by Amanda Harvey
A volume indicator is a type of technical analysis indicator that provides information about potentially favorable times to enter or exit a trade based on the level of trading volume which the option or underlying stock is experiencing.
As well as specifically designed indicators which are used to analyze volume levels, and to provide signals based on the data, the very most basic way of using volume as an indicator is to simply study the volume information itself.
Volume is an important consideration when selecting which securities to trade. In general, high volume indicates considerable trading interest in the security and paves the way for significant movement in price, as well as creating greater liquidity. A security trading with a very low volume is unlikely to generate enough activity to drive any substantial price movement.
The level of volume can also provide signals in regard to likely changes in the direction of price movement. Volume that increases with a move upward in price tends to support an upward trend, and many traders see this as a signal to trade in the direction of the movement. A rising price which is accompanied by falling volume may indicate a loss of enthusiasm among traders for the security, and can also be a precursor of an imminent reversal.
Using volume data or a volume indicator is a valuable method for confirming the strength of a trend and is often applied in combination with other types of indicators.
The Volume Oscillator
A volume oscillator is a type of indicator which calculates the relationship between two moving averages in order to assess the fluctuations in volume. The volume indicator plots the difference between a fast and a slow moving average on a chart, and depicts values which move above or below a ‘zero’ line. A positive value indicates that there is enough trading volume to support a continued trend, whereas a negative value shows lack of enthusiasm for the trend and may indicate an impending reversal in price direction.
The On Balance Volume Indicator (OBV)
This indicator developed by Joe Granville, and presented in his 1963 book “Granville's New Key to Stock Market Profits,” was one of the first indicators to measure the flow of volume. Granville suggests that movement in volume is often a precursor to price movement, and as such, the OBV can be used to predict an upcoming movement in price.
When the OBV is rising, this reflects stronger volume flow, and often precedes a price rise. A falling of the OBV indicates lessening volume, and may be followed by a subsequent drop in prices. The OBV uses a simple calculation of adding the volume from the latest period to the prior period’s OBV value if the volume has a positive value (the close is higher than the previous close), or subtracting the latest volume value from the preceding OBV if the volume is negative in value (the close is lower than the previous close).
The Money Flow Index (MFI)
This indicator uses both price and volume to calculate a value which is used to determine the strength of the prevailing trend. The MFI is frequently described as a volume-weighted RSI as it is calculated by adding the component of volume to the Relative Strength Index (RSI). The RSI is a momentum indicator designed to identify situations in which a security is overbought or oversold. When the MFI moves in the opposite direction to the price, this is frequently interpreted as a signal that a price reversal is imminent.
Whether a trader is simply studying raw volume data, comparing it with price or range, or applying it to a specifically designed volume indicator, the amount of trading activity experienced by a security is highly relevant. In choosing securities on which to trade, as well as determining potential entry, exit, or reversal points, volume is a key data element to take into consideration.