Volume Trading Strategy: Trading Time Frames and Indicator

TRADING TIME FRAMES AND INDICATOR SELECTION

Up to this point in our Volume Analysis, we have developed our ability to recognize technical volume trends and technical volume/price patterns with the help of volume overlays. We have explored the charts of simple and complex trading environments and provided some basic illustrations of how volume plays into the analysis of trend continuation, reversal, and sideways patterns. Now we shift our attention to how best to use Volume Analysis to navigate the trading terrain.

In order to navigate successfully, a trader is faced with several strategic choices. One of the most critical, in our view, is, “Which volume indicators and oscillators should I select to best support my trading time frame?” This chapter examines the parameters a trader should consider in making this decision, provides a detailed explanation of the nature of indicators and oscillators and the combinations thereof, and offers guidance in the process of indicator selection.

Trading Time Frames and Signal Frequency

It’s worth our noting briefly that the selection of a trading time frame will determine, to a greater or lesser degree, the number of trading signals generated, interpreted, and acted upon over a given time period. The best way to illustrate this signal frequency is by example: A trader working within five-minute time frames will have to deal with many more signals in a trading day than someone trading in daily or weekly time frames. Trading in shorter time frames is a demanding and more time-intensive approach, while longer time frame traders generally have fewer and less frequent signals to interpret. Although a longer time frame may appear simpler, trading off fewer signals has its own inherent risks. Often, a shorter time frame with increased signal frequency can yield more trading opportunities.

Selecting Volume Indicators and Oscillators for Your Volume Analysis

As every trader knows, the selection of trading tools can feel overwhelming. There are dozens, perhaps hundreds, of technical tools to choose from. The indicators we have chosen to discuss are those that can supply an additional volume dimension to your trading strategy. Although there is no such thing as one size fits all in trading, we do have some parameters that can help in navigating the volume terrain. Indicators perform differently under different trading conditions, so seek to utilize a volume component that will be versatile and provide signals to complement your existing strategy. Consider including the following in your Volume Analysis:

• A bar plot of volume so that you can quickly refer to current volume patterns. As price is inextricably tied to volume, every technical price charting formation will have a confirming volume pattern.
• A VMA or other volume overlay to act as a leading or confirmatory indicator. (Use settings that complement your trading time frame.) Depending upon your VMA time setting and its sensitivity to change points, the VMA will provide you the conviction behind the price trend, tops and bottoms, and turning points.
• A macro, or longer-term, indicator to identify the direction of the prevailing trend. Trades in the direction of the larger-degree trend have a higher chance of success. One such indicator is On-Balance Volume, Which gives a trade good read on longer trend and provides a basic framework from which trades in the direction of the trend can be favored.
• A volume indicator or oscillator complementary to your trading time frame. Having both volume- and price-based components, these tools are able to identify not only the direction of the prevailing trend, but the conviction as well.
• When using and combining indicators, it is wise not to combine indicators that are redundant or that measure and display the same technical patterns.

Longer-Term versus Mid- to Short-Term Volume Indicators and Oscillators

The volume indicators and oscillators listed here are discussed in more depth in Chapters 8, 9, and 10. We’ve placed these technical tools in their most user-friendly time frames; as such, these placements are intended to act only as preliminary guidance.

Longer Time Frame Volume Indicators

The following indicators and oscillators work best at displaying a more accurate picture of the longer-term or prevailing trend. Longer time frame indicators generate fewer trading signals Please note that all of these are examined in more detail in Part Two.

1. Accumulation/Distribution
2. Cumulative Volume Index (broad market indicator)
3. Intraday Intensity
4. Negative Volume Index
5. On-Balance Volume
6. Positive Volume Index
7. Volume Accumulation Oscillator
8. Volume Price Trend
9. Volume moving average (settings: 60 days or longer)

Mid to Short Time Frame Volume Indicators

This set of indicators works best at detecting shifts in price and/or volume momentum over a short to intermediate time frame. Mid and short time frame indicators generate more frequent buy/sell signals, depending upon the sensitivity of their settings.

1. 10-Day open ARMS (board market indicator)
2. 30-Day open ARMS (board market indicator)
3. Chaikin Advance/Decline Oscillator
4. Chaikin Money Flow
5. Demand Index
6. Ease of Movement
7. Force Index
8. Money Flow Index
9. 10-Day Up/Down Volume Oscillator (broad market indicator)
10. ARMS Index (broad market indicator)
11. Volume Oscillator
12. Volume Rate of Change
13. Leibovit Volume Reversal
14. Volume moving average (settings: short, up to 5 days; mid, 5 to 60 days)

Broad Market or Individual Security Indicator

The indicators mentioned previously that are marked “broad market indicator” use price and volume data from the major exchanges. These are required for broader market analysis and may not be suited to analyzing an individual security. However, if that security does track equivalently with a broad market indicator, then these tools can be used. Doing a simple price overlay of the security against the broad market indicator will answer this question. Any of the other indicators/oscillators listed previously, however, could be applied directly to an equity, index, or commodity, if so desired.

Indicators versus Oscillators

Volume Analysis provides traders with visual tactics to discern trends and patterns. Our charts contain volume indicators and oscillators designed to represent variations on the volume/price relationship. These mathematical formulas, which include volume, may reflect these aspects of price and volume in various weightings, as a single variable or set of numbers. When charted, these formulations can help spot trend strength, divergences, reversals, and other useful characteristics of price and volume over a given time period. As you read more about these trading tools, you’ll soon discover that they fall into two categories: indicators and oscillators. Most traders will deploy an assortment of indicators and oscillators to fit their particular market and trading style.

One way to understand indicators and oscillators is to understand the difference between the two.

Indicators

A technical trading indicator is derived by applying a formula to a series of data points of price and/or volume. This produces a series of resulting calculated values that are usually graphically shown above or below the price chart. Creating a series of calculations and plotting them over time allows for analysis of where todays value is in relation to past values.

Volume indicators are used to provide an extra level of analysis in addition to simple price and volume action alone. This type of analysis is used to either confirm a trend or show where the price trend may be ready to change (i.e., a divergence). Indicators often provide buy and sell signals based on their patterns. It is important, however, to use a weight-of-the-evidence approach by confirming indicator signals with price and volume patterns to validate that signal. For example, it is normally unwise to execute a sell signal flashed by an indicator without confirmation when the behavior patterns of both price and volume indicate that a robust uptrend is in place.

Oscillators

An oscillator is a technical tool that applies a formula to a series of data points that move above and below a center line or between upper and lower boundary levels on a set scale as its value changes with each time period. Oscillators are most commonly used to track momentum—the rate at which price or volume rises or falls. As price or volume rises in a healthy uptrend, momentum also increases. If price or volume continues to rise, but at a slower rate, then momentum will not keep pace, showing a divergence in the oscillator. A divergence shows that a trend is weakening and may be ready for a reversal.

Oscillators come in two types. Banded oscillators use “overbought” and “oversold” lines that give signals when crossed, while centered oscillators generate signals when they cross above or below a central line (usually with a value of zero). Centered oscillators are best for identifying the strength and/or direction of the trend, with readings above the center line showing positive momentum and readings below the center line showing negative momentum. Banded oscillators, in contrast, can identify when the trend has become overextended, such as overbought

 Chart 7.1 Banded Oscillator Example, QQQQ, Nasdaq 100 Trust ETF

readings in a downtrend or oversold readings in an uptrend, which can provide great trade setups. Centered oscillators can show extreme readings above or below the center line, but they are not best suited for that purpose.

Chart 7.1, the daily record of the Nasdaq 100 Trust ETF (QQQQ) shows the Money Flow Index (MFI), which is further defined in Chapter 10 as an example of a banded oscillator. You can see one of the drawbacks of using a banded oscillator in a trending market. Notice how the MFI did not reach the oversold zone (a reading below 20) during the 2009 bottom and for the entire uptrend.

It is important to know the characteristics of any indicator that you use and how it behaves in trending and nontrending markets. As with any indicator or indicator combination, select the ones you find most user friendly and learn how they work —both independently and together.

Chart 7.2 shows the Demand Index as an example of a centered oscillator using zero-line crossovers to generate buy and sell signals. Crosses above the zero line from below are buy signals, while crosses down below the zero line from above are sell signals.

Chart 7.2 Centered Oscillator Example, Money Flow Index, Nasdaq 100 Trust ETF

Oscillators as Predictive Tools

One of the main concepts behind the use of oscillators is their ability to show divergences, or a weakening of the current price trend, which some say makes them "leading" indicators. There really is no such thing as a leading indicator, only a leading technical pattern, since all indicators are constructed using past data.

Divergences reveal that a trend is weakening, but such divergences can last for weeks. This means that exiting a trade prematurely merely on the existence of a divergence can cost a trader much in the way of profits. There are two types of divergences. A positive divergence occurs when price makes a new low but the oscillator does not, while a negative divergence occurs when price makes a new high but the oscillator does not.

In either case, the divergence is viewed as a nonconfirmation of price action, which serves as a warning that a change in trend direction may be near. But traders shouldn't stop their Volume Analysis at this point: Trading divergences should always include some form of confirmation by at least one additional source before making a trade. For example, a divergence shown by the Money Flow Index would need confirmation from a separate indicator, such as the Leibovit Volume Reversal. (For more on this specific indicator, see Chapter 9.)

 

Chart 7.3 Confirmed Divergences, VR Money Flow Index, with VMA, U.S. Dollar Index

The example of the U.S. Dollar Index in Chart 7.3 shows how the MFI was showing a clear negative divergence as price made new highs. Naturally, such a divergence calls into question whether an aggressive trader should go short or take profits on the long side. As discussed previously, when a divergence occurs, it is unwise to exit prematurely or jump in with a position against the trend, as divergences can last for days or even weeks. This example also shows the use of a second indicator to confirm the divergence. In this case, it is a volume indicator, the 9-day volume moving average (VMA) plotted at the bottom of the chart.

The Leibovit VR is a very good indicator for showing when control of the market is shifting from sellers to buyers, or in this case, from buyers to sellers. Notice in Chart 7.3 how the VR pinpointed the best time to act on the negative divergence in the MFI.

Using Oscillators with Other Indicators

Oscillators are most effective when used in conjunction with other Volume Analysis methods, such as overlays and volume patterns, to determine support/resistance, trendlines, and so forth. It always helps to look at oscillator signals in the proper context as they relate to other methods of analysis.

One of the drawbacks of oscillators is that they can give false or whipsaw signals. That is another reason to use oscillators with other trading tools. Doing so helps reduce the number of false signals that may be generated.

Matching Volume Indicators and Oscillators with Market Conditions

Often a trader must choose the trading indicator that best suits the current market environment. Is one indicator or another more useful in trending markets or in range-bound markets? How should a trader view the indicator and oscillator selection process? For example, banded oscillators, such as the Volume Oscillator described at the end of Chapter 10, which fluctuate between upper and lower bands, are widely believed to be best suited for range-bound markets, as they show overbought and oversold situations.

To use oscillators for this purpose alone, however, takes away from another valuable use of oscillators —their ability to show the strength and sustainability of an existing trend. In general, assigning different indicators to different market conditions presents a host of issues regarding trading analysis, including timely identification of range-bound versus trending markets and frequent changes in strategies. In our experience, simple is better.

One option we highly recommend is to use a trending or longer-term volume indicator with a short- to intermediate-term indicator or oscillator that covers most market conditions. In Part Two, where specific indicators and oscillators are discussed, we do suggest combinations of indicators and oscillators that make sense in specific trading environments, but for the most part we prefer designing a strategy that works across trading environments.

Still, it is important to learn the characteristics of your preferred indicators and how they actually behave under different market conditions. Once you get comfortable with your chosen indicators and the signals they send, you will know at a glance what type of market trend is prevalent. For example, if a longer-term trending indicator such as On-Balance Volume (see Chapter 9) is moving higher (higher highs and higher lows), you know that the market or security is in a recognizable uptrend. The same reading can also be made by looking at an oscillator, because in uptrends oscillators tend to top and bottom at different levels, that is, to move in a different range from what they do in downtrends. It is also important to know where support and resistance levels are and to watch how price, volume, and your indicators behave as these support and resistance areas are encountered. Doing so can keep you one step ahead of the crowd in knowing whether a trend will continue or whether a trading range or reversal is forming.

As an example of how oscillators perform differently in uptrends versus downtrends, note in Chart 7.4 how the Money Flow Index (MFI; further described in Chapter 10) tends to top and bottom at lower levels in a down-trend versus higher levels in an uptrend. Since the MFI is a banded oscillator, it uses the level of 80 for overbought and 20 for oversold. Blindly using and accepting only these levels can cause a trader to miss out on some great trading opportunities, as the MFI, when used with its common default setting of 14 periods, rarely reaches 80 (overbought) in downtrends and likewise rarely reaches 20 (oversold) in uptrends. It is important to plot the indicator and note its characteristics on any market or security you trade so that you can know where to expect range shifts and turning points based on tine trend.

Chart 7.4 Money Flow Index Oscillator, Contrasting Behavior in Uptrend versus Downtrend, Nasdaq 100 Trust ETF

Indicators versus Volume and VMA

While volume is a tremendous tool for measuring trader sentiment, it is only one dimension of the analysis process, much like using price action alone. For this reason, in our Volume Analysis we never lose sight of the fact that volume and price movement are inextricably linked. The key is to look at both volume and price together —or to use indicators that combine volume and price components.

Volume and the volume moving average (VMA; see Chapter 3) are great for spotting trends and turning points in sentiment. They fall short, however, as they are unable to identify the direction of the price trend or the proper price points at which trades should be entered and exited.

Longer-term trending indicators such as On-Balance Volume (Chapter 9), in contrast, use the daily change in closing price to determine whether the volume for the day has been positive or negative. Short-term to mid-term oscillators such as the Money Flow Index use price data before volume data are applied to their calculation. Both of these indicators have the ability to give a sense of both direction and strength of price movement, which are the most critical components of trend determination. Volume measures the strength or conviction behind the identified price trend, giving a trader clues to whether the trend is likely to continue or deteriorate. Essentially, it is our view that both types of Volume Analysis are complementary and serve to confirm each other.

Position Traders: When to Exit and Stand Aside

When trading the market and using indicators, it is always wise to heed the warning signals given by your preferred indicators. Position traders, who are less interested in catching turning points than they are in riding trends and protecting profits, should consider using multiple volume indicator combinations to signal when there is real trouble ahead. The example of the Nasdaq 100 Trust ETF (QQQQ) in Chart 7.5 uses the combination of Volume Price Trend (VPT) and the MFI and volume with a 9-period VMA.

The example given by the steady uptrend followed by the volatile reversal in the first half of 2010 (punctuated by the “flash crash”) is telling. Notice in the move higher off the March 2009 low through January 2010 that VPT continues to make higher highs as price pushes higher. Even though these increments were marginal, they were higher just the same,

 

Chart 7.5 Multiple Indicators Signal a Downturn, 2010 1H, Nasdaq 100Trust ETF

thus validating the rally. Now take a look at MFI just below VPT in Chart 7.5. This is an example of knowing the characteristics of your selected indicators. MFI bottomed at the 37 to 40 level throughout the uptrend. Each time MFI moved down to that level, a momentum bottom was formed as MFI reversed higher, giving an indication that prices were ready to resume their uptrend.

The first sign of trouble for the uptrend was in January 2010 as MFI made the lowest low along the way, clearly breaking down through the 40 level, all the way down to 27. This was a sign that, during this pullback, sellers were applying more pressure than in any other previous pullback, during the rally. That didn't signal that the uptrend was over; it merely showed that the uptrend was losing its strength.

The uptrend resumed following the pullback as price pushed out to new highs in March, grinding higher into May. As price continued higher, note how MFI made its final high on March 18 and began to decline as price continued higher. That shows an obvious loss of momentum, but what about the major trend? What is VPT showing? Notice how VPT never eclipsed its January high, even as price moved considerably higher into May. That was a major sign that the uptrend was laboring.

Finally, take a look at the VMA in the very bottom frame of Chart 7.5. Note how it never increased during the final push higher into May. Other rallies lacked impressive volume to that point, but there were at least periodic surges in volume that managed to push the VMA higher. There were no such surges in the March-May 2010 period, showing that buying pressure was waning.

Now lets zoom in on the final rally from the February 2010 low to the May 2010 high to see where risk or equity exposure could have been reduced (see Chart 7.6). Of course, as with any trading strategy, you need to have a plan for how much risk you are willing to take off the table and when, but the combination of indicators in this situation would have given ample warning to allow for the execution of such a plan.

Chart 7.6 shows how a trendline was drawn off the February 2010 low. Even though VPT and MFI are showing signs of trouble, there is still a definite uptrend in prices supporting the plot of a trendline. When that trendline is violated, it is time to move to cash and stand aside.

Prior to the trendline being violated, however, the new high made in March is not validated by either VPT or MFI. That signaled that equity exposure should be reduced. That wasn't necessarily a signal to exit and stand aside because divergences can last for weeks—as was the case here. 

Chart 7.6 Seeing a Downturn before It Happens,2010 1H, Nasdaq 100 Trust ETF

Selling into rallies was the best plan, as price continued to grind higher with an obvious loss of momentum.

One final piece of the warning puzzle: Volume finally began to pick up in late April 2010 as price chopped sideways. Again, this was another change in the characteristics of the rally. Volume had been uninspiring to that point, and when it increased with difficult upward price movement, that was a sign that sellers were putting solid overhead supply on the market. On April 27, the uptrend line off the February low was violated, which gave plenty of time to move to cash before the May 6 flash crash occurred.

Indicator and Oscillator Sensitivity

When incorporating indicators into your volume Analysis, it is important to select the proper trading time frame parameters. For example, when using MFI on a daily chart, the most commonly used setting is 14 days, as used in the previous examples. A time frame of 5 days gives more over-bought/oversold readings, while a time frame of 21 days gives fewer—but perhaps stronger—overbought/oversold readings. The long-term example from August 2008 of the Nasdaq 100 Trust ETF (QQQQ) in Chart 7.7

 Chart 7.7 Five-Day Money Flow Index, Nasdaq 100 Trust ETF (QQQQ)

shows the number of overbought/oversold reading generated with the 5-day versus the 21-day setting.

Notice on the 5-day setting how MFI reached the overbought/oversold levels many times throughout the 22 months shown. Settings this sensitive give many false signals, so care must be taken to find the right balance between quantity and quality of signals.

As for the 21-day setting (see Chart 7.8), note how it never quite reached the oversold level in the 22 months shown, while it reached the overbought level only once, in March 2010. When it did reach that level, however, the signal was strong and important, given what followed.

These are simple examples of how the time frame settings can affect the performance and frequency of signals in an indicator or oscillator.

Chart 7.9 displays a 30-minute view of the U.S. Dollar Index continuous contract with the combination of VPT and MFI. Even though the 30-minute time frame is considered very short by less active traders, a true sense of trend can be determined by both price action and VPT. As VPT makes a series of lower highs and lower lows, it shows real intraday weakness in the U.S. Dollar Index. That means that since the trend is down, MFI can be used as a trade filter to identify potentially profitable short position as it rises to overbought levels (above 80) and crosses back below 80.

Chart 7.8 Twenty-One-Day Money Flow Index, Nasdaq 100 Trust ETF

Chart 7.9 Money Flow Index, Sell Setups in a Downtrend, U.S. Dollar Index

However, the trade should not be executed without a trigger such as a move that takes out a prior low. One reason for this is that the MFI reflects momentum and requires some other form of confirmation to determine that the downtrend is indeed resuming. Note how the downtrend from June 9 through June 17, 2010 yielded some great intraday shorting opportunities.

The next example shows how combining indicators at the opposite end of the time spectrum can also be effective. Chart 7.10 is a weekly frame of the SPDR Gold Shares ETF (GLD). The indicators paired in this example are Accumulation/Distribution and Ease of Movement. Accumulation/ Distribution is a cumulative trending indicator, while Ease of Movement is a centered oscillator, meaning that it generates signals when it crosses above or below its center line—which has a value of zero. The Ease of Movement indicator tends to bottom very close to the zero line in uptrends and top very close to the zero line in downtrends. In this example we are only interested in those crossovers that push decisively above or below the zero line.

Note in Chart 7.10 how Accumulation/Distribution shows a solid uptrend since the 2004 low with the exception of one corrective period in the second half of 2008. By pairing Accumulation/Distribution with Ease

Chart 7.10 Weekly Chart of the SPDR Gold Shares ETF (GLD)

of Movement, an effective trend-following strategy can be developed. Blindly buying and holding during this period would have ultimately worked out for the buyer, but no doubt he or she would have developed stomach ulcers along the way. Using a Volume Analysis strategy combining these indicators would have helped a gold trader sleep better at night, especially during the 2008 meltdown when GLD lost over 30 percent.

The GLD example in Chart 7.10 has the zero line marked in Ease of Movement. Crossovers of this line provide signals to either take long positions or move to cash. This strategy doesn't catch every ounce of upside, but it allows a trader to catch the meat of each trend while sitting out the sharp selloffs.

Up until now we have looked at some of the more conventional volume indicator pairings. In this final example, we will add another layer to take the guesswork out of the timing of our entry. The U.S. Dollar Index example in Chart 7.11 shows how a combination of indicators in a five-minute time frame can yield great results.

The plot follows the MFI and VPT on June 20, 2010. First, note that the VPT is making higher lows while the MFI is bottoming at around the 40 level even as price has pulled back. Both are bullish characteristics.

 

Chart 7.11 Money Flow Index and Volume Price Trend, Combined in Short Intervals, U.S. Dollar Index, Continuous 5-Minute

With a setup like this, it is time to look for a long trade entry. The question is: What will be the trigger to execute the trade?

A conservative solution would be to wait for the previous resistance level to be taken out. A more aggressive solution would be to simply buy here with a price stop just below the previous lows. Since the first option would leave precious profits on the table and the second would be more of a exercise in blind faith, lets add one more piece to our analysis, the Leibovit Volume Reversal.

Notice in Chart 7.11 how the Positive VR between 10 a.m. and 11 a.m. signaled that buyers were taking control of the market. In this case, the Positive VR is backed up by the positive setups in both VPT and MFI, and it led to a very successful trade. 

Summary

• Volume Analysis requires understanding volume technical indicators and oscillators and how they perform and apply to the market conditions and securities being traded.
• To a large degree, finding the right indicators among multiple combinations of indicators takes practice and experience; there is no "one size fits all” solution.
• One of the more challenging tasks in an analysis is designing combinations of indicators to support a trading time frame. It isn't just about selecting the indicators; it’s also about selecting complementary time frames and setting trading parameters.