THE POWER OF VOLUME PROFILE TRADING.
By The North God
1. What Is Volume Profile Trading ?
One of the most common ways for traders is to make use of the common concepts in technical
analysis. These concepts include aspects such as utilizing supply & demand zones , where banks are
mostly involved in price and also technical indicator based trading setups.
However, a new approach to technical analysis called volume profile has also been making the
rounds.
An established futures trader, Steidlmayer is an independent trader having joined the Chicago Board
of Trade in 1963.
One of the major claims of using volume profile strategy is that is allows you to build the market
concept based on the study of volumes printed on the y-axis on the price chart.
Volume as an indicator is not uncommon. It is commonly used during the technical analysis of a
stock chart. Volume is also widely prevalent in forex trading as well. However, for the most part,
volume is confined to the x-axis. The volume indicator basically shows the amount of transactions
that take place during a session. Based on whether price was bullish or bearish, the volume bars are
painted accordingly. This is known as volume profile or market profile.
With volume profile, traders focus on areas where a reversal could occur. Some say that volume
profile analysis gives an "unfair" advantage due to the market context and that such methods are
used by large institutions and banks.
Be that as it may, volume profile strategy makes for an interesting study as it puts the often taken
for granted volume bars in context and allows for some unique insights into the markets when
trading.
But before we begin, let's start from the very basics, what is volume?
What is volume?
Volume, or volume of trade shows the total number or quantity of contracts or shares that are
traded for a specific security. Volume can be measured on just about any financial security.
Most commonly, volume is used in futures and stocks. Due to the fact that futures and stocks are
traded at an exchange, one is able to get a fair idea on the quantity of contracts or shares that
change hands.
Volume is also used in the forex markets. However, the major drawback here is that due to the OTC
nature of forex execution, it is difficult to get a full picture of the true volume for the forex markets.
Still, many brokers offer the volume indicator, plotted as a histogram on the x-axis. This volume, in
most cases captures just a small percentage and therefore does not reflect the true picture.
Regardless, many forex traders continue to prefer to use the volume indicator. The first chart below
shows the basic layout of a stock chart with the volume bars displayed at the bottom of the chart
Figure 1: Basic stock chart with volume bars plotted on the x-axis
The volume basically represents the amount of transactions that take place. Volume can also be
used to measure the liquidity of the security in question. Generally speaking, volumes are reported
once an hour by exchanges. However, these days of electronic trading can report volumes on a tick
by tick basis. Still, these volumes that you see in real time are only estimates. The true and actual
volume is showed only the next day for the previous day.
When volumes are high, it signals that the security is liquid and active. A security with higher volume
also tells you that the order executions and the spreads are better.
What is volume profile strategy?
The volume profile strategy is basically a study of the volume based on price.
This is a bit different compared to the regular volume bars that we mentioned
in the previous section of the article.
While regular volume tends to display the total volume of the security for a
given session, volume profile displays the volume of the security for a given
price.
As a result, volume profile is plotted on the y-axis as it deals with price. To
explain this in simpler terms, volume profile takes the total volume that is
traded at a specific price level during the specified period and then divides the
total volume.
This is then categorized into the buy volume or sell volume and makes this
information available visually as it is plotted on a histogram on the y-axis.
The next chart below shows a sample chart with the volume profile. For
context, we also retain the regular volume bars on the x-axis.
Figure 2: Volume profile example
The longer horizontal volume bars are the ones of interest. These bars
represent the price where there is the highest amount of volume. In other
words, the price level depicted by the horizontal volume bars indicate the
price where most of the activity has taken place.
This price is commonly referred to as the point of control or PoC. The name
comes from the fact that the price in question had the most control of the
market at the time. The volume profile bars can be plotted across different
time frames. The horizontal volume bars are updated every time there is a
new order that is filled. Every time the volume profile bars are updated, they
can change the position.
A common occurrence is to see the point of control or the price where most of
the activity takes place, starting at the top of the chart as a new trading
session begins. Over the course of the day, this point of control can shift
thereafter to a different price level. In market profile or volume profile
analysis, there are some technical jargons that are commonly used. They are
defined below.
Before definition
High Volume Nodes: These are price levels that have the highest activity around a
price level. The high volume nodes can be viewed as an indicator for consolidation
of price.
In the high volume nodes, you can commonly see a high level of both buying and
selling activity. Price also remains at this level for a long period of time. The high
volume nodes imply the fair value for the security in question. When price
approaches a previously established high volume node, you can expect price to
consolidate or move sideways. It is less likely that the market will immediately
break past a previous high volume node. Due to the high amount of activity that
takes place at the high volume nodes, price tends to gravitate back to these
levels. The high volume nodes are also seen as levels where there is a high
amount of institutional buying and selling taking place.
Low Volume Nodes: These are the exact opposite to the high volume nodes. The
low volume nodes signify a drop in the volume around a price level. The low
volume nodes are created as a result of a breakout in price after consolidation.
During a breakout, you can often observe that price breaks with an initial burst of
volume and later it drops off. These drop off levels imply that the price of the
security is at an unfair value. When price approaches a previous low volume node,
there is a greater chance that price will break past that level due to the unfair
value. The price of the security will not spend must time at this level compared to
the high volume nodes.
Point of Control: The point of control is the price level at which there is the
highest activity that takes place. Note that time is not of the essence here.
Therefore, the point of control takes into account only the price level which has
seen the most consolidation. The point of control, from a trading set up
perspective is said to be the level where you could place your stops or entry levels
for a trade. Price also tends to revisit the previous point of control levels. This
tends to act as both supply and demand.
Value area: The value area is basically the percentage of all the volume that is
traded. The default setting for the market profile indicator is 70%. The value of
70% is based on the normal distribution curve.
The next chart below shows all the above technical terms visually.
Figure 3: Market or Volume profile – Terminology
So far, we outlined what is volume and how volume profile differs from the
traditional volume indicator that is commonly used. With the volume profile
indicator plotted on the price chart and on the y-axis based on the point of
control, the high and low volume nodes, you can now get a clear picture of what
is happening.
One of the most commonly used volume profile trading set ups is to use the
POC(point of control) as supply and demand areas.
We already noted that the high volume nodes are areas of consolidation where
most of the transactions take place, but price moves sideways. These areas can be
used as supply and demand. Similarly, the low volume nodes which tend to have
little activity can also be used as areas where price could either quickly reverse or
drop off.
One of the main differences in using volume profile trading set ups is that they
are reactive in nature. The common ways to plot supply and demand are basically
through rectangle zone and identifying areas of consolidation. Similarly, using
volume profile analysis, a trader can build a reactive market context using this
strategy.
Volume profile in forex
Figure 4: Volume profile trading set up, example
In the above chart, you can see that we have used a black zone with no
background identified (poi=point of interest). The black zones in the value area
indicate areas of volume nodes.
The red thick line indicates the point of control. If you were to trade the chart
based only on the supply (poi), you will notice that after the bearish sell signal (on
the right), price initially falls to the point of control and bounces back.
However, a little while later, price breaks the point of control. At this point, short
positions can be taken after the point of control is cleared with a strong bearish
candlestick.
With the supply already signaling a sell, a short position here can be
taken down to the low value node. The most amazing point about this set up is
that you entered the trade at the strong point of the trend and booked profits
right at the low value node. Following the decline to the low value node area of
0.84812 – 0.84780, price bounces back higher.
The trading set ups shown here is just one of the many ways that volume profile
can be incorporated into developing a trading plan or strategy. Traders can
experiment with the volume profile indicator with the understanding and the
explanation provided in this article.
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