Most traders have seen stocks that have soared 1,000% or even 10,000% in a given day, but we quickly skim past them and move on to other opportunities. The reason is simple: These huge gains occur on penny stocks that have almost no volume, and without volume, there’s little to no opportunity to profit.
Beyond providing context to the price, volume can be used to gauge the market’s interest in a security both in the moment and over time, making it a powerful technical indicator to understand.
Let’s take a look at how traders can use volume to improve their performance — including in some unexpected ways.
Why Volume Matters
Volume is the measure of how much a security has been traded over a given period of time. In practice, it enables traders to measure the level of interest and liquidity in the security.
There are many ways that you can use volume:
- Market Interest – Volume shows you how much interest there is in a given security at a given point in time. The volume times the market price gives you the dollar volume.
- Momentum – Rising volume suggests that there’s greater bullish or bearish momentum. Falling volume suggests that momentum is waning and there could be a reversal.
- Confirmation – Volume can serve as confirmation of a breakout or breakdown in the price, particularly in the bars immediately following the move.
Volume Indicators & Overlays
It’s helpful to look at volume when analyzing prices, but sometimes, you need more context into volume trends to understand what it all means. Volume-based technical indicators and oscillators provide these insights on price charts and can be helpful when deciphering opportunities.
Let’s take a look at three of the most popular volume-based indicators and how to use them to gain insights.
On-Balance Volume (OBV)
On-Balance Volume, or OBV, is a momentum indicator that uses volume to predict price change. By summing the volume on up days and subtracting volume on down days, the indicator attempts to show when the market is accumulating shares and when it’s divesting shares independent of price. Volume may paint an entirely different picture than price.
In the above chart, the on-balance volume indicator confirms that there’s volume behind the trend higher. This volume starts to level off before the price trend ends, which could help traders get out at an ideal time before a reversal takes place.
There are two important limitations to note. First, OBV is a leading indicator that says little about what actually happened in the past. Second, large volume spikes can have a lasting impact on the indicator. This means that you may want to use other indicators in conjunction with OBV, including lagging indicators, to get the full picture.
Chaikin Money Flow
Chaikin Money Flow is another popular momentum indicator that measures the amount of money flow over a period of time. Rather than taking the cumulative total volume, this indicator as a specific look-back period of ~20 days and creates an oscillator that fluctuates around a zero line. This can create an easier-to-read indicator of money flow than OBV.
In the above chart, traders may notice the divergence forming between the price and Chaikin Money Flow indicator, suggesting that there could be a reversal. The price reverses direction shortly after the indicator crosses below the zero-line.
The Klinger oscillator is similar to Chaikin Money Flow in that it measures volume using an oscillator, but its calculation focuses more on force volume. Force volume takes the actual volume, trend direction, and so-caled temp into consideration in order to become sensitive enough for short-term money flow trends rather than showing only long-term.
Raindrop Charts & Volume
Most traders use volume as a simple overlay on a bar or candlestick chart to reference when looking at price movements. The problem with this approach is that this only shows the amount of volume that happened throughout the entire day — not what prices the volume occurred at or when the volume occurred during the day.
We created Raindrop charts to address these shortcomings and build volume into the price chart. Each price bar contains a histogram of volume and is divided into the first and second half of the session. That way, you can quickly see at what prices the volume occurred at and when during the day it occurred (e.g. morning or afternoon sessions).
Since these charts are relatively new, they are open to interpretation in many different ways. We’ve found that Blue Raindrops could be effective for identifying support and resistance levels, as well as reversals, since they highlight indecision a lot more clearly than doji candlestick patterns (since they include volume trends).
The Bottom Line
Most traders know to look at both price and volume to understand what’s happening in the market, but many don’t make regular use of volume-based indicators. By taking the time to understand these indicators, you can ensure that you’re seeing the real activity behind the price. Raindrop charts make this even easier by showing the dynamics on the price chart.