Volume Analysis for Beginners

When it comes to day trading, we all agree that understanding price movements is crucial for making trading decisions.

But what if I told you there’s another crucial factor you need to consider to make even better trading decisions? Imagine having an additional tool that can help you confirm trends, identify potential reversals, and gauge the strength of price movements. This tool is volume.

In this article, we’re going to get introduced to the basics of volume and how it can enhance our trading. We’ll focus on one essential volume indicator, the Volume Weighted Average Price (VWAP), and discuss the formula in detail so we get a clear understanding of how it works. By the end, you’ll have a better understanding of volume and how it can complement your analysis.

What is Volume?

Volume refers to the number of shares traded in a market during a given period. It is a fundamental metric in trading that indicates the activity level of a stock. High volume means more traders are active, while low volume indicates fewer traders.

Why is Volume Important?

Volume is crucial because it shows the level of interest in a stock. Higher volume often means higher liquidity, which can lead to more stable price movements. On the other hand, low volume can lead to more volatility and price slippage.

Volume and Price Relationship

Volume and price are closely linked. When a stock experiences high trading volume, it generally means there is strong interest, which can drive the price up or down significantly. Low volume might suggest that the price movement lacks conviction and may not be sustainable.

There is a belief in technical analysis that volume precedes price changes. This means that significant changes in volume can often be a leading indicator of future price movements. For instance, a sudden spike in volume might indicate that a substantial price move is imminent, as increased trading activity reflects heightened interest or sentiment in the market.

Significance of High and Low Volume Days

• High Volume Days: These days often coincide with significant price moves and can be indicators of strong market sentiment. Can confirms the strength of a trend.
• Low Volume Days: These can indicate a lack of interest or uncertainty in the market, often leading to weaker price movements. Can suggest that the trend might not be strong and could reverse.

Practical Applications of Volume Analysis

• Confirming Trends:
  • Volume can validate price trends. For instance, a strong uptrend with increasing volume is more likely to continue than one with declining volume.
  • Example: Use volume to confirm the strength of a price breakout from a resistance level.
• Identifying Reversals:
  • Changes in volume can signal potential reversals. For example, a downtrend with decreasing volume might reverse if a volume spike occurs on an up day.
  • Example: Look for divergence between price and volume (e.g., price making new highs while volume decreases) to spot potential reversals.

Volume Indicators – VWAP

Volume Weighted Average Price (VWAP) is a popular technical indicator used by traders to determine the average price a stock has traded at throughout the day, based on both volume and price.

Formula and Math Behind VWAP

VWAP = (Sum of (Price_i * Volume_i)) / (Sum of Volume_i)
      

Typical Price = (High_i + Low_i + Close_i) / 3
      

Price_i * Volume_i
      

Sum of (Price_i * Volume_i)
      

Sum of Volume_i
      

VWAP = (Sum of (Price_i * Volume_i)) / (Sum of Volume_i)
      

Suppose we have the following data for a stock over three time intervals:
| Time Interval | Price ($) | Volume |
|---------------|-------------|--------|
| 1             | 100         | 200    |
| 2             | 102         | 150    |
| 3             | 101         | 250    |

1. Calculate the Price-Volume Product for Each Interval:
   - Interval 1: 100 * 200 = 20000
   - Interval 2: 102 * 150 = 15300
   - Interval 3: 101 * 250 = 25250

2. Sum the Price-Volume Products:
   20000 + 15300 + 25250 = 60550

3. Sum the Volumes:
   200 + 150 + 250 = 600

4. Calculate VWAP:
   VWAP = 60550 / 600 = 100.92
      

Suppose we have the following data for a stock over three time intervals:
| Time Interval | Price ($) | Volume |
|---------------|-------------|--------|
| 1             | 100         | 2000   |
| 2             | 102         | 150    |
| 3             | 101         | 250    |

1. Calculate the Price-Volume Product for Each Interval:
   - Interval 1: 100 * 2000 = 200000
   - Interval 2: 102 * 150 = 15300
   - Interval 3: 101 * 250 = 25250

2. Sum the Price-Volume Products:
   200000 + 15300 + 25250 = 240550

3. Sum the Volumes:
   2000 + 150 + 250 = 2400

4. Calculate VWAP:
   VWAP = 240550 / 2400 = 100.23
      

What VWAP Represents

VWAP gives traders an idea of the average price at which the stock has been trading throughout the day, considering both the price and the volume. It helps in comparing the current price to the VWAP to determine the market’s trend:

• Above VWAP: If the stock price is above the VWAP, it indicates a bullish trend (buying pressure).
• Below VWAP: If the stock price is below the VWAP, it indicates a bearish trend (selling pressure).

VWAP is a cumulative indicator, meaning it is recalculated throughout the trading day, giving an updated value as more data (price and volume) comes in. This makes it dynamic and highly responsive to the day’s trading activity.

VWAP vs. SMA: Key Differences Explained

The Volume Weighted Average Price (VWAP) and the Simple Moving Average (SMA) are both essential tools in technical analysis, but they serve different purposes and are calculated differently.

Volume Consideration

• VWAP: Takes into account both price and volume. It multiplies the price of each trade by the volume of that trade, sums these products, and then divides by the total volume for the day. This makes VWAP a more accurate reflection of the average price at which a stock has traded, weighted by the volume of each trade.
• SMA: Considers only the price. It calculates the average of a security’s prices over a specified number of periods, giving equal weight to each price point regardless of the volume traded.

Calculation Period

• VWAP: Resets at the beginning of each trading day, making it particularly useful for intraday trading. It provides traders with a benchmark price for the current trading session.
• SMA: Can be calculated over any period (e.g., 5-day, 50-day, 200-day), making it versatile for analyzing longer-term trends and smoothing out price data over days, weeks, or months.
• *Anchored VWAP: Unlike the standard VWAP, the anchored VWAP can be applied over longer time frames and does not reset daily. Instead, it allows traders to select a specific starting point (such as a particular date or event) and calculates the volume-weighted average price from that point onward. This makes anchored VWAP useful for analyzing longer-term trends and key price levels over days, weeks, or even months.

Usage and Application

• VWAP: Primarily used by intraday traders and institutional investors to gauge the average price of a stock throughout the day, helping them to determine optimal entry and exit points. It ensures that trades are executed at a price that reflects the day’s average activity.
• SMA: Used by traders and investors to identify overall trends, support and resistance levels, and to smooth out price fluctuations. It is a fundamental tool for spotting long-term trends and potential reversal points.

Practical Differences

• Intraday Benchmark vs. Trend Indicator: VWAP provides an intraday benchmark that is volume-sensitive, which is crucial for understanding the day’s price action relative to volume. SMA, on the other hand, is a straightforward trend indicator that helps identify the direction and strength of a trend over a specified period.

In summary, VWAP gives a more detailed intraday analysis by incorporating volume, making it very useful for day traders. SMA, by averaging prices over longer periods without considering volume, is better suited for identifying long-term trends and smoother price movements. Both indicators are powerful when used correctly but serve different analytical needs in trading.

Viewing Volume and VWAP on TradingView

To effectively use volume and VWAP in your trading, you’ll need to know how to view these indicators on your trading platform. Here’s a quick guide for TradingView:

1. Viewing Volume:
   • Open your chart on TradingView.
   • Click on the “Indicators” button at the top of the screen.
   • Search for “Volume” and select it. This will display the volume bars at the bottom of your chart, showing the number of shares traded during each time interval.
2. Adding VWAP:
   • Click on the “Indicators” button again.
   • Search for “VWAP” and select it. The VWAP line will appear on your chart, showing the volume-weighted average price throughout the trading session.

Conclusion

Understanding volume and its indicators is crucial for us as aspiring day traders. Volume provides insights into the level of interest and activity in a stock, and when combined with price action, it can validate trends and potential reversals.

The Volume Weighted Average Price (VWAP) is a powerful tool that helps traders understand the average price a stock has traded at throughout the day, weighted by volume. Unlike Simple Moving Averages (SMA), which only consider price over a specified period, VWAP incorporates both price and volume, making it particularly useful for day trading. VWAP resets at the beginning of each trading day, providing a dynamic and accurate reflection of the day’s trading activity.

Bottom line, volume and volume indicators are clearly something every day trader needs to fully understand and master.