Volume spread analysis is a school of thought that believes volume plays a crucial role in understanding moves of prices in financial markets. This text will highlight 5 core arguments that solidify this basic premise.
Volume Spread Analysis
1- Technical analysis is not enough.
An argument in favor of technical analysis is the idea that the securities’ prices may not be linked to their fundamentals. The behavior of financial markets is frequently a result of momentum, confidence, and sentiment. In this sense, traders analyze security price chart to know what is the upside and downside potential.
However, reading the market solely from prices is insufficient. Markets move on supply and demand, and so, volumes are also an important part of the equation.
Volume Spread Analysis is a good way to understand how the concepts of supply and demand influence prices. It allows spotting imbalances between buyers and sellers by looking at prices and volumes.
VSA helps traders understand what the major players are doing and benefit from their actions. When a small trader buys or sells a pair, he/she certainly will not influence the price. However, when a big bank trades millions of a certain currency, this will probably move the market up or down. Usually, these big traders have more information and knowledge about the markets, so it is wise to be on their side. Through volume analysis, traders can know if market makers are buying or selling and take advantage of their positions.
2- It’s all about perceived value.
Fundamental analysis states that we can always grasp the intrinsic value of a financial instrument – stocks, currencies, commodities, etc. An assessment of the economy would allow traders to explain oscillations in prices.
On the contrary, volume-based traders say that to fully know what goes on in the markets, we should rely on perceived values instead of intrinsic value. And what does perceived value mean? This is how different professional traders view a financial instrument. And this is always contextual and acquired through an analysis of volume.
Below you can find the evolution of the price to book value since 2000 of the S&P 500. This metric is considered an approximation of the perceived value. It’s possible to see how traders permanently evaluate companies above their book value, taking in mind other analysis besides the fundamental one.
3- Price and volume are inter-related.
Past prices are an important aspect to understand moves in financial markets. However, the analysis of price is not enough.
A lot of technical analysis theories say we can solely rely on the analysis of price to understand the next move. These can take the form of different theories: Dow theory, Elliot wave theory, harmonic theory, candle-based trade, etc. The bottom line for all these traders is that everything is reflected in prices and different patterns.
Volume spread analysts say that the analysis of price is incomplete. We need to understand where the money is and where it will be in the future. Only then we can try to predict what is going to happen in the markets.
4- The cause of moves is volume.
We already dismissed fundamental and technical analysis as the sole explanations for moves in financial markets. Now, let’s look at how volume spread analysts justify these moves.
In their opinion, we need to look at prices in relation to volume. It is only this interconnection between price action and volume that justifies moves in financial markets.
In the chart below you can observe how major moves in prices or price reversions were always accompanied by volumes higher than normal. An analysis of volume in this situation would help traders identify these movements of prices.
Relation between price movements and higher trading volumes
5 – It’s all about understanding the role of different traders in the market.
The 5th core idea is that different kinds of traders carry different sorts of information – and we can base our trading strategy on this idea.
Volume spread analysis tends to emphasize three different types of traders: retail, commercial and professional. Retail traders are those who have small accounts and tend to trade erratically. They do not have any particular trading strategy and traditionally tend to buy and sell when the uptrend/downtrend is exhausted.
Commercial traders are investment banks whose function is to place orders in the market to satisfy clients’ needs. They can also function as market makers. These traders have an impact because they often carry large orders, which usually cause volatility. However, they don’t have any strong rationale supporting their trading decisions.
Professional traders are large traders that are in the game to win, and they are behind most trends. These are the types of traders that volume spread analysis tends to be concerned with – the successful volume trader is the one that detects what these traders are doing.
The following chart illustrates the power of large traders in moving the markets. On the left side, large traders reduced their positions, which caused a downside movement in prices. Prices traded sideways while these traders had stable positions and, when they started buying, prices moved upside. A small trader aware of what large traders were doing could follow their steps and take advantage of this information.
COT Report Large Traders
Wish to know more? Learn more about volume spread analysis in this article.
In a big picture (daily timeframe) USDJPY is moving upwards (Mark-up phase). You see that it is possible to draw an up-trendline with several touches (5 times market touched this line).
In H1 timeframe we have 2 important levels: resistance and support.
Long-term resistance. This level has been showing itself during long period. Several times the market turned near this level. The longer resistance is working, the stronger it becomes. Now it will require effort to cross this line. Effort can be recognized as a high activity (high volume) or no interest (no demand/no supply) in the market (can be analyzed through volume spread analysis).
Last time we had an up-thrust near this resistance. Up-thrust is a wide spread up-bar, accompanied by high volume, to then close on the low. Up-thrusts are usually seen after a rise in the market, where the market has now become overbought and there is weakness in the background. Up-thrusts are frequently seen just before a down-move. Analytical Trader has detected two very weak signals (Major Supply) in this place and later the market moved down to the long term support.
Now the price has reached the long-term support and VSA indicator detected strong signal (background is strong). It is possible that the market will reverse in this place.
AUDUSD M30 Trade analysis:
- At the time of entry background was strong – it is wrong to be bearish in this place. Only weak background is a sign that imbalance between supply and demand is in favor of supply.
- Strong signal before trend changed. In addition, there is no weak signal. This is also wrong for a short trade.
- Entry was made when dynamic trend turned from green to red – ok.
- The trade was not closed after strong signal appeared in the chart. You should close the trade immediately in this place. Reversal signal is supporting exit in this level.
NZDUSD is moving in a trading range. The area between the upper and lower trend lines is known as the trading range. In VSA terms, the (sideways) market is trading within its range, and will continue to do so until applied (selling or buying) effort makes it break out.
A trader who uses VSA principles will analyse price action in the top and bottom quarters of the trading range, because important observations take place in these areas, as the price heads for the supply or support lines.
The area above the supply (higher) trend line is known as overbought and the area below the support (lower) trend line is referred to as oversold.
One more important line in this chart – long-term resistance. Price already several times reversed near this line. Therefore, it is important to observe price behavior near this area.
- Background was strong.
- Strong signals (2 Minor Demand signals) before trend changed. Reversal signal also confirms market turn in this place.
- Dynamic trend turned from red to green.
- Entry in a low volume down-bar. Stop-loss below previous low.
- Exit by reaching TP level.
Total: + 37 Pips
There is a very interesting pattern in AUDUSD chart. Movement is limited by two important lines:
- Upper limit: long-term resistance
On 04.12.15 we had high activity on the top of the market when price was near the level of previous high (look at the volume and spread). Then up-thrust happened. Up-thrusts can be recognised as a wide spread up-bar, accompanied by high volume, to then close on the low. Up-thrusts are usually seen after a rise in the market, where the market has now become overbought and there is weakness in the background. Up-thrusts are frequently seen just before a down-move. Analytical Trader has also detected weak signal (Supply) on this bar. The market started to move down. I want to draw your attention that high of up-thrust is slightly higher than long-term resistance (previous maximum). Usually traders place stop-losses on this level or buy-stops to open a long trade in this place. In our case the stop losses were activated, long trades were opened, but the market has immidiately turned down leaving the traders with losses. This is a quite reliable setup after which we can expect prices to fall.
- Lower limit (support): up-trendline with several touches (already 5 times market turned near this line)
The longer support is showing itself, the stronger it becomes. Reversal signals appeared each time before market turned.
Now there is a high probability that prices again approach the long-term resistance. This pattern is also known as an ascending triangle. Eventually market will break one of these lines. VSA and Reversal indicators will help us understand the direction of break-out. Usually it is accompained by high volume and wide spread bars.
NZDUSD H1 Trade analysis:
- At the time of entry background was strong – background didn’t have time to turn weak and it is wrong to go short in this case
- Weak signal (Minor Supply) before trend changed (moreover this signal appeared near mid-term resistance) – this is a correct setup for a short trade.
- Entry after dynamic trend turned red – it is o’k (the best way to open trade in a low volume up-bar while the price is not far from market turn). It is better to place stop-loss above resistance (in our case it is below – not o’k).
- Trade has to be immediately closed after two Minor Demand or Demand, Major Demand signals, because there is a big chance that prices will turn direction after this signal. Reversal signal also confirms market turn in this place.
This is a near resistance trade which was opened after up-thrust in USDJPY.
In this chart we have long-term resistance which was created by previous high. At first market was rising, than we had an up-thrust (2 wide spread bars with high volume).
Up-thrusts can be recognized as a wide spread up-bar, accompanied by high volume, to then close in the middle or on the low. Up-thrusts are usually seen after a rise in the market, where the market has now become overbought and there is weakness in the background.
High of the first bar has almost reached the resistance level but closed in the middle. Further weakness showed in the second bar which closed on the low. VSA indicator detected 2 very weak signals here (Major Supply). Reversal indicator also suggested that market can turn in this place.
- In H1 timeframe background was neutral. In this case you should check above timeframe. H4 was weak, so it is o’k for a short trade.
- Several very weak signals (Major Supply). Reversal indicator also confirms market reversal in this place.
- Entry was made when dynamic trend was red.
- Exit after 2 Minor Demand signals (Reversal signal also confirms the exit)
Total: + 110 Pips
In daily timeframe it is obvious that USDCAD is moving in Mark-up phase (market is rising). Up-trendline is supporting the price (price turned near this line 5 times already). Background is strong.
In H4 timeframe we can see that character of movement was changed after the price has broken resistance created by previous high (note that there was no weak signals in this timeframe or Reversal signal when price approached this resistance). After the resistance was broken, market started to move up with new pattern (angle is very steep). It is possible to draw another trendline here. There is no resistance at this price level. Background is strong, therefore we can look for a place to go long. But be careful if you see stopping volume or buying climax, because the angle of up-trendline is too steep. Very often you can see such movement before market reversal.
USDCAD M15 Trade analysis:
In this chart you can see a very popular entrance among traders – buy stop at the level of previous high. I will analyze this trade from the view of Analytical Trader.
- At the time of entry background was strong – it is a correct part for a long setup.
- There were several weak signals (two Minor Supply) before trend changed and no strong signals. It shows that selling has entered the market. It is very risky to go long in this case.
- Reversal signal also confirms that market can turn down in this place.
- Dynamic trend turned from green to red – it is wrong for a long setup.
- Trade has to be immediately closed after two Supply or Supply, Major Supply signals, because there is a big chance that prices will turn direction after this signal.
“Reversal” is our new indicator which accurately detects price reversals. It can be used alone and together with VSA indicator. In last case you will have the greatest advantage in your trading and the best view of the market.
AUDUSD was moving in descending triangle. It was possible to draw a down-trendline and market turned 4 times near this resistance. Lower limit of this triangle was a support line. Recently it was broken by wide spread down-bars with high volume.
The following trade was opened after another reversal near the down trendline:
- At the time of entry background was weak.
- Weak signal (Minor Supply) before trend changed. Reversal signal also confirms market reversal in this place.
- Dynamic trend turned from green to red.
- Entry when price still didn’t move too far (stop-loss is placed above down-trendline)
- Exit after 2 Minor Demand signals
Total: + 77 Pips
