Justin is an active trader with more than 20-years of industry experience. He has worked at big banks and hedge funds including Citigroup, D. E. Shaw and Millennium Capital Management.
Trading strategies, which consider the amount and nature of trading activity in any market, work on the basis that they offer an insight into market direction, which price data alone just can’t offer. Make no mistake, price is the ultimate measure of any investment or trading idea and will always be the determinant of profit or loss, but volume-based analysis incorporates other factors.
Building an understanding of the nature of the dynamic relationship between buyers and sellers can be used to create strategies that give an indication of where price may be heading next.
There are several popular volume-based trading strategies. All are based on freely available market data and basic maths. However, the subtle differences in how they are calculated means that they offer a slightly different take on market mood. They’ve been around a while so are an established part of technical analysis. Even if you don’t intend to use volume trading strategies yourself, knowing what other traders are using to make their decisions is always a good thing.
In this article, we’ll use real-life trade examples to look through:
One analogy to consider is an open outcry trading pit, which characterised most stock and commodity exchanges prior to them being computerised. A day when hundreds of traders are taking part in a huge number of deals and price moves of a small amount is a better indication of market sentiment than one when a handful of traders carry out a small amount of business and price moves a lot.
The day with higher volumes gives a better idea of how the ‘real’ money views the market and a better idea of the direction it will head despite the price move being smaller.
Measuring this money flow can be done in a variety of ways.
This measure considers the change in volumes over time. If using a daily timeframe, the volume traded on day two is added or subtracted from the volume traded on day one. On days when the closing price on day two is greater than the closing price on day one, the second period’s volume is added to the previous one. If the closing price in the second period is lower, then the second volume number is subtracted from the first.
The cumulative nature of this sequence continues, so that on day five, the number is added or subtracted from that of day four, which is a number based on the data from days one to four.
The daily price chart for GBPUSD shows OBV declining over a period of months. The key periods to study, and those that back up the credentials as being a leading indicator, are when price is trading sideways but OBV is trending. This represents momentum building up to a point where price then follows the lead provided by OBV.
In the below chart of daily GBPUSD prices, OBV starts to trend downwards on 26th May, as marked by the first red bar, but price trades sideways. It’s not until 11th June that price ‘catches up’ and starts to fall. Due to the divergence, the price fall is more extreme from that point and marked an opportunity to sell short based on OBV trending in the previous days.
The Volume by Price measure applies the simple trick of displaying the data on the vertical axis. This switch means that it’s easy to identify the actual amount of an asset traded at specific price levels. As a result, there is an opportunity to spot where the real money is buying and selling in the market.
Keeping a track of the points where institutional investors are getting involved offers a good clue as to the next price move.
The above Volume by Price chart shows the year-to-date price moves for Microsoft stock. The bars on the left-hand axis, which protrude the most and display the peak in trading activity, occurred in February, March and April when the stock was trading between $230 and $237.50. In the below chart, it’s possible to see the green segment of the longest bar – which represents buying activity at that price level – extending further out into the chart than all but three other complete candles.
What does this tell us? The subsequent price surge gives a clue. It was at this price range that real money moved into the market to take long positions. This period was preceded by a price fall, and anyone who was still selling in March and April was bailing out and passing their positions on to institutional players such as pension and hedge funds. They built positions by easing into positions over an extended period of time, so as to get in at a good low average price until the moment came when sellers left the market and price rallied.
Volume-based strategies don’t necessarily need to incorporate clever mathematical principles to be effective. The features on OBV and Volume by Price are nice to have, but even a higher-level view of volumes can help to identify trading opportunities.
Following the core data relating to volumes captures the essence of using trading volumes to spot days when important trends are confirmed. Any day with a spike in trading volume is associated with a greater number of buyers and sellers being involved in coming to a consensus about which way the market is going.
In the week beginning 24th February 2020, trading volumes in the US 500 index spiked from 7,082,554 to 21,703,220. The threefold increase in activity was a major flag that a significant market move was about to take place. The S&P 500 lost 9.6% in value during that week of peak volume, but the aftershocks carried on for some time afterwards, and by 23rd March the index was another 25.67% lower in value.
The trading opportunity in the S&P 500 case study was to sell short on the back of the uptick in volume, with a stop loss set above the top of that first weekly candle. As this particular move was part of a major market sell-off, the exit point is not marked by another spike in volume. In fact, the moment that markets turn and head upwards again is associated with a drop in volumes. This reflects ‘normality’ returning to the market and the panic being over. The change in tick volume was a reduction in size, but it still provided a reliable indicator to enter into long positions.
Big funds, which are the ultimate drivers of prices, are well aware that their actions can distort the market. If the real money is keen on taking a position, it has to build its position with a degree of patience or else its own buying activity can drive price away from the target entry price. They use strategies such as VWAP to help them average into positions, and while the price might not move, the volumes data will. This is why volume trading strategies can offer an insight into the workings of the market and act as a leading indicator of price moves.
Tick Volume and OBV offer up valuable information about the state of the market and that something is going on. They don’t offer much specific help in terms of setting trade entry, trade exit points and stop loss limits.
In the case where these measures generate a trading signal, trade execution levels and stop losses would need to be calculated using price-based metrics. A whole range of supporting indicators then come into play, including moving averages, Fibonacci levels and Heiken Ashi candlesticks.
The Trade by Volume metric does offer a better steer on what price levels are important. It comes down to the data being handily presented on the vertical axis of the chart. In the case of Microsoft, the price range between $230 and $237.50 represents a significant support level. Between February and April 2020, this was the level where real money considered the sell-off in the stock and thought that enough is enough. Stop losses set below $230 would work on the basis that a large segment of the market considers this the point where the stock is undervalued and worth buying.
In terms of trade exit points, volume is again relatively limited in terms of being able to convert the sign that sentiment is changing into an exact price figure at which to close a position. It can signal that exiting a trade might be a good idea, but not necessarily at which price level.
Trade by Volume calculations again have the edge over OBV and Tick Volume because they can illustrate at what level the real money is beginning to close out positions. Other indicators, such as a break of the 10-day simple moving average, would need to be brought into play, particularly if trailing stop losses are to be applied.
Volume strategies are great at providing a clear indicator of a potential breakout, but all indicators benefit from being used in conjunction with others. Whatever your trading style, incorporating signals from the below strategies can improve trading performance:
When considering what else to incorporate into a volume-based strategy, it is also worth questioning the chosen timeframe. Adjusting chart timeframes from one hour, to one day, to one week can offer a different view of the situation.
Successful trading is based on spotting the direction in which most of the market is heading, and volume-based strategies offer a clue to sentiment shifting. One potential hazard to watch out for is that a volume spike is due to a support or resistance level being tested, rather than a full-blown reversal forming. Another disadvantage is that volume strategies can point to something happening in the markets, but converting this into price entry points requires the use of other indicators.
Volume is an important metric to follow. A lot of other strategies, such as trendline breakouts, work more effectively when volume is incorporated into the decision-making process. Strategies that use volume as a primary indicator, such as OBV and Trade by Volume, tend to be more effective in quieter markets when it’s easier to spot the moves made by ‘real money’. However, when they work, they can offer a chance to get into a trend at the very start of its move.
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