What is volume profile trading?
One of the most common ways for traders is to make use of the common concepts in technical analysis. These concepts include aspects such as utilizing support and resistance levels, price action based techniques, chart patterns and technical indicator based trading setups.
However, a new approach to technical analysis called volume profile has also been making the rounds.
Steidlmayer, the author of Trading with Market profile has been widely attributed to developing the concepts of volume profile trading.
An established futures trader, Steidlmayer is an independent trader having joined the Chicago Board of Trade in 1963.
One of the major claims of using volume profile strategy is that is allows you to build the market concept based on the study of volumes printed on the y-axis on the price chart.
Volume as an indicator is not uncommon. It is commonly used during the technical analysis of a stock chart. Volume is also widely prevalent in forex trading as well.
However, for the most part, volume is confined to the x-axis. The volume indicator basically shows the amount of transactions that take place during a session. Based on whether price was bullish or bearish, the volume bars are painted accordingly. This is known as volume profile or market profile.
With volume profile, traders focus on areas where a reversal could occur. Some say that volume profile analysis gives an "unfair" advantage due to the market context and that such methods are used by large institutions and banks.
Be that as it may, volume profile strategy makes for an interesting study as it puts the often taken for granted volume bars in context and allows for some unique insights into the markets when trading.
But before we begin, let's start from the very basics, what is volume?
What is volume?
Volume, or volume of trade shows the total number or quantity of contracts or shares that are traded for a specific security. Volume can be measured on just about any financial security.
Most commonly, volume is used in futures and stocks. Due to the fact that futures and stocks are traded at an exchange, one is able to get a fair idea on the quantity of contracts or shares that change hands.
Volume is also used in the forex markets. However, the major drawback here is that due to the OTC nature of forex execution, it is difficult to get a full picture of the true volume for the forex markets.
Still, many brokers offer the volume indicator, plotted as a histogram on the x-axis. This volume, in most cases captures just a small percentage and therefore does not reflect the true picture. Regardless, many forex traders continue to prefer to use the volume indicator.
The first chart below shows the basic layout of a stock chart with the volume bars displayed at the bottom of the chart.
Figure 1: Basic stock chart with volume bars plotted on the x-axis
The volume basically represents the amount of transactions that take place. Volume can also be used to measure the liquidity of the security in question. Generally speaking, volumes are reported once an hour by exchanges. However, these days of electronic trading can report volumes on a tick by tick basis. Still, these volumes that you see in real time are only estimates. The true and actual volume is showed only the next day for the previous day.
When volumes are high, it signals that the security is liquid and active. A security with higher volume also tells you that the order executions and the spreads are better.
What is volume profile strategy?
The volume profile strategy is basically a study of the volume based on price. This is a bit different compared to the regular volume bars that we mentioned in the previous section of the article.
While regular volume tends to display the total volume of the security for a given session, volume profile displays the volume of the security for a given price.
As a result, volume profile is plotted on the y-axis as it deals with price. To explain this in simpler terms, volume profile takes the total volume that is traded at a specific price level during the specified period and then divides the total volume.
This is then categorized into the buy volume or sell volume and makes this information available visually as it is plotted on a histogram on the y-axis.
The next chart below shows a sample chart with the volume profile. For context, we also retain the regular volume bars on the x-axis.
The longer horizontal volume bars are the ones of interest. These bars represent the price where there is the highest amount of volume. In other words, the price level depicted by the horizontal volume bars indicate the price where most of the activity has taken place.
This price is commonly referred to as the point of control or PoC. The name comes from the fact that the price in question had the most control of the market at the time.
The volume profile bars can be plotted across different time frames. The horizontal volume bars are updated every time there is a new order that is filled. Every time the volume profile bars are updated, they can change the position.
A common occurrence is to see the point of control or the price where most of the activity takes place, starting at the top of the chart as a new trading session begins. Over the course of the day, this point of control can shift thereafter to a different price level.
In market profile or volume profile analysis, there are some technical jargons that are commonly used. They are defined below.
High Volume Nodes: These are price levels that have the highest activity around a price level. The high volume nodes can be viewed as an indicator for consolidation of price.
In the high volume nodes, you can commonly see a high level of both buying and selling activity. Price also remains at this level for a long period of time.
The high volume nodes imply the fair value for the security in question. When price approaches a previously established high volume node, you can expect price to consolidate or move sideways. It is less likely that the market will immediately break past a previous high volume node.
Due to the high amount of activity that takes place at the high volume nodes, price tends to gravitate back to these levels. The high volume nodes are also seen as levels where there is a high amount of institutional buying and selling taking place.
Low Volume Nodes: These are the exact opposite to the high volume nodes. The low volume nodes signify a drop in the volume around a price level. The low volume nodes are created as a result of a breakout in price after consolidation.
During a breakout, you can often observe that price breaks with an initial burst of volume and later it drops off. These drop off levels imply that the price of the security is at an unfair value.
When price approaches a previous low volume node, there is a greater chance that price will break past that level due to the unfair value. The price of the security will not spend must time at this level compared to the high volume nodes.
Point of Control: The point of control is the price level at which there is the highest activity that takes place. Note that time is not of the essence here. Therefore, the point of control takes into account only the price level which has seen the most consolidation.
The point of control, from a trading set up perspective is said to be the level where you could place your stops or entry levels for a trade. Price also tends to revisit the previous point of control levels. This tends to act as both support and resistance.
Value area: The value area is basically the percentage of all the volume that is traded. The default setting for the market profile indicator is 70%. The value of 70% is based on the normal distribution curve.
The next chart below shows all the above technical terms visually.
Figure 3: Market or Volume profile – Terminology
Volume profile trading set ups
So far, we outlined what is volume and how volume profile differs from the traditional volume indicator that is commonly used.
With the volume profile indicator plotted on the price chart and on the y-axis based on the point of control, the high and low volume nodes, you can now get a clear picture of what is happening.
One of the most commonly used volume profile trading set ups is to use the price levels as areas of support and resistance.
We already noted that the high volume nodes are areas of consolidation where most of the transactions take place, but price moves sideways. These areas can be used as support and resistance. Similarly, the low volume nodes which tend to have little activity can also be used as areas where price could either quickly reverse or drop off.
One of the main differences in using volume profile trading set ups is that they are reactive in nature. The common ways to plot support and resistance levels are basically through trend lines and identifying areas of consolidation. Similarly, using volume profile analysis, a trader can build a reactive market context using this strategy.
Volume profile in forex
The next chart below shows some simple examples.
In the above chart, you can see that we have used a 20 and 50 period exponential moving average. The dashed black lines indicate areas of low volume nodes.
The red thick line indicates the point of control. If you were to trade the chart based only on the moving averages, you will notice that after the bearish sell signal (on the right), price initially falls to the point of control and bounces back.
However, a little while later, price breaks the point of control. At this point, short positions can be taken after the point of control is cleared with a strong bearish candlestick. With the two EMA’s already signaling a sell, a short position here can be taken down to the low value node.
The most amazing point about this set up is that you entered the trade at the strong point of the trend and booked profits right at the low value node. Following the decline to the low value node area of 1183 – 1175, price bounces back higher.
Figure 5: Volume profile trading set up, example 2
In the next chart above, we simply fast forward the chart but retaining the old values. Here, you can see that after the initial bounce off the low value node area, you can see a new point of control. When we combine the moving averages and the point of control, you can see how price reacts to the point of control.
This is the area where you would be entering the trade to the long side.
With the two period EMA’s already in a bullish signal, the long position from the point of control is take targeting the previous low value node. Notice how price consolidates at this area and the previously formed low value node turns into a high value node?
Booking profits here once again shows how you can enter the trade at the strongest point in the trend.
What we currently see on the charts is that price is near a high value node. Therefore, we could expect to see the price decline and retest the previous high value node around 1292 – 1285 level.
In conclusion, volume profile analysis shows traders the price levels and the amount of volume that was traded during the session. Volume profile is dynamic in nature and changes as the market evolves. At the same time, volume profile also builds the market context.
The trading set ups shown here is just one of the many ways that volume profile can be incorporated into developing a trading plan or strategy. Traders can experiment with the volume profile indicator with the understanding and the explanation provided in this article.