Technical indicators are very essential for traders and investors. Moving Averages, MACD, and the Relative Strength Index (RSI) are some of the most commonly used indicators. Volume on the other hand is one of the most underrated indicators partly because of its simplicity. However, the fact is that volume is the most important indicator because of its underlying principle.
In a normal market, price of commodities move because of supply and demand. When the demand of a product exceeds the supply, it results to a higher price. On the other hand, when the supply exceeds the demand, the price of the commodity comes down. The financial market works in the same way. For instance, when there is a huge demand for dollars, its price against the purchasing currency will go high.
According to Anna Couling, author of the best-selling book, A complete guide to volume price analysis noted that traders who focus primarily on volume achieve more in their trading than their counterpart who ignore it. This is because volume represents the total number and value of transactions during a particular time. The chart below shows a 10-year Google chart with the average section at the bottom. Notice how well the volume indicator reflects the price.
Why volume is important
To traders and investors, volume is very important for two main reasons. One, volume shows the psychological level of traders. Second, volume is a good tool to use to check or confirm a trend. For instance, when the price of an asset is moving up with a high volume, it indicates that the trend is stronger, therefore creating a bullish signal. On the other hand, if the volume of the asset is moving down with a high volume, it indicates a sell-off. Volumes are also important indicators of divergence. A divergence is always evident when an increase in volume in an upward trend leads to the reduction in price of the asset.
The key principle when doing volume price analysis is that a price drop on large volume shows that something might have triggered the move. This ‘something’ could be a news or economic release such as the non-farm payrolls or an interest rate decision.
Traders also use volume as a way to confirm chart patterns. Some of these patterns are: head and shoulder, triangles, and flags. Experienced or successful traders when identifying and confirming these chart patterns always refer to the volumes. For example, if the volume of an asset is high, chances are that it will confirm the formation of these chart patterns.
This strategy was developed by Joseph Granville who is regarded as an important figure in technical indicators. It is an important indicator which is based on whether prices of assets close higher or lower in the previous day. The indicator rises or falls before the actual prices of the assets are indicated. When using on-balance volume, a new high is a representative to the power of the bulls and weaknesses in the bears leading to a buy opportunity. On the other hand, a new on-balance volume low is a representative of a bear market. Finally, when on-balance volume shows a signal that differs with the actual prices, it shows a shift in price or divergence.
This is another very important volume indicator which takes into account the opening and closing prices of assets. When the Accumulation/Distribution indicator shows a positive number, it is an indication that the prices were higher than when they opened. When the figure is negative, it shows the opposite. A wide range between the opening and closing price is an indicator that the AD is strong. However, it is very important to look at the patterns of the A/D highs and lows. This is because when a market opens higher and closes lower, it represents a lower upward-trending market.
For a day trader, volume is very important as a key psychological indicator. It shows when traders in the market are fearful (leading to a sell off) and when they are bullish (leading to a price hike). However, at some instance, the volume of an asset will go up before a sell-off happens leading to a sharp diversion. At these instances, it is very important to combine the volume indicators with other technical and fundamental indicators.