The Concept of Volume and Price
One of the parameters that can be used to confirm the trend of a currency pair is volume. Volume can be defined as the number of contracts that are traded within a specified time period. The time period referred to here could be a day, a week or a month. It could even be as low as one tick.
Volume is well suited as a confirmatory parameter in forex, because the forex market does not suffer from undue arbitrage. Volume data can be incorporated into price charts in different ways. These are listed below:
- Candlestick Charts
A candlestick chart may sometimes display a volume bar as a vertical bar which represents the total volume for the specific time frame, below the main price bar. This picture below indicates what this looks like:
- Equivolume Charts
Equivolume charts incorporate data about price and volume into a single bar. They were created by Richard W. Arms in 1971. The charts are created by widening the price bar along the horizontal plane, with the degree of widening being proportional to the volume traded within the time period. So while the vertical length of the bar represents the price range for that period (high and low prices), the horizontal width of the bar represents the volume of the asset traded.
According to the Arms’s Equivolume charts,
- A candle with a wide body shows heavy volume.
- A candle with a thin body shows light volume.
- Red candles show that price is decreasing, while a black candle shows that price is going up.
The significance of these candles is seen at price extremes. Heavy volume at the end of a brief price correction indicates that buyers are about to swarm the market. The reverse is also the case. When a wide down candle forms after an upside correction, it is an indication that sellers would soon storm the stage to force a downtrend.
The snapshot below illustrates how a wide, up candle which also closed above the horizontal resistance (R), provided an early signal on the entry of buyers into the market, eventually forcing the trend upwards. Price can clearly be seen rallying up to form new highs.
Richard Arms Jr. was also able to use the shape, height and width of the rectangular price/volume bars to give information about price range as well as volume. He also found that the use of supplementary tools such as trend lines and channels also provided extra signals which enhanced the performance and results obtained with his equivolume charts.
Volume Statistics: The Role of Indicators
Volume change and not volume itself, is the statistic that is most important when using volume to confirm trends. Volume changes to the upside when prices are rising or declining, is indicative of a continuation of the trend. If the volume starts to decrease in an uptrend or downtrend, this could be an early sign of trend reversal. Higher volume is more significant in an uptrend than in a downtrend.
If price advance or decline is halted even when the volume is high, this is a sign that the trend has potentially come to an end.
Two sets of indicators incorporate volume in their action. These are indexes and oscillators.
Indexes are usually represented by single lines in the indicator window. Index lines may lead or lag; a trader should be more concerned with indexes that lead. Leading indexes change direction before the price does and are therefore predictive. This provides an opportunity to trade a divergence of the index line and the price. Examples of volume-based indexes include the On Balance Volume (OBV) and the Accumulation Distribution Indicator (AD).
Oscillators tend to move from one market extreme to another, making them good for trading range-bound markets. They are also amenable to being used in trading divergences and also for trend line-based trades. Examples of volume-based oscillators are Money Flow Index (MFI), Volumes Indicator and Chaikin Money Flow indicator.
The On-Balance-Volume (OBV) is defined as the sum of the daily volume which has been added to the previous day’s index if the closing price was higher than the previous day’s close, OR subtracted from the previous day’s index if the closing price was lower than the previous day’s closing price. The OBV is best plotted on a daily chart.
By itself, the OBV line offers no help. But the trend of the OBV relative to the price is of importance. Recall that we earlier said that the volume-based indexes such as the OBV change direction before the price does, and is therefore useful in spotting divergences.
- If price attains a new high but the OBV does not, this is negative divergence which could precipitate a downside reversal.
- If price is attaining new lows but the OBV fails to do so, an upside reversal may be in the offing as a result of the positive divergence.
These two scenarios only work when markets are trending. In a range-bound market, the support and resistance of the OBV index line is then used as the trading signal of choice. A break of the support or resistance will indicate a price breakout in the direction by which the break of the OBV support or resistance has occurred.
OBV in a trending market showing negative divergence
The snapshot above shows what happens when the OBV indicator is used in a trending market to showcase a negative divergence. A trend line is used to connect the highs of the OBV index line on one hand, and the price highs on the other. The directions of the trend lines differ, with that of the OBV pointing downwards while that of the price highs is still rising. The negative divergence trade entry was confirmed by the appearance of the bearish engulfing pattern, leading to a sell entry signal.
OBV indicator showing trend line break signal in a range-bound market
The second situation shown here is that of the OBV indicator at work in a range-bound market. Here, a trend line is applied to the price highs as well as the OBV index line highs. The signal is only valid when the OBV breaks its trend line resistance, which incidentally occurred when price was pulling back to its own broken trend line that now acts as a support. The BUY entry point is shown on the charts.
Money Flow Index
The Money Flow Index measures the flow of money into and out of a security. Buyers make money flow into a security, while sellers take money out of a security. The Money Flow Index uses the up days (when buyers are on top) and the down days (when sellers dominated the market) to determine how money flowed into or out of the security.
Money Flow Index = 100 -100 / (1 + MFR) where MFR is the Monet Flow Ratio, calculated using the positive and negative money flow for a time period.
As an oscillator, the range of values of the Money Flow Index is between 0 and 100.
- Values between 80 and 100 indicate high money flow and an overbought market.
- Values closer to 0 indicate low money flow and values that are <20 indicate an oversold market.
The Money Flow Index can be used to detect overbought/oversold signals (in a range bound market) as well as divergence signals in a trending market.