What is Volume?

Volume refers to the total number of transactions that occur over a given time period. That is, in the case of derivatives trading, the number of times a contract exchanges hands. Every transaction in a market contributes to that market's volume.

Traders often observe volume trends to guide trading strategies and make important decisions. Staying abreast of volume patterns enables traders to forecast the magnitude and direction of price action with greater efficacy. Looking at volume tells us about market dynamics that include price and time components.

Examples of Volume-Influenced Market Dynamics

• High-Liquidity Periods

• Price Ranges

• Contract Rollover Considerations

High-Liquidity Periods

Increasing volume is a byproduct of more buying and selling, which is naturally correlated with tighter bid-ask spreads. When the bid-ask spread is tight, traders are able to enter and exit positions at more favorable prices.

Similar to how options traders look at Implied Volatility (IV) relative to Realized Volatility (RV), traders can look at Average Daily Volume over time to see how today’s levels match up against historical levels.

During the 2017 crypto rally, volume predominated in the early morning Asia hours. Since then, the highest-volume crypto trading periods have gradually shifted to mirror U.S. equity market hours. Peak crypto market volumes are converging on the U.S. market open and close.

Key Price Levels

Volumes often spike or plummet at particular thresholds. An influx of volume as price dips to a support level may indicate traders flipping bullish. An influx of volume at a support level may hint at shorts piling in or longs being liquidated.

Decreasing volume as price falls to a resistance level may signal traders flipping bearish as the momentum behind a rally fizzles out. Volume does not differentiate between the opening, closing, buying, or selling of positions, so it's a useful but not all-telling metric.

Contract Rollovers

Rollovers refer to the process by which traders exit dated derivatives contracts approaching expiry and replace them with longer-dated contracts in order to maintain exposures without dealing with settlement and expiration.

Rolling a futures contract allows traders to preserve their positions and subvert potential risk-management imbalances. When the volume of the longer-dated contract surpasses that of the shorter-dated contract, traders tend to roll.

Declining volume in a futures contract approaching expiration often prods traders holding the contract to close their positions and replace them with longer-dated contracts.

Looking at Volume, Price, and OI to Guage Market Sentiment

• Volume ⬆️, Price ⬆️, OI ⬆️ = Bullish 📈

• Volume ⬇️, Price ⬇️, OI ⬇️ = Bullish 📈

• Volume ⬇️, Price ⬆️, OI ⬇️ = Bearish 📉

• Volume ⬆️, Price ⬇️, OI ⬆️ = Bearish 📉

Sharp price swings accompanied by dramatic changes in volume (i.e, exhaustion moves) are often emblematic of altered fundamentals, whereas sharp price swings accompanied by minute changes in volume are typically less noteworthy.

The beginning or end of a trend is often preempted by exhaustion moves (sharp and concurrent fluctuations in price and volume). Exhaustion moves can occur to the upside or the downside.

Volume-Based Trading Strategies

There are a number of metrics and technical indicators based on volume. Some popular ones include, On Balance Volume (OBV), Cumulative Volume Delta (CVD), Volume Weighted Average Price (VWAP), the Klinger Oscillator, and the Accumulation Distribution Line (ADL).

On Balance Volume (OBV)

OBV is a cumulative indicator that gauges buy and sell pressure. When an asset closes at a higher price at the end of a day than it did the previous day, all of that day’s volume is deemed up-volume.

When an asset closes at a lower price at the end of a day than it did on the previous day, all of that day’s volume is deemed down-volume. The continuation of an upward trend is signaled by both price and OBV making higher highs and higher lows.

The continuation of a downward trend is signaled by price and OBV making lower highs and lower lows. OBV adds volume on up-days and substracts volume on down-days.

In a rangebound market, rising OBV hints at the prospect of a breakout to the upside, while falling OBV is suggestive of an impending breakout to the downside.

Negative divergence is the term that describes OBV failing to make higher highs despite price making higher highs. It indicates that a continuation of an upward trend is unlikely.

Positive divergence describes the inverse process (i.e., OBV failing to make lower lows despite price making lower lows). It indicates that a continuation of a downward trend is unlikely.

Cumulative Volume Delta (CVD)

CVD shows us the cumulative changes in volume traded by aggressive buyers and sellers, respectively, in a given market, over a specified time period.

Aggressive buyers and sellers are defined as those executing market orders.

CVD is often employed by order flow traders seeking to confirm the direction of price movement.

A negative CVD describes a trading period dominated by aggressive sellers, while a positive CVD describes a trading period dominated by aggressive buyers.

CVD sheds light on behavioral patterns being exhibited by buyers and sellers, but it does have its limitations.

It excludes limit orders, and due to the potential ramifications of this, it should be viewed as a useful tool — not gospel.

If CVD is negative, a market is dominated by aggressive sellers, and price may continue downward.

As price falls, a big fish with a resting buy limit order on the books may have his sizeable order filled, resulting in a reversal to the upside, invalidating CVD's assumptions.

Volume-Weighted Average Price (VWAP)

VWAP measures average price on a volume-weighted basis and is popular among intraday directional traders. Price trading above the VWAP indicator line signals an uptrend. Price trading below the VWAP indicator line signals a downtrend.

Traders identify bullish momentum when prices are trading above VWAP and bearish momentum when prices are trading below VWAP. A sideways drifting market is characterized by prices ranging above and below VWAP.

Klinger Oscillator

This technical indicator seeks to detect short-term price action (and longer-term trends) by comparing changes in volume to fluctuations in price. The oscillator aims to highlight differences in two moving averages that aren’t purely based on price.

An uptrend is indicated when price breaches a long-term moving average and the oscillator encroaches on zero. The continuation of a downtrend is indicated by the oscillator dipping below the signal line (i.e., 13-period moving average).

Accumulation Distribution Line (ADL)

ADL is a volume-based indicator that measures supply and demand dynamics by comparing closing prices with local highs and lows to derive a so-called “proximity value”. Proximity value is multiplied by volume to assign higher weights to market moves that correspond to higher volumes. Traders use the metric to confirm the continuation of existing trends or detect emerging ones. Price and ADL making higher highs and higher lows indicate that an upward trend will likely maintain momentum.

Price and ADL making lower highs and lower lows indicate that a downward trend will likely maintain momentum. Climbing ADL in a rangebound market hints at a potential breakout to the upside. Falling ADL in a rangebound market hints at a potential breakout to the downside.

When ADL is not making lower lows while price is making lower lows, the downward trend is unlikely to persist (i.e., a positive divergence is indicated). When ADL is not making higher highs while price is making higher highs, the upward trend is unlikely to persist (i.e., a negative divergence is indicated).

Conclusion

Volume refers to the total number of transactions in a market over a certain period. In derivatives trading, it's the number of times a contract changes hands. Every transaction adds to a given market’s volume.

Traders use volume trends to inform trading decisions and forecast price direction and magnitude. Monitoring volume helps traders plan more effectively. Ultimately, volume is merely one piece to the puzzle, but nevertheless, it's a critical one for active traders.

Start analyzing volume patterns to fortify your trading repertoire. Then put your skills to use at dex.zeta.markets.