Volume Analysis: Using Trading Volume to Confirm Price Movements

What are the two pillars of technical analysis? They are price and volume analysis. While evaluating price movements to make trading decisions is common, many traders, especially beginners, often overlook the importance of trading volume to back their market analysis. Are you among them, too? Then, this blog is for you. Learn all about volume analysis in stock market and its significance in trading to enhance your trading skills and make informed decisions.  

What is Volume Analysis?

Volume analysis is a method used by traders to evaluate the strength or weakness of a price trend based on trading volume. The trading volume refers to the number of shares or contracts traded in a security or market during a given period. Traders analyse volume to gauge the strength of price trends and validate its sustainability. Using volume analysis allows traders to refine their insights into market sentiment and potential price direction changes, enabling them to make more informed trading decisions.

Volume Indicators

Volume indicators are technical analysis tools traders use to assess the strength or weakness of price movements based on trading volume. These indicators help traders analyze the buying and selling activity in the market, providing insights into market sentiment and potential price trends.

Some of the popular volume indicators often used by traders are explained briefly hereunder. 

• On-Balance Volume (OBV)

On-Balance Volume (OBV) is one of the widely used volume indicators. It calculates the cumulative volume by adding the day's volume on up days and subtracting it on down days. The idea behind OBV is that volume precedes price movements. A rising OBV confirms an uptrend as higher volumes accompany upward price movements and indicate buying pressure. A falling OBV, on the other hand, suggests a potential downtrend as higher volumes accompany downward price movements and signal a selling pressure. Traders often use OBV to confirm the strength of price trends and identify potential trend reversals.

• Volume Weighted Average Price (VWAP)

Volume-Weighted Average Price (VWAP) is a volume indicator that calculates the average price of a security based on both volume and price throughout the trading day. It gives traders an idea of the average price at which a security is traded relative to its volume-weighted average. This allows traders to assess whether they are buying at a premium or discount compared to the average market participant. VWAP is particularly useful for intraday traders who want to gauge the fairness of their trade prices and make informed decisions based on market dynamics.

• Accumulation/Distribution Line (A/D Line)

The Accumulation/Distribution Line (A/D Line) measures money flow into or out of security by analysing the relationship between closing prices and trading volumes. A/D Line is used to assess buying and selling pressure. An increasing A/D Line indicates accumulation, suggesting buying pressure as more money flows into the security and can potentially lead to upward price movements. Similarly, a decreasing A/D Line indicates distribution, signalling a selling pressure and potential downtrends. Traders often rely on the A/D Line to confirm trends and identify potential reversals or continuations in trends.

• Chaikin Money Flow (CMF)

Chaikin Money Flow (CMF) is a volume indicator that combines price and volume to measure buying and selling pressure. CMF is also a technical analysis tool used to assess the strength of price trends and identify potential market reversals. Positive CMF values indicate buying pressure as more money flows into the security, which can potentially drive the prices higher. On the other hand, negative CMF values suggest selling pressure and indicate potential downtrends. Traders use CMF to confirm price movements and make informed trading decisions based on the flow of money in the market.

• Money Flow Index (MFI)

The Money Flow Index (MFI) is a volume indicator which is similar to the Relative Strength Index (RSI) but incorporates volume data. Traders use MFI to identify overbought or oversold conditions in a security. High MFI readings indicate overbought conditions and potential reversals, while low MFI readings suggest oversold conditions and potential buying opportunities. Traders often use MFI alongside other technical indicators to confirm price movements and make informed trading decisions.

What is a Positive Volume Index?

The Positive Volume Index (PVI) is a tool used to gauge the impact of increased trading volume on market dynamics. It compares the trading volume of the current day with that of the previous day to determine if there has been an increase. An increase in the volume can lead to an adjustment in the PVI. A change in the Positive Volume Index indicates that prices are influenced by significant trading volumes. This change reflects buying and selling activities in substantial volumes which impacts price movements accordingly.

The formula to calculate PVI is,

PVI = PVI previous + { [ (CP today - CP yesterday) / CP yesterday] * PVI previous }

Where,

• PVI - Positive Volume Index

• PVI previous - Positive Volume Index of the previous day

• CP today - Closing Price of today

• CP yesterday - Closing Price of yesterday

What is a Negative Volume Index?

The Negative Volume Index (NVI) is a metric used to assess the impact of decreased trading volume on market dynamics. It compares the trading volume of the current day with that of the previous day to determine if there has been a decrease. A decrease in volume triggers an adjustment in the NVI. A change in the Negative Volume Index indicates that prices are influenced by reduced trading volumes. This shift reflects lower buying and selling activities which impacts price movements accordingly. 

The formula to calculate NVI is,

NVI = NVI previous + { [ (CP today - CP yesterday) / CP yesterday] * NVI previous }

Where,

• NVI - Negative Volume Index

• NVI previous - Negative Volume Index of the previous day

• CP today - Closing Price of today

• CP yesterday - Closing Price of yesterday

Conclusion

Analyzing trading volumes is a key tool for traders. Examining the trading volume alongside price movements can give traders valuable insights into market sentiment and potential price trends. The use of volume price analysis in trading methodologies empowers traders to make informed decisions by accurately identifying trend confirmations or reversals and navigating stock markets with higher precision.