Many traders ignore volume. Although volume is a simple concept, it is difficult to analyze correctly due to inherent challenges in the markets. These challenges make it impossible to read true volume with standard volume indicators. Read through this article to learn the best way to overcome volume distortions and how using a TradeStation indicator called Time Segmented Volume will increase your trading “edge”.
Often traders use average volume indicators where the average of volume is calculated over a given number of past bars to see if volume is increasing or decreasing over that time period. It is okay to look at volume this way, but you will be missing the most vital volume information. This is not the best approach to analyze volume.
Volume has inherent distortions which cause faulty analysis by many traders. For example in the stock market (and other markets to a lesser degree), the opening of the day is fraught with a multitude of orders that had built up overnight and all get processed at once. This large influx of trade volume creates a major distortion to what is actually happening in the market.
Another distortion is created in the middle of the day when the majority of market makers go to lunch and market activity slows down immensely. This is called the lunch doldrums.
A third distortion happens at the end of the day, when traders try to adjust their orders before the market closes. They may want to be flat overnight or they might want to get into a trade, but this influx of orders at the end of the day is another distortion to volume.
Another inherent challenge to using a volume average indicator is that every instrument has considerably different levels of volume. For example compare, GE with 40 million shares per day vs. a stock with 100,000 shares per day. This vast difference makes it difficult to read volume from one symbol to another symbol.
Additionally, if you change from one time frame to another there will be huge volume differences. The volume on a 1 minute bar chart is much different than the volume on a 60 minute bar chart or a daily chart. The key to getting past these challenges is to use the time segmented volume TradeStation Indicator.
Time segmented volume is the way to get consistent volume data and eliminate all the volume distortions that we discussed above. Here’s the key to why time segmented volume works: Let’s start with volume on a 5 minute chart and for this example, look at the 10:15 bar. Now take the average of only the 10:15 bars over the prior month and compare that average to the current 10:15 bar. The difference will give a true reading on whether today’s 10:15 bar volume is higher or lower in comparison to the exact same time bars over the past month.
Now when you read the 10:15 bar you read the price bar against the volume bar. For example, let’s say the price action shows a larger than normal bar, maybe 2 times normal. Let’s say price started out close to the bottom of the bar with no wick, and it runs up and closes close to the top of the bar. This means a strong bullish bar, but if you look down and you see less than average volume, then you should be cautious about the price movement. In contrast, if you see 200% or 300% percent volume you’ll know that increased volume was the reason for the extra large price bar. In this example the price bar and volume bar are in harmony.
Alternatively, if you saw that same 200% – 300% volume bar, but the price action looked completely different, let’s say it was a bar that was 1.5 times normal size. Let’s say it started very close to the bottom for the open, it ran up to a high and then it pulled back and closed in the lower third. This is a bearish sign. Now this would be saying a major switch took place and the volume was cause by bearish selling volume. The sellers came in and over dominated the buyers and pushed it from the top of the range clear down into the bottom of the range before closing. If this bar occurred at the end of a multiple bar move up it is probably the end of the up cycle and it might be time to reverse your trade direction.
The key to understanding volume is reading price action and volume action on the same exact bars, using time segmented volume to give you the true volume information you need, and reading the chart to see if price and volume are in harmony or if they are divergent. Time segmented volume can confirm the move, make you suspect of the move, or tell you if it is the end of the move and if a likely change in direction is coming. In any case, using time segmented volume will eliminate volume distortions and increase your trading edge.