Volume is the study of how many buyers and sellers there are over a given time period. DTR uses volume to determine relative strength of a security for a breakout or reversal. When paired with candlesticks it helps the trader visualize and quantify strength for a breakout or breakdown.
Volume can be added to your chart through a variety of indicators such as "Volume", "Net Volume", "Volume Oscillator", and the "Volume Weighted Average Price (VWAP)". I personally only use the "Volume" indicator which works like candlesticks. The Volume closes green if it was mostly buying volume and closes red if price action was mostly selling volume.
Why Volume Trading Works
Trading using volume and candlesticks confirms the following:
- Volume confirms the strength of a trend or suggests its weakness
- Rising volume indicates rising interest. Increasing green volume equals rising bullish momentum. Increasing red volume equals rising bearish momentum
- Decreasing volume suggests a decline in interest, or a statement of no interest. It tells you that buyers or sellers do not have strength in numbers
- Extreme volume readings, like outlier volume spikes, can indicate algorithm trading, reversals, or tops and bottoms
- Strong volume at a specific price level indicates strength and that an area is either a key level or an area of support or resistance
- Volume helps indicate relative momentum and allows traders to follow only the strongest trades
High or Low?
Volume is the second most valuable item of data after the price action. Large volume signifies that there are a large number of market participants involved in the price action, including banks and hedge funds, who bring the most money into the markets. If the financial institutions are trading, it means they are interested in a price at certain level and their sizing can push the price up or down. By using candlesticks and volume you can identify when institutions are trading.
Low volume tells us that there are very few participants in the market, and that neither buyers nor sellers have any significant interest in the price. In this scenario, no financial institutions will be involved, and therefore any moves from individual traders will be weak. Low volume moves can be easily reversed by an institutional trader who decides to take the other side.
Volume and Trend
Volume helps us to determine the health of a trend. An uptrend is strong and healthy if volume increases as price moves with the trend, and decreases when the market moves into a counter trend. These are called correction periods or ‘pull backs’. You wouldn't want to go to a party if they were turning down the volume as you got there. Whenever we see a new trend form we need to see that the trend is actually strong. Strength is visualized by increasing, outlier volume. Your trend is strong when you have more market participants than the previous candle and more market participants than average.
When prices are rising and volume is decreasing, it tells traders that a trend is unlikely to continue. This is called a volume divergence. Price action and volume are telling an inconsistent story. If the price was actually strong then you would expect to see increasing volume. Prices may rise but bulls are vulnerable to sellers taking over control. Once sellers are able to establish a bearish pressure (increasing red volume), price will sell off.
A downtrend is strong and healthy if volume increases as prices move lower and decrease when the price begins to re-trace ('pull back') upwards. When a market is falling and volume is decreasing, the downtrend is unlikely to continue. Prices will either continue to decrease, but at a slower pace or stop falling and start to rise.
Volume and Reversals
When volume spikes at certain price levels, especially on longer time frames such as the daily or weekly charts, traders can view those bars as possible areas of reversal. If there is significant interest, as revealed by the volume bar, it means the level is an important one. Levels become important when lots of participants start or trim positions there. This will be shown as increasing outlier volume. This simple correlation between price, volume, and trend allows traders to identify important areas of support and resistance and can make valid plans to trade those moves.
When volume spikes are extreme, larger than historical spikes, they are called a volume climax. Volume climaxes often indicate reversals but traders should still look for reversal clues by pairing candlesticks and volume. Single volume spikes alone can often bring the market to an abrupt halt as volatility will immediately increase. These extreme volume spikes often occur during fundamental economic announcements which can occur daily. News can cause a spike in volume for a single day then disappear again. Reversals, however, happen not over a single day but over a series of days. If higher than average volume stays in the market for several days, a huge volume spike or a volume climax, will often signal a point of market reversal.
Volume and Breakouts
Volume can help to validate all kinds of breakouts. When the market is consolidating on low volume, an increase in volume can signify that a breakout is due. A breakout occurring on rising volume is a valid breakout, while a breakout with low volume is more likely to be false. Why? Simply because the lack of volume signals a lack of interest from the market and traders.
Trend lines and other breakouts are validated or voided in exactly the same way. So, as you can see volume is without question the most important and powerful indicator of all. It is remarkably accurate at predicting future moves. When you start to incorporate Volume Price Analysis in association with a volume indicator, you then have an amazing trading tool at your disposal.