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First Steps in Understanding Volume Analysis and How It Leads Price


First Steps in Understanding Volume Analysis and How It Leads Price

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Basically, volume is a measurement tool that reflects the overall activity in an instrument based on the number of buyers and sellers in the market. In other words, volume shows the enthusiasm of buyers or sellers during a specified period, as well as the liquidity of the instrument. Although volume may be displayed differently on charts, it is typically displayed as a single, non-directional, histogram which represents the total number of buyers and sellers for a given period. Non-directional means that as price is making higher highs or lower lows, the volume bars will typically be making new highs.

Typical volume indicators represent the overall number of buyers or sellers for each specified bar. A trader may look at this type of volume representation to evaluate the liquidity of the instrument. This tells him or her whether there is sufficient activity to enable one to enter or exit a position easily.

Volume can also be displayed as Volume Up (buyers) or Volume Down (sellers). This type of volume bar shows the volume displayed as two separate indicators, Volume Up (green histogram bars) and Volume Down (red histogram bars). By displaying volume in this manner, a trader can compare the buying volume to the selling volume for a specified period.

By comparing the two volume displays, a trader can assess whether there is more enthusiasm shown by the buyers or by the sellers during a specified period. In an uptrend, buyers should have more enthusiasm than sellers. When a market reaches a top, buyers will lose enthusiasm and sellers will take over. In a downtrend, sellers should have more enthusiasm than buyers. At the bottom, sellers will lose enthusiasm and buyers will take over.

The biggest issue for new traders, when studying volume, is identifying these specific patterns — or volume divergence as it is referred to. The first step is simple — understanding volume divergence.

Volume divergence is when price goes in one direction and volume goes in the opposite direction. For example, a few types of volume divergence that are revealed when using a non-directional volume indicator (all volume histogram bars are plotted above a zero line):

  • Price is making a higher highs

    • Volume is making lower highs
  • Price is making equal highs

    • Volume is making higher highs
  • Price is making lower lows

    • Volume is making higher lows
  • Price is making equal lows

    • Volume is making higher lows

When volume divergence is identified, then the trader can expect an immediate short-term reversal. For example, when volume divergence occurs on the highs, the trader would anticipate a reversal to test for sellers. In order for price to reverse and create a downtrend, sellers must show interest. If no interest is shown, then price will continue on its original path.

As with most other trading indicators, volume can be as complex or as simple as a trader chooses to make it. Today, there are many types of volume indicators available. Some are based on averages of actual transactions of buyers versus sellers over a specified period. Others are based on order flow, a measurement of buyers versus sellers from actual order flow. Some are more complicated than others and there is no one volume indicator that is magical. The efficacy of a volume indicator is more dependent upon how well the trader can understand and interpret the volume at any given period than on the indicator itself.

Source by Gail Mercer

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