First Steps in Understanding Volume Analysis and How It Leads Price

Basically, volume is a measuring instrument that reflects the overall activity of an instrument based on the number of buyers and sellers in the market. In other words, volume shows the enthusiasm of buyers or sellers over a period of time, as well as the liquidity of materials. Although the volume may appear differently on the chart, it is usually displayed as a single, non-directional, histogram representing the total number of buyers and sellers for a given period of time. Non-directional means that as prices move higher or lower, volume bars will usually create new highs.

The General Volume Index represents the total number of buyers or sellers for each specific bar. A trader can look at this type of volume presentation to assess the liquidity of the material. It tells him or her that there is enough activity to enable one to easily enter or exit a position.

Volume may also be displayed as volume up (buyer) or volume down (seller). This type of volume bar shows the volume displayed as two separate indicators, volume up (green histogram bar) and volume down (red histogram bar). By displaying volume in this way, a trader can compare the amount of purchase with the amount of sale for a given period of time.

By comparing the two volume displays, a trader can evaluate whether buyers or sellers have shown more enthusiasm in a given period of time. In an uptrend, buyers should have more enthusiasm than sellers. When a market reaches the top, buyers will lose motivation and sellers will take over. In a downward trend, sellers should be more motivated than buyers. Below, sellers will lose motivation and buyers will take over.

The biggest problem for new traders, when studying volumes, is identifying these specific patterns – or as referred to as volume divergence. The first step is simple – to understand volume divergence.

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

  • Prices are rising higher
    • Volume is made low low high
  • Prices are creating equal heights
    • Volume highs are made
  • Prices are going down
    • The volume is made higher or lower
  • Prices are falling equally
    • The volume is made higher or lower

When volume divergence is detected, the trader can expect an immediate short-term reversal. For example, when there is a volume divergence in height, traders will expect a reversal to test sellers. In order to counteract the price and create a downward trend, sellers must show interest. If no interest is shown, the price will continue on its original path.

Like other trading indicators, volume can be as complex or simple as a trader chooses to make it. Today, many types of volume indicators are available. Some are based on the average of actual transactions between buyers vs. sellers over a period of time. Others are based on order flow, buyer vs. seller measurement from actual order flow. Some are more complex than others and there is no one volume indicator that is magical. The effectiveness of a volume index depends on how well the trader understands and interprets the volume over a given period of time.

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