We’ve discussed various technical indicators in our previous posts. Relative strength index, moving averages, 52-week highs, and exotic-sounding TA indicators like Ichimoku Kinko Hyo have all been dissected here. All such indicators have distinct advantages and weaknesses, and we’ve discussed where they can be best employed. Aside from that, you’ll notice that we always emphasize the importance of not using just one indicator for trading in each and every one of our articles. 52-week high trading, for example, can benefit significantly from using Fibonacci Retracement to plot resistance ranges. Of course, indicator pairings are subjective and largely depend on the trader’s goals. But there’s an indicator that can be used to complement almost all other indicators out there for investing and trading: volume and, by extension, volume oscillator.
What is volume?
Trading volume is the graphical representation of how many shares of an asset have moved in a given period of time. In options trading and other derivatives, volume indicates the number of contracts that changed hands during the indicated session.
Volume bars usually reflect the color of the candlestick they represent, making it easier to see the overall context of the trading session.
Volume’s importance in trading
Many analysts consider volume an essential indicator for identifying which market movements have weight behind them and which ones are likely to fizzle out. This makes sense because, as a rule of thumb, increased volume indicates increased market interest. Whether that interest means a rise or fall in stock price largely depends on context. For example, spotting an uptrend stock with increasing volume (relative to previous levels) can mean that it’s an excellent potential buy. Similarly, a stock in the beginning or middle of an uptrend that displays decreased volume could be a sign of an oncoming price drop.
In downtrends, volumes usually spike during or before the start of the price drop. Downtrends generally feature lower trading volumes within sessions, and an increase in volume can indicate a change in trend or further price breakdowns.
Higher volume also means higher liquidity, making buying or selling shares easier.
What are volume oscillators (VO)?
The volume oscillator indicator plots a line by measuring the relationship between two averages (fast and slow). Fast averages or cycles are typically plotted in 14-day or trading sessions, while slow averages use the past 28 days or sessions. The results are plotted using a line chart, with the 0 level as the neutral point. Any movement above the 0 line is considered a positive volume reading, while any dip below is a negative volume reading.
Here is the formula used to plot the oscillator:
The length of the cycles can be adjusted according to trader preference. Typically, the closer the cycles are and the shorter the fast average is, the better for short-term trading. Some traders use 8/20 or 10/18 averages. There have been a lot of arguments with regard to setting up these averages, but the best way to utilize volume oscillation is to backtest extensively to see which combination better fits your trading style.
There are several variants of the volume oscillator, and their availability is different for every stock charting website.
How do you use the volume oscillator for trading?
As mentioned earlier, the volume oscillator is a complementary indicator used to confirm signals other indicators produce. And since it’s called an oscillator, you can expect the line to move wildly across the 0 line. Interpreting the volume oscillations may be tricky because of this. But there’s an easy breakdown of the signals:
Positive reading
Any directional price movement with frequent positive volume readings is considered a signal for the continuation. If the uptrend displays mostly positive readings, then it is likely that it will continue. The same applies to downtrends.
Low or negative reading
Consistent negative or low readings indicate that the price action (uptrend or downtrend) is losing steam, potentially signaling a reversal. If the price is going sideways, the low readings can be taken as continuation signals.
Low or negative reading
Consistent negative or low readings indicate that the price action (uptrend or downtrend) is losing steam, potentially signaling a reversal. If the price is going sideways, the low readings can be taken as continuation signals.
Examples of using the volume oscillator with other indicators
Let’s look at how VO can help strengthen trading signals generated by other technical indicators.
Relative Strength Index
RSI plots out price movements on a 0-100 chart, and it identifies overbought (70 and above) and oversold (30 and above) conditions. Overbought conditions may indicate that it’s time to either sell or short a stock. Oversold conditions, meanwhile, can signal opportunities to buy. RSI is a great reversal indicator, and the volume oscillator can generate a confirmation signal.
In this example, the initial RSI overbought signal and VO-positive crossing came at the same time. But as you can see, the price still went down after the first signals appeared — but that price drop was where the downtrend stopped. Hence, it served as a signal that the downtrend is losing its momentum.
Traders who entered at the first signals may have gone in the red for a short duration, but those that held still had the chance to come out on top. Those who waited for confirmation of reversals i.e., when RSI crossed above 30 and stayed there for several sessions, would have gotten the best entry prices.
Moving averages
Moving averages create a line that filters out the noise of daily price movement. Golden crosses and death crosses are the most common signals sought by MA users, and it’s generated by plotting out a short-term average (usually 50-MA) and a long-term average (200-MA) on a stock chart.
In this particular case, a VO spike and increased price action coincided. The golden cross appeared a few trading sessions later, during the retest period after the breakout. This would have been a particularly good entry point.
Disadvantages of the volume oscillator
Like all trading indicators, VO has some blind spots, chief of which is something that I’ve often repeated throughout this article. It also shares similar drawbacks with most technical indicators. Here is the list of disadvantages:
- CANNOT BE USED IN ISOLATION
- Lagging indicator
- Susceptible to false signals (especially with massive buy orders)
- Subjective signals
Conclusion
The volume oscillator, like volume itself, can be a powerful complement to your trading strategies. Partner it with your favorite indicator and do some extensive backtesting to see if it’s the right fit for you.
