A look at volume based indicators

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A Look At Volume Based Indicators

Volume Indicators For Binary Options

Volume is a well known indicator of market direction. The number of people involved in a given movement, relative toe the number of people involved on an average basis, is an key metric defining the strength or lack of strength in the market. The trouble is that tracking changes in volume on your own on other than very basic level can be quite messy. Fortunately for us there are a number of volume based indicators that can be of service to us. These tools are great methods of finding trend following signals as well as potential areas of reversal.

On Balance Volume

On Balance Volume or OBV for short is an indicator developed in the 1960’s by Joseph Granville. He believed, and rightly so, that a change in underlying volume without a representative change in stock price, was an indication of future movement. His theories were incorporated together to form this indicator which compares the closing prices of two consecutive trading sessions. If the price on the second day is higher than that on the first that days volume is considered “up volume” and added to the previous day’s reading. If the second candles close is below the first day that volume is considered to be “down volume” and subtracted from the previous days reading. Over time the indicator will display convergences and divergences that are timely indications of potential market reversals.

The Volume Oscillator

The Volume Oscillator is a basic volume tool that uses two moving averages to create its plot. There is one fast and one slow moving average, usually 14 and 28 bars respectively. The fast moving average is then subtracted from the slow moving average to create the indicator. An increase in volume associated with an increase or decrease in prices shows strength in the underlying trend. Likewise, a decrease in volume can show an underlying weakness. In this way the indicator can confirm trends, predict breakouts and reversals and produce trend following signals. Because of the way in which this indicator is derived it can change direction very quickly, making the longer term analysis ie peaks and troughs, more valid.

The Force Index

The Force Index is a tool derived by Dr. Alexander Elder and described in his book “Trading For A Living”. This is a great book and a recommended read but that is another story. This indicator uses volume and price action to produce a reading of the strength, or “force”, of a movement. Dr. Elder believes that three things account for market movement; direction, extent and volume and this indicator takes all three into account.The formulation is very simple. The close of the current period is subtracted from the close of the prior period and then multiplied by the volume, thus if today’s close is higher the resulting number will positive and if today’s close is lower the reading will be negative. The bigger the move and the bigger the volume the more force behind the move. While not as good for determing direction from day to day, or bar to bar, it is a great tool for measuring trend strength through convergence/divergence and for identifying areas of potential reversal.

Volume Flow Indicator

The Volume Flow Indicator is considered by many to be an improvement on the OBV, which is already a decent indicator. The major differences are in how the data is derived and then how it is displayed. Unlike OBV which compares two closing prices and then simply adds or subtract volume the VFI uses a more complex calculation. First, the VFI uses “typical” prices, which is the average of the high, low and close. This is then applied to volume to produce a positive or negative reading with certain cut off limits that are intended to smooth out wild swings in volume. This is then smoothed again using a moving average, usually 50 bar, to produce a super smooth oscillator that travels above and below a central zero signal line. This indicator is easier to use than the OBV because it produces less whipsaws but also means you may have to wait a little longer for a signal to fire. Like with all oscillators this one is good for a number of different type of signals including divergence, convergence, support and resistance, trend strength and crossovers.

volume based indicators produce similar signals but not all are the same.

My Last Thoughts

These are all great tools and incredibly useful for traders. However, I think that VFI is the best and easiest to use. The formulation is more complex but with the smoothing creates an easier to read indicator and one that will produce far less false signals. If you look at my graphic above you can see that the first three indicators all produce a line that more or less follows the same path while the VFI produces a much different line that is more in tune with the underlying market trend. However, whichever you choose, I am sure it is easy to see just how well the addition of a volume based indicator can be to your strategy.

Volume-Based Indicators

Volume-based indicators represent another important group of indicators used in technical analysis. They help us to spot even very small changes in volume traded in the market, which often precede a trend reversal. Information yielded by these indicators is most valuable during the last stages of a trend.

Introduction

The notion “volume” denotes the overall amount of contracts (stocks, currency lots or futures) that was traded in the market during the given period of time. Volume can be viewed according to selected timeframe, i.e. we can view the volume traded for one minute, one hour or one day.

Technical analysts view volume as an indicator, which informs us about the pressure on change of the price. If volume is high, the pressure to change the price in direction of the current trend is high, which implies that the trend will probably remain in effect for some time. On the other hand, when volume is low, pressure to change the price is low as well, which means that the current trend will probably end soon.

This theory is based on the premise that higher volume traded in the market means that more traders are willing to execute their trades at the current prices. They either believe that current pricing of the contracts is correct or that the trend will still remain in effect for some time. Conversely, if the volume is low, there are only few people willing to execute their trades at the current prices, which means that they either believe that the current pricing of the contract is inadequate or that the trend is going to reverse soon.

This implies that the volume should be rising and be higher when the price is moving in the direction of the trend. For example, if there is an upward trend in the market, then the volume for the days when prices were rising should be higher than for the days where prices were falling. If this is not the case, a divergence between volume and price exists. Such a divergence often precedes the end of the trend.

Purpose and use

Volume-based indicators can be just like the volume considered both leading and confirming indicators. This means that they can detect changes in the trend even before they manifest themselves, but they can also be used to confirm or reject signals generated by other indicators or technical analysis methods (e.g. chart patterns).

Besides, many traders believe that volume precedes the price. According to this idea, every significant move in price should be preceded by either a rise in volume (if a new trend is emerging) or a fall in volume (if a trend is ending).

Some of the volume-based indicators function as oscillators, whereby they help the trader to determine the time when the price is changing very fast and a correction is impending by generating the overbought /oversold signals.

However, probably the most common use of these indicators is represented by finding divergences between price and volume. If the price is still reaching new highs, but the volume is dropping, there is a bearish divergence in the market, which usually precedes the reversal of the upward trend. Conversely, if the price keeps attaining new lows, but the volume is dropping, there is a bullish divergence, which precedes a trend reversal and thus can be considered a buy signal.

Pros and cons

The main advantage of this group of indicators compared to other indicators or methods is that they take into account the two most important kinds of data available in the market, namely the price and the volume. Almost all other indicators take into account only the price. Hence, in theory, volume-based indicators should provide us with better and more precise trading signals.

On the other hand, volume can also distort generated signals, which happens mainly when the trend starts on low volume, which increases only gradually. That’s why these indicators should be used together with other tools of technical analysis.

Money Flow Index (MFI)

MFI is a special kind of oscillator that reflects changes in price as well as changes in volume in the particular market. Like most of the oscillators, it is primarily used to detect overbought/oversold stages of the market, but it can be also used to find divergences between MFI and price. MFI is computed as follows:

We first compute the typical price for a given day:
Typical price= (day’s high + day‘s low + day’s close)/3

Subsequently, we use the typical price to compute the money flow for our market on the given day:
Money flow = typical price for the day X volume traded on the day

The money flow approximates to some extent the value of stocks that were traded during the day. We compute money flow for all the days in our selected period (usually 14 days). After this we separate the days into the days with positive money flow (i.e. the days on which the typical price was higher than the previous day’s typical price) and the days with negative money flow (typical price lower than the previous day’s typical price). In case the day’s typical price is equal to the previous day’s typical price, the day is ignored.

  • Positive money flow represents buyers’ confidence about rising prices.
  • Conversely, negative money flow represents sellers’ confidence about falling prices.

    Subsequently, we compute the money ratio:
    Money ratio = (sum of positive money flows ) / (sum of negative money flows)

    Finally, we compute the MFI itself as:
    MFI = 100 – (100/ (1 + money ratio))

    MFI can reach the values from 0 to 100. It works like a standard oscillator and is very similar to RSI.

  • Readings above 80 represent the overbought zone and thus constitute a sell signal.
  • Conversely, if the indicator reaches values under 20, it implies an oversold zone and thus represents a buy signal.
    Divergences are found in the same manner as with other oscillators. For example, if the price reaches a new, higher high, but the MFI does not attain a new high or even decreases, it constitutes a bearish divergence, which precedes the end of the trend. Similarly, if prices during a downtrend keep reaching new lows, but the MFI does not, a bearish divergence is in place, which usually precedes the end of a downward trend.

    Force index

    Is an indicator developed by the famous trader Alexander Elder, which measures trend’s strength, while recognizing its direction. It reflects both price and volume traded in the market. Force index’s values represent buying or selling pressure in the market. If the values are very high (and positive), it means that there is a big buying pressure in the market that is pushing the price upward, and that’s why a strong upward trend is in effect. Conversely, very low negative values indicate selling pressure and thus a strong downward trend. Force Index is computed according to this formula:

    The result of this computation is smoothed by the means of an exponential moving average in order to decrease indicator’s volatility. However, Force Index is most often present in the charts in form of a histogram, whose midpoint value is 0. Most traders buy in case the exponential moving average of the Force index is negative and conversely, they sell if this average turns positive. However, according to Elder, the trades should not be made against the direction of the trend that is represented by 13-day exponential moving average of Force index.

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    How to Use Volume to Improve Your Trading

    Volume is a measure of how much of a given financial asset has traded in a period of time. For stocks, volume is measured in the number of shares traded and, for futures and options, it is based on how many contracts have changed hands. The numbers, and other indicators that use volume data, are often provided with online charts. Looking at volume patterns over time can help get a sense of the strength or conviction behind advances and declines in specific stocks and entire markets.

    Basic Guidelines for Using Volume

    When analyzing volume, there are usually guidelines used to determine the strength or weakness of a move. As traders, we are more inclined to join strong moves and take no part in moves that show weakness—or we may even watch for an entry in the opposite direction of a weak move. These guidelines do not hold true in all situations, but they offer general guidance for trading decisions.

    Key Takeaways

    • Volume measures the number of shares traded in a stock or contracts traded in futures or options.
    • Volume can be an indicator of market strength, as rising markets on increasing volume are typically viewed as strong and healthy.
    • When prices fall on increasing volume, the trend is gathering strength to the downside.
    • When prices reach new highs (or no lows) on decreasing volume, watch out; a reversal might be taking shape.
    • On Balance Volume and Klinger Indicator are examples of charting tools that are based on volume.

    Trend Confirmation

    A rising market should see rising volume. Buyers require increasing numbers and increasing enthusiasm in order to keep pushing prices higher. Increasing price and decreasing volume might suggest a lack of interest, and this is a warning of a potential reversal. This can be hard to wrap your mind around, but the simple fact is that a price drop (or rise) on little volume is not a strong signal. A price drop (or rise) on large volume is a stronger signal that something in the stock has fundamentally changed.

    Exhaustion Moves and Volume

    In a rising or falling market, we can see exhaustion moves. These are generally sharp moves in price combined with a sharp increase in volume, which signals the potential end of a trend. Participants who waited and are afraid of missing more of the move pile in at market tops, exhausting the number of buyers.

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    At a market bottom, falling prices eventually force out large numbers of traders, resulting in volatility and increased volume. We will see a decrease in volume after the spike in these situations, but how volume continues to play out over the next days, weeks, and months can be analyzed using the other volume guidelines.

    Bullish Signs

    Volume can be useful in identifying bullish signs. For example, imagine volume increases on a price decline and then the price moves higher, followed by a move back lower. If the price on the move back lower doesn’t fall below the previous low, and volume is diminished on the second decline, then this is usually interpreted as a bullish sign.

    Volume and Price Reversals

    After a long price move higher or lower, if the price begins to range with little price movement and heavy volume, this might indicate that a reversal is underway, and prices will change direction.

    Volume and Breakouts vs. False Breakouts

    On the initial breakout from a range or other chart pattern, a rise in volume indicates strength in the move. Little change in volume or declining volume on a breakout indicates a lack of interest and a higher probability for a false breakout.

    Volume is often viewed as an indicator of liquidity, as stocks or markets with the most volume are the most liquid and considered the best for short-term trading; there are many buyers and sellers ready to trade at various prices.

    Volume History

    Volume should be looked at relative to recent history. Comparing today to volume 50 years ago might provide irrelevant data. The more recent the data sets, the more relevant they are likely to be.

    Volume Indicators

    Volume indicators are mathematical formulas that are visually represented in most commonly used charting platforms. Each indicator uses a slightly different formula, and traders should find the indicator that works best for their particular market approach. Indicators are not required, but they can aid in the trading decision process. There are many volume indicators to choose from, and the following provides a sampling of how several of them can be used.

    On Balance Volume (OBV): OBV is a simple but effective indicator. Volume is added (starting with an arbitrary number) when the market finishes higher, or volume is subtracted when the market finishes lower. This provides a running total and shows which stocks are being accumulated. It can also show divergences, such as when a price rises, but volume is increasing at a slower rate or even beginning to fall.

    Chaikin Money Flow: Rising prices should be accompanied by rising volume, so Chaikin Money Flow focuses on expanding volume when prices finish in the upper or lower portion of their daily range and then provides a value for the corresponding strength. When closing prices are in the upper portion of the day’s range, and volume is expanding, the values will be high; when closing prices are in the lower portion of the range, values will be negative. Chaikin money flow can be used as a short-term indicator because it oscillates, but it is more commonly used for seeing divergence.

    Klinger Oscillator: Fluctuation above and below the zero line can be used to aid other trading signals. The Klinger oscillator sums the accumulation (buying) and distribution (selling) volumes for a given time period.

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