If an underlying price has been trending sharply for some time, do you take an opposite trade? If yes, you are said to be fading the price. This week, we look at a tool that will help you decide on fading prices using derivatives.

Time price opportunity

Market profile chart captures price on the Y axis and time on the X axis. Typically, time is represented in 30-minute blocks. The price during the first 30 minutes is denoted by A, the next 30 minutes by B and so on. If an underlying opens at, say, 790, then the chart prints A in the first column against the price. If the price continues to move up during the first 30 minutes, the chart continues to print A vertically for each price. Suppose the price at the start of the next 30 minutes is same as the last price in A, then the chart will print B horizontally next to that A. You can determine the most-accepted price that the underlying takes during a trading day. This price is referred to as the point of control and will have the most horizontal letters printed on the chart.  

Two structural aspects to the chart that is important for fading prices are the poor high and poor low, and one-time framing. Picture an underlying that is rising intraday, but traders are unwinding long positions towards the end of the day. This could be an indication that the price may fail to rise the next day — an opportunity for you to fade the price. Note that fading refers to betting on price reversals.

Using market profile chart, you can decide to fade a price when you observe a poor high or poor low. Take the last two time-blocks, L and M. Suppose L period ends at a price of 820 and M starts printing at 820 and the price does not move up. It could be because traders are unwinding their long positions. This is referred to a poor high, meaning the high is structurally weak. Prices could reverse by the end of trading and continue downwards the next day. The point of control becomes your price target if you want to fade the high. On the downside, you could decide to fade the low when you identify a poor low.

It is best to use futures to fade prices, given that fading prices is an advanced strategy. The benefit with futures contract is its near one-to-one movement with the underlying compared to options. You must, however, use tight stops to manage the trade, as the strategy is risky.

Who does it suit?
Fading prices are short-term trades, appropriate for intraday traders and buy-today, sell-tomorrow traders
Optional reading

One-time framing occurs when no subsequent time period (block of 30 minutes) trades below (above) the previous time period when prices are rising (falling). It is risky to fade such trending prices. Note that fading prices are short-term trades, appropriate for intraday traders and buy-today, sell-tomorrow traders.  

The author offers training programmes for individuals to manage their personal investments