There’s a reason why trading volume has been a standard indicator on every piece of charting software over the last 30 years… it provides a crucial edge.
Volume provides you with logical insight into the activity of market participants at varying price levels. I believe volume analysis helps traders to become more reactionary to price movements rather than trying to predict where price will go next, as is the case with most technical indicators.
There’s countless tools and indicators for you to learn as you dive deeper into volume, but they all require an understanding of basic volume analysis. This guide is the initial primer you’re going to need before diving deeper.
So, let’s get into it!
What is Trading Volume
Trading Volume is the total number of shares or contracts a security traded for a user defined session. Traders analyze volume to determine the intent and aggression of market participants.
When trading stocks, volume will be expressed in shares. Whereas, when trading derivatives such as index futures, volume will be expressed in contracts.
When you buy a stock, you “share” in the ownership of the company. Whereas, a futures “contract” is a legal agreement to buy or sell a particular commodity or security at a predetermined price at a specified future date and time.
Trading volume is calculated by simply taking the number of shares or contracts exchanged between a buyer and seller in a single transaction.
For example, if you buy 100 shares of TSLA from a seller, the total volume for that transaction is 100.
Buy and sell transactions like this occur repeatedly throughout the trading session.
The volume indicator keeps track of all these transactions and displays them as a histogram on the x axis of your charting software. The time period each volume bar on the histogram represents will be determined by the chart interval you decide to use.
For example, every volume bar on the daily chart seen below represents the total volume traded for that day.
Most traders find it useful to add a simple moving average to the volume indicator to easily spot higher than average volume as seen below.
Now that you have a basic understand of how volume is calculated, let’s look at how you can use volume to improve your trading.
How to Use Trading Volume
We analyze volume to confirm breakouts, continuation of trends, and trend reversals. Shortly, we will look at some real examples, but first you have to understand the story that volume tells you.
The easiest way to understand volume and its relationship with price movement is to think about what’s happening in terms of market participation when volume is increasing versus decreasing. It’s not very complicated, so don’t over complicate it, as is often the case in trading.
Volume increases as more market participants (buyers and sellers) enter the market.
Volume declines as market participants leave the market.
We use our knowledge of participant activity to confirm trends, breakouts, and reversals.
Let’s look at some examples to illustrate this.
1. Trend Confirmation
In order for a security to trend, the rising prices in an uptrend or falling prices in a downtrend must attract new market participants to enter the market. Failure to do so will lead to the trend stalling and price action going sideways (chop) or reversing.
In the above example, price is trending upwards and takes out the $10 handle (heavy resistance notated by number of sellers).
Once price broke through $10.00, new participants failed to enter the market as represented by the declining/flat volume.
Simply put, not enough new aggressive buyers entered the market above the $10 handle to take price higher.
As price stalls, buyer’s who bought the surplus of offers at $10 will begin to liquidate their positions driving prices down ending the trend.
In this example, when price breaks through the $10 we see new participants come into the market confirmed by the increase in volume and the trend continues.
This process repeats over and over in every trend until price reaches a level that fails to attract new market participants.
Let’s take a look at a real example on the eMini-S&P 500.
On the above 15 minute chart you can see the uptrend continued to be confirmed as volume continued to rise with price. Notice how the trend eventually stalls as volume declines.
You can use volume not only to confirm a trend but to assist in your trade management as well.
For example, if you hold a long position in an uptrend and begin to notice volume starting to decline (similar to the above example) you can exit some or all of your position.
2. Breakout Confirmation
Similar to confirming the continuation of a trend, we can also use volume to confirm the start of a new trend as price breaks out of a range.
In the above example, price breaks out the range on higher than average volume, signaling new participants entering the market, increasing the odds the sell off will continue.
We can also use volume to spot false breakouts as seen below.
Price broke out the bottom of the range, but lower prices didn’t bring new participants in the the market notated by below average volume.
3. Reversal Confirmation
When I’m looking to play a reversal in the market I want to see capitulation.
Capitulation is a dramatic surge of buying pressure in a rising market or selling pressure in a declining market. As the move accelerates, it will reach a point where traders unwilling to suffer further losses snowballs, leading to a surge in price as traders make a mass surrender.
Capitulation can mark the end of a trend as those who didn’t exit during the panic are unlikely to do so soon after.
Capitulation shakes out the so called “weak hands”, traders lacking conviction, and replaces them with more risk-tolerant holders who may not have suffered losses in the recent decline, resulting in a price reversal.
Volume Based Indicators
Now that you have a solid grasp on trading volume, let’s take a look at a few more volume indicators you can use to further expand your volume analysis.
1. Volume Profiles
First on the list is volume profiles, which are at the core of most of my trading strategies.
Volume profiles can be used to:
- Develop context around your trading patterns
- Determine if markets are imbalanced or balanced
- Determine areas of high and low liquidity (HVN’s and LVN’s)
- Determine key areas of support and resistance
If you’re interested in learning more about volume profiles I’ve written a comprehensive guide you can read here.
2. Volume Weighted Average Price (VWAP)
Volume-weighted average price (VWAP) is an indicator that plots the average price a security has traded throughout the day, based on both price and volume.
It’s a benchmark used not only by intraday traders, but other time frame participants as well.
VWAP can be used to:
- Determine areas of high liquidity
- Find retracement opportunities
- Determine trend (from an intra-day perspective)
3. Average Daily Volume
Average Daily Volume is simply a user defined moving average of daily volume. The most popular among traders is a 20 or 30 Simple Moving Average. (I use 20)
You already know everything you need to in order to use this indicator.
You will apply the confirmation techniques you just learned to confirm trends, breakouts, false breakouts, and reversals but now it’s simply on a daily chart. This can provide you with macro context for your intraday setups.
Let’s go through the chart above as an example.
Pre-market I would have looked at this chart and recognized that yesterday we broke out of the range on higher than average volume.
As you learned earlier, this increases the odds that price will continue to move lower as new participants are entering the market.
Now this doesn’t mean I’m just going to go short on the open. However, it’s going to give me a short bias when trading intraday.
I most likely would have been less aggressive with my trade management on short positions and much tighter management on long positions.
Volume analysis is an extremely powerful tool for day traders, one you can build an entire trading career around. Trading volume is just the tip of the iceberg when it comes to volume analysis.
Dive in and check them out.
If you have any questions or something cool to say about trading volume, make sure to leave a comment below!