecosystem. Read our introductory article on Market profile here, which would help you to understand the basic concepts. In this post, we would understand how to trade options using market profile.
The leverage that options provide can be dangerous for your capital if you don’t manage the risks properly. Many people suggest using option spreads to mitigate the risk and some suggest to use it as a hedging instrument for your future and cash positions. But I find these suggestions to be useful only for those who have a slightly longer term view on the markets.
If you are like me who wants to keep the exposure duration to minimum, then you need to trade options at the right time. Timing is the key to successfully trade options on the shorter time frame. Market profile is one of the most effective methods to time your option trades.
Why timing Option trades is important?
The reason timing your trades is important is because of following reasons:
- Time value of options: We all know the inverse relation of time to expiry and value of options. And if you trade out of the money options then this becomes a bigger issues for option buyers.
- The Non-linear nature of option movements: At the money option is supposed to have a delta of 0.5 i.e. a 10 point move in the underlying should give you a 5 point move on the ATM option, but this relation does not always hold.
- Adding to it the effect of volatility on premium and you have a seemingly unsolvable equation on your hands.
Many accounts have gone bust trying to trade options because it provides the promise of great reward at seemingly insignificant capital outlay at the outset.
For instance, at the time of writing 11 Sep 2017 Nifty ATM Call option with 10000 Strike price is trading at 110/- that is a total cost for buying that option of 8250/-. Compare this to the contract value of roughly 7,50,000/-. So you can effectively get the benefit of trading 7,50,000/- worth of Nifty by paying 8,250/-.
But that is what most traders fall for. This extreme leverage also has the other side. If the price does not move in your favor or it remain sideways, the time decay kicks in and your capital will evaporate
Even when the price moves in you favor and the volatility drops you stand to make negligible profit as drop in volatility causes drop in option premium.
Common Solutions You Should Not Try
Now people try a variety of things to cope with this problem. They try ratio spreads, use black box timing systems, apply all sort of technical studies to the option charts, try to chase breakouts and breakdowns, and many many more things.
But all these have questionable success ratios. How do I know about this, well trust me I have tried every thing in my 12+ years of trading career.
“So is there not a way out of this rut?”, you ask. I say there is a definite way out of this. You can use these beautiful trading instruments to your advantage. Also avoid falling into common traps that are set for gullible traders who flock to these highly leveraged instruments in search for quick profits.
Trust me there is no free lunch on the street.
Market Profile – My Preferred Solution
I have struggled with all the problems mentioned above and found that the best solution is Market Profile. Now, Market profile is not a trading system, but it helps you to improve your market understanding a great deal.
How does improved market understanding helps in trading options?
Well, it helps in the following ways:
- Timing your trades to perfection.
- Avoid getting into options at the wrong time.
- Achieve great reward to risk ratios.
- Most importantly, reduce the stress inherent in trading options.
All you have to do is follow the step by step model I would outline below to start trading options using market profile.
See Market Profile In Action – Real Trade Example
First of all let me take you through an example to trade options using market profile. A real trade I took and shared in my private slack group.
One of the key principles I use in my trading is that of “expected and unexpected behavior”. The following examples highlights this very important concept in trading. Lets look at the charts below:
The chart shows that Day 1 was a nice ‘D’ shaped curve, which signifies that the market is in balance as per Market profile. Both buyers and sellers are present in equal strength.
Day 2 moves sharply lower below Day 1 range, thus trapping the buyers in that zone. Now if we reach this zone again the trapped buyers would like to exit and that will create supply in the markets.
It shows an Order Flow Chart (my primary timing tool). The rally in F period as seen from the above chart shows that market was trying to enter the supply zone from Day 1. And if market finds acceptance inside the supply zone we would see further continuation of up move.
But the order flow chart shows a lot of strong buying (deep green prints) when price was trying to enter the supply zone. And the expected behavior of such strong buying is continuation of up move. But the next period ‘G’ could not take out the high of F period, suggesting exhaustion on part of buyers.
This was our opportunity to initiate a short trade or buy put options.
This chart shows the subsequent follow through to the short trade. We exit part of our trades at a fixed target and rest we carry with a trailing stop loss. The trade shows the first part which was exited at a fixed target of 2:1 reward to risk ratio.
Above examples were shared just for educational purpose, to show how using Market Profile and Order Flow charts can improve your trade timing.
Step by Step process to trade Options using Market Profile
Step 1: Study the prior day’s activity and prepare 2-3 potential scenarios which can guide your trading the next day.
Here is the chart of our preparation on the prior day. You can see we had outlined clearly a bearish possibility and marked important levels on the chart. We also marked the blue ovals which gives an idea on what action we have to see to expect a certain move.
Step 2: Be flexible, since markets do not care about your preparation. The preparation is for yourself. See how we moved much lower than what was envisioned in PAP2 (Potential Auction Paths). Also, the markets never could move above the 24324 levels to warn us of any potential up move.
Step 3: Use reliable timing tools to spot precise entry points. We don’t put trades blindly at previously marked reference levels. But we study the markets development in real time and position ourselves accordingly to take advantage of the fleeting opportunities. In present case, the moment the order flow chart showed potential for a short we jumped on to our favorite option.
Step 4: The payoff from a successful options trade can be huge in percentage terms. The current trade gives more than 50% payoff on the buy price within matter of minutes. But don’t be fooled by this as this huge payoff has another side too. Unless you have great analysis and timing tools like Market Profile and Order Flow charts. You cannot expect to be on the right side of the markets all the time. So have a sensible trade management plan to book profits in a phased manner.
Step 5: Record your trades both profitable and loss making, so that you can come back later to it and learn what was it that led to a nice trade. You can then try to repeat the same process and keep reaping the rewards.
So, this is how I trade markets using Market Profile charts. I primarily use Market Profile charts to understand the current context the market is operating in. This helps me formulate the possible scenarios that may develop over near future to take advantage of.
Then, I use my favorite timing tool Order Flow chart to pinpoint my entries and exits, the way it is seen in the example above.
Let me know in the comments section what you feel about my method. Feel free to ask any questions or doubts I will be happy to answer.