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How to Trade With Volume

Contents

  1. What is volume?
  2. How to trade breakouts with volume.
  3. Why trading breakouts is difficult.
  4. The significance of candlesticks.
  5. Re-drawing a trendline.
  6. How to set a profit target when trading a triangle.
  7. Trend confirmation with volume.
  8. High volume: A common misconception.
  9. How to Trade with Volume divergence.
  10. Summary.

1. What is a Trading Volume?

The volume shows the number of contracts or stocks that change hands over a specific time period (Murhpy 1999). It is displayed using green and red vertical bars along the bottom of the chart (as shown in Fig. 1 below). If the volume bar is green it means that price closed higher than it opened and if the volume bar is red, it means that price closed lower than it opened. Each volume bar represents a specific frame. This article will teach you the fundamentals you need in order to know how to trade with volume in a profitable way.

2. How to Trade Breakouts With Volume

‘As a rule, the resolution of all price patterns (the breakout point) should be accompanied by heavier trading activity if the signal given by that breakout is real.’ (Murphy 1999). 

To define a breakout we must first define a trend-line. A trend-line is a line that goes through at least 2 reaction lows or highs in a trend. The more reaction lows or highs the trend-line goes through, the more importance it has. Also the longer the time period in which the trend-line spans, the more significance it has. For example, in Fig. 1 below, the white arrows mark each reaction low or high that defines the trend line as a support (lower trend-line) or resistance (upper trend-line). Because the upper trend-line has 4 reaction highs, the lower trend-line has 7 reaction lows and the triangle pattern has spanned over 111 days, it is clear that these trend-lines have significance.

how-to-trade-with-volume-1

As price continues to bounce between each trend-line and move into a smaller and smaller area, it becomes increasingly likely that one of the trend-lines will no longer be able to support or resist the trend. At some point, a ‘breakout’ will occur where the price will surge past either the resistance or support and will continue to move in that direction usually by a large amount. Therefore, it is very valuable to be able to know when a break out has occurred.

3. Why Trading Breakouts is Difficult

Being able to identify a true breakout can be extremely difficult. The conventional method is to wait for the price to break one of these lines and as long as the move is accompanied by a large spike in volume, then the break out is said to be valid. However, in Fig. 1, the pink box shows how there was a large spike in volume as people attempted to sell heavily and break the lower trend-line. The lower wick (in the pink box) shows how price moved below the trend-line but there were too many buyers at these prices which held the price and pushed it back up well above the lower trend-line.

The pink box in Fig. 1 is, therefore, an example of a ‘bear-trap’. The ‘bears’ (those who were selling, aka ‘entering a short position’) were trapped by the ‘bulls’ (those who were buying) because the price went below the trend-line but very quickly rose up again. This means that those who went short (the bears) got trapped in a losing position by those who entered a long position (the bulls). Thus, you must be very careful when trading breakouts because you may get trapped in a losing position if you are not careful. 

In hindsight, we can see that in Fig. 1, the pink box would not have been a good place to enter a short position. However, in real-time, there was large volume, so it would have seemed like a good time to enter a short position. 

Wait For a Candle to Close When Trading Breakouts

A better approach you can use to trade breakouts is to wait for a candle to close beyond the trend-line resistance or support by at least 1-2% and IF the candle has a large volume, then you can enter a position in the direction of the break-out. A stop-loss can be placed on the other side of the trend line, e.g. if the price breaks upwards through a trendline, enter a long position (buy) and set your stop-loss slightly below the trend-line. This is effective because once price breaks up through a trendline, that line now will act as a support rather than a resistance. When price breaks below a trendline, that trend-line will now act as resistance rather than a support.

how-to-trade-with-volume-2

Fig. 2 above shows the next time that price broke up through the upper trend-line (shown by the yellow box). The candle closed beyond the trend-line by 4% and it was accompanied by a very large spike in volume. Therefore, you are probably thinking that you should go long and set your stop-loss slightly below the upper trend-line right? Usually, this is the correct thing to do however in this case the candle that broke the trend-line had an extremely long upper wick (as shown in the yellow box) which warns that this is in fact not very bullish at all. 

4. The Significance of Candlesticks

A candlestick can tell you who is in control at any time and can be viewed as a tug of war between the ‘bulls’ (those buying who are hoping for the price to increase) and the ‘bears’ (those selling who are hoping for the price to decrease). Compared to the opening price of this candle, the bears defended their ground very well and only conceded 30% of the entire move upwards as they quickly pushed price back down into the lower 3rd of the range before the candle closed. Thus, this candle indicates strength from the bears. 

5. Re-Drawing a Trendline

As shown in Fig. 3 below, the upper trendline can easily be re-drawn to make the candle in the yellow box look like a ‘bull trap’.

how-to-trade-with-volume-3

In Fig. 3 above, orange 1 and it’s arrow illustrate how there was a significant amount of buying pressure which held the price and caused a small bounce upwards. This reversal point is called a reaction low and is significant because it can be used to draw a trend line. Orange 2 shows how there was significant selling pressure which stopped price from rising and caused a reversal. This is called a reaction high and we can now draw a trendline between the reaction low at orange 1 and the reaction high at orange 2. In Fig. 3 the upper trendline has been extended and shows the candle in the yellow box as a bull trap. As you can see, this no longer seems like a good place to go long.

Key Takeaways:

  1. You should always take note of a candle with a very long wick, especially if it has high volume as it will often precede a reversal.
  2. Always identify at least one alternative way that a trendline can be drawn to prevent you from entering ineffective trades.

Once you have re-drawn the upper trend-line, you must wait for the next break of the upper (resistance) or lower (support) trend line. Fig. 4 below shows how a large red candle closed well beyond the lower trendline (support) after the 8th test of the lower trend-line and there was a large spike in volume as shown in the pink box. Do you think that this would be a good time to go ‘short’ (sell)? Please scroll down to see if you are correct.

If you said that you should enter a short position then well done, you would have made a very nice profit! Because the support now becomes a resistance, you should set a stop-loss slightly above the lower trend-line.

6. How to Set a Profit Target When Trading a Triangle

First, you should extend the upper and lower trend-lines to the point where the triangle began and then connect the two lines with a vertical line as shown in Fig. 5 below. Measure the height (see h) and subtract this value from the breakout price to obtain your profit target. If the price broke upwards, you would add h to the breakout price. If you want to be conservative then instead of setting a profit target equal to h +/- the breakout price, you can set a target equal to ( h x 0.618 ) +/- breakout price. 0.618 is a Fibonacci ratio and often marks reversals (the method is taken from Gorman & Kennedy, 2013).

how-to-trade-with-volume-5

7. Trend Confirmation With Volume

Volume should rise in the direction of the trend. In an uptrend, the volume should rise as price moves higher and should fall during pullbacks (aka ‘dips’). As long as this can be seen, the volume is said to be confirming the trend. In Fig. 6 below volume rises when the price rises and falls when the price falls or moves sideways (Murphy 1999).

how-to-trade-with-volume-6

In a downtrend, the volume should be higher during drops in price and lower during bounces, as shown in Fig. 7 below. If this pattern continues, the selling pressure is greater than the buying pressure, so the downtrend should continue (Murphy 1999).

how-to-trade-with-volume-7

8. High Volume: A Common Misconception

Higher volume does not mean that just because the trend has been moving up that it will continue to move up. The highest amounts of volume often coincide with the very top of the trend. The lowest amounts of volume occur at the bottom of the trend. Fig. 8 below shows how currently volume in Bitcoin is very low (9th of May 2019 at the time of writing), thus we could be close to or have already witnessed the bottom of the long term trend.

how-to-trade-with-volume-8

9. How to Trade with Volume Divergence

Traders are always looking for signs of divergence. Volume divergence occurs when there is a higher high in price (shown as B being higher than A in Fig. 9 below) while the volume for the higher peak is relatively much lower. This scenario will alert you to reduced buying pressure. If the volume also seems to be rising when the price is falling, the trader begins to worry that the uptrend is in trouble (Murphy 1999). What do you think happened after this volume divergence occurred in Fig. 9? See Fig. 10 below to see if you were correct.

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how-to-trade-with-volume-10

10. Summary

  • Divergences between volume and price movements can indicate an upcoming reversal in the trend.
  • All-time highs often occur with the highest volume and all-time lows with the lowest.
  • Volume can help you to trade breakouts because if a breakout occurs with low volume this indicates weakness and warns against getting trapped in a losing trade.
  • Candlesticks with very long wicks and high amounts of volume often precede reversals.
  • Volume can be used to confirm the validity of uptrends and downtrends.

To improve your skills trading, be sure to also read about RSI, Elliott Wave Theory, and Candlesticks Part 1 and Part 2. By combining all of these methods together, you can develop a great trading strategy to help you gain financial freedom.

References

  • Gorman, W. and Kennedy, J. (2013). A visual guide to Elliott Wave Trading: Bloomberg 
  • Murphy, J. J. (1999). Technical analysis of the financial markets – A comprehensive guide to trading methods and applications: The New York Institute of Finance

Thank you for reading, I hope you enjoyed this post.

Please feel free to email me at luca@bbod.io for more information about trading or join the BBOD Telegram, Youtube, and Facebook groups for more great trading related education and news.

Written By Luca Williams

Disclaimer

This article has been prepared solely for informative purposes and should not be the basis for making investment decisions or be construed as a recommendation to engage in investment transactions or be taken to suggest an investment strategy in respect of any financial instruments or the issuers thereof. BBOD will not be liable whatsoever for any direct or consequential loss arising from the use of this publication/communication or its contents. 

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