Volume Based Technical Analysis
The volume oscillator measures the relationship between 2 volume moving averages (VMAs), showing the divergence between two 2 VMAs with different settings. We call the shorter-term VMA the "fast VMA" (VMA1 on IV chart); the longer-term VMA is called the "slow VMA" (VMA2 on IV chart).
The formula for calculating the volume oscillator is:
Volume Oscillator = [Fast VMA] - [Slow VMA]
Accordingly, a percentage volume oscillator (PVO) can be derived from the above formula; it is calculated as follows:
PVO = ([Fast VMA] - [Slow VMA]) / [Slow VMA]
The VMA itself shows the average volume over a specific timeframe. By calculating and charting the difference between a slow and a fast VMA, you can determine the extent to which the fast VMA trades above or below the slow VMA. This provides an indication of the intensity of short-term trading activity compared to the average trading activity over a longer time span.
Assume that on June 17, 2005, you analyze the S&P 500 index using a 1-day VMA as the fast VMA and a 10-day VMA as the slow VMA. Assume you find that the:
- 1-day VMA has a value of 2,394,012 K of shares;
- 10-day VMA has a value of 1,780,324 K of shares;
- Volume oscillator (1/10) is 613,688 K;
- and the PVO value is 34.5%.
By reviewing volume oscillator values, you can draw the conclusion that the trading activity on the S&P 500 on June 17 exceeded the average trading activity established over the past 10 days by 34.5%. On June 17, the S&P 500 gained 0.78%. As a result of the volume surge during the price advance seen on that day, the S&P 500 proceeded to decline by almost 2% over the next few days.
The volume oscillator allows a mathematical evaluation of volume surges. Using this tool, you can gauge the impact a volume surge might have on the market. Large positive oscillator values are indicative of significant volume surges. If such volume surges occur while an index is trending higher, they are by our definition "buying volume surges". Conversely, if such volume surges appear during a bearish market, we call them "selling volume surges" (for further details on these definitions, please refer to our Chart School). By further analyzing the corresponding volume oscillator values, traders can evaluate to what degree a particular surge is likely to impact the market - over the short-, mid-, and long-term.
The chart below shows an example of an intraday volume oscillator. Two VMAs are compared: a 15 minute VMA as the fast VMA, and a 1-day VMA as the slow VMA.
Chart #1: Example of an intraday volume oscillator. S&P 500 index. April 22, 2005. 15 minute = fast VMA; 1-day = slow VMA.
The above example clearly shows how the peak value of the volume oscillator corresponds to the point at which the index reverses its trend from down to up.
The PVO value provides an indication as to the magnitude of a particular volume surge. Basically, it shows how high the 15-minute VMA surged in relation to the daily average volume (1-day VMA). You can see this on our regular volume charts as well; however, because each day's average volume output varies, it is difficult to evaluate volume surges or to compare them to surges in the past. The benefit of the PVO value is that it is amenable to comparisons - it represents a percentage value. By using the PVO Quotes, you can analyze volume surges in the past, establish critical PVO values where the trend is most likely to reverse (over various timeframes), and build a trading system that best fits your trading style.
For the study of volume surges over various timeframes, we recommend the following VMA settings. Please note that the settings may also vary depending on your personal trading style:
Table #1: Recommended VMA settings
Before you apply the volume oscillator as a trading indicator, we suggest that you browse through our chart history. This will help you determine the best settings for both the fast and the slow VMA, and it will as assist you in establishing at which PVO levels trend reversals are most likely to occur.
An example to illustrate the above: Assume a trader makes 1 - 2 trades per week. He or she could use a 1-day and a 10-day VMA and define a PVO alert level of 20%. If this trader then sees a volume surge on a 15-day chart and a PVO of (1/10) - meaning the fast VMA (i.e., the 1-day) VMA is trading 20% above the slow (i.e., the 10-day) VMA - there is a good chance the market will soon reverse its current trend, at least for the short-term.
NEXT: On-Balance Volume
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