Volume is the only other historical information available apart from price when it comes to analyzing stocks in the spot market however it not all give the attention it deserves, especially by the beginners. Volume Indicators help us in interpreting the volume data by either smoothening it or combining it with the price.
Volume data can help one confirm price trends, breakouts, support/resistance levels, patterns, etc. as the volume is an indicator of mass participation and interest in any security.
What is Volume? :
The market consists of buyers and sellers. For a trade to occur, both must settle at a particular price. If there has been a transaction of one share between them, it means that the volume has increased by one. Volumes can also be seen in futures and options or the derivative markets. In the derivative markets, one unit of volume represents a trade of 1 contract or 1 lot.
The volume bars
The volume bars are most often plotted below the price. Each bar represents volume for the respective price candle. Increasing or decreasing the height of the bars represents increasing or decreasing volume as the height is proportional to the volume. The exact value of the volume can be known by hovering the mouse over the bars.
The color of the volume bar depends on the closing price of the candlestick. If the close is higher than the previous close, the color of the volume bar is green. If the close is lower than the previous close, the color of the volume bar is red.
Popular Volume Indicators:
Volume Weighted Average Price:
The indicator looks just like the moving average when it is plotted on the price. VWAP represents the average price throughout the day which is weighted by volume i.e price moves with higher volumes are given more weightage while calculating the indicator.
VWAP can be used to identify the direction of the trend during the day. One interesting thing about the indicator is that it is plotted only on intraday timeframes from 1 min to 4 hours. The indicator is not defined for Daily or higher candle intervals.
Institutional traders often refer the VWAP to place their trades. They use the indicator as a benchmark to decide whether the current price is good for buying or if the stock is overpriced. If the price is trading below the VWAP, it is said to be at a discount for the day whereas if it is trading above the VWAP, the price is considered expensive. The indicator often becomes unreliable during the opening of the day
The calculation :
Typical Price = (High+Low+Close)/3
The calculation of the indicator is reset at the opening of each trading day.
On Balance Volume Indicator:
On Balance Volume indicator is plotted below the price. The indicator relates volume flow to changes in the price of the stock. The indicator is formed by cumulating a total of positive and negative volumes. This will be explained again when we discuss the calculation of the indicator. The indicator is used to confirm the price movement. If the price is making a new high, OBV also must make a new high otherwise a condition of divergence is formed and it indicates a potential reversal.
The divergence condition is shown in the image below. As we can see, when the higher high was not confirmed by a new high in OBV indicator, the prices declined. This is a bearish divergence condition. There are various different types of divergences and they can be applied with other indicators as well. We will cover divergences in detail in our upcoming posts.
- If the current candle’s closing price is higher than the previous candle’s closing: Current OBV = Previous OBV + Current candles’ volume
- If the current candle’s closing price is equal to the previous candle’s closing price: Current OBV = Previous OBV
- If the current candle’s closing price is lower than the previous candle’s closing price: Current OBV = Previous OBV – Current session’s volume
Money Flow Index:
The money flow index is an oscillator that oscillates between 0 and 100. It uses price and volume data to identify overbought and oversold conditions. When the indicator is above 80, the price is said to be overbought. When it is lower than 20, the indicator is said to be oversold. The divergence which was discussed earlier can also be applied using the Money Flow Index.
The formulas are :
- Calculate the Typical Price of each of the last 14 candles.
- Decide whether the Raw Money Flow will positive or negative for each candle. If the typical price is higher than in the previous period, Raw Money Flow is positive. If the typical price is lower, Raw Money Flow is negative.
- Calculate the Raw Money Flow of each candle by multiplying the typical price and volume of all the individual 14 candles. The value should be negative or positive depending on the step 2 conditions.
- Add positive money flows and negative money flows and calculate Money Flow Ratio as per the formula shown above.
- Use the ratio calculated in step 4 to calculate the Money flow Index.
The calculation looks very overwhelming however it is just for understanding. The indicator value is calculated automatically by the charting platform.
Volume is a very important data which is available along with the price. Volume and volume indicators are used to confirm the price move. Price moves confirmed by or accompanied by high volumes are more significant and strong. In this post, we have discussed three common volume indicators. In the upcoming 2nd part, we will be covering more indicators.
These indicators can be combined along with the indictors calculated purely from price to create trading strategies. The strategies must be backtested before it is used for trading in the live markets.