How to use volume for trading

Introduction

Volume is a key fuel that drives the market. Volume tends to reveal when major operators are moving in and out of the market. Without volume, nothing moves. Although price is best indicator of potential future price movement, the volume offers additional evidence to corroborate bullish or bearish setups. 

Volume can indicate potential underlying weakness and be a timing indicator for potential breakouts. Volume with bar range also offers insight into the actions of buyers and sellers, especially when extremely low or high volume is present.

What is volume?

Volume is the number of shares or contracts traded over a specified period in any trading market, such as stocks, bonds, futures, and options. In the spot forex market, there is no true volume reported but tick volume is used. 

What is tick volume?

Tick volume is the number of recorded price changes, regardless of volume or the size of the price change that occurs, during any time interval. Tick volume relates directly to actual volume, because as the market becomes more active, prices move back and forth from bid to ask more often. 

If only two trades occur in a 5-minute period, then the market is not liquid. Tick volume gives a reasonable approximation of true volume and can be used as a substitute. Higher-than-normal tick volume at the beginning of the day implies higher volume throughout the day.

How is volume portrayed?

The most common portrayal of volume is a vertical bar representing the total amount of volume for that period (usually at the bottom of the price chart). Figure 1 shows volume statistics for Apple using this method. This method is simple and assumes no direct relationship between price and volume. It just displays the data.

Figure 1

The relationship between price and volume

Volume is regarded as a supporting or secondary indicator of potential future price action. Volume is an indication of market participation.

To confirm the trend, volume should do one of two things (seen in Figures 2 and 3):

1. Increase as price rises and decrease on any downside retracements in a preexisting uptrend (bullish volume action). 
2. Increase as price declines and decrease on any upside retracements in a preexisting downtrend (bearish volume action). 

Figure 2

Figure 3

When studying volume, you should remember two basic principles:

1. A rise in volume indicates that market participants are interested in seeing the price go higher in an uptrend (or lower in a downtrend) and are willing to buy higher in an uptrend (or sell lower in a downtrend) to participate in the unfolding market action.
2. A decline in volume indicates that market participants are losing interest in seeing the price go higher in an uptrend (or lower in a downtrend) and are more willing to buy lower in an uptrend (or sell higher in a downtrend), as shown in Figures 4 and 5.  

Figure 4

Figure 5

Volume Divergence

When comparing price and volume patterns, you’ll want to determine whether they align. If so, the probabilities favor an extension of the trend. If price and volume disagree, this tells us that the underlying trend is not as strong this is called a volume divergence, as shown in Figures 6 and 7. 

Figure 6

Figure 7

Volume precedes price

Technicians believe that volume precedes price, meaning that the loss of upside pressure in an uptrend or downside pressure in a downtrend shows up in the volume figures before it is manifested in a reversal of the price trend. 

Volume normally leads to price during a bull move. A new high in price that is not confirmed by volume should be regarded as a red flag, warning that the prevailing trading trend may be about to reverse, as seen in Figure 8. 

Figure 8

Volume buying and selling climaxes

Buying climax, also called blow-off, occurs at market tops prices suddenly begin to rally sharply after a long advance, accompanied by a large jump in trading activity, and then peak abruptly. The buying climax candle often closes near the middle or the low of the candle, which suggests there is a good short-selling opportunity and the high of the buying climax candle will be a strong resistance, as shown in Figure 9. 

Figure 9

A selling climax occurs at market bottoms prices suddenly begin to drop sharply after a long decline, accompanied by a large jump in trading activity, and then bottom abruptly. The selling climax candle is often close near the middle or the high of the candle. This suggests it’s a good buying opportunity and the low of the selling climax candle will be strong support, as shown in Figure 10. 

Figure 10

Two‐Dimensional Volume Analysis

You can also analyze volume two-dimensionally by (shown in Figure 11): 

• Volume by price identifies the total volume traded at each price level.
• Volume by time represents the total volume traded over a specified time interval or period.

Figure 11

Volume indicators

Technical analysts can use four key volume-related indicators, all with the purpose is of determining whether the current price movement is supported by trading volume. Here’s how each of the four works: 

1. On-balance-volume (OBV)

The daily data that is cumulated into the index is the volume for the day adjusted for the direction of the price change from the day before. Thus, it is the total daily volume added to the previous day’s index if the price close was higher and subtracted from the previous day’s index if the price close was lower than that of the previous day. This index is a cumulative sum of the volume data and is plotted on a daily price chart. 

The idea behind the OBV index is that high volume in one direction and low volume in the opposite direction should confirm the price trend. If the high volume is not confirming the price trend an impending reversal is suggested. Figure 12 shows Apple’s stock price versus the OBV indicator. 

Figure 12

2. Volume oscillator

The volume oscillator is merely the ratio between two moving averages of volume. It’s used to determine when the volume is expanding or contracting. Expanding volume implies strength to the existing trend, and contracting volume implies weakness in the existing trend. It’s useful as a confirmation indicator for trend and for giving advanced warning in a range or consolidation formation of the direction of the next breakout. 

For example, if within the trading range, the oscillator rises during small advances and declines during small declines, it suggests that the eventual breakout will be upward, as seen in Figure 13. 

Figure 13

3. Money flow index (oscillator)

Another method of measuring money flow into and out of a stock is the money flow index (MFI). It considers “up” days and “down” days to determine the flow of money into and out of equity, shown in Figure 14. 

The MFI is an oscillator with a maximum of 100 and a minimum of 0. When positive money flow is relatively high, the oscillator approaches 100; conversely, when negative money flow is relatively high, the oscillator approaches 0. 

Figure 14

A level above 80 is often considered overbought and below 20 oversold. These parameters, along with the period, are obviously adjustable.

4. Volume-weighted average price (VWAP)

If there is one level widely used by large institutions, it is VWAP, shown in Figure 15. Huge transactions seek to execute at the price level where the VWAP is found and that is why it has elevated its level of importance. 

The VWAP represents the average price of all contracts traded during a particular period. It is displayed on a chart like a traditional moving average and its position varies as trades are executed. Generally, depending on the trading style, the VWAP of the session, the weekly or the monthly is used. 

The VWAP is used by institutional traders primarily as an average to determine the value of the asset at that point in time, so they consider that they have bought low if the price is below and high if it is above. Institutions have taken the VWAP as a reference measure with which to judge the quality of their executions, hence its relevance and the fact that we treat it as an important trading level.

Figure 15