One of the most common ways traders use technical analysis is by using common concepts of technical analysis. These concepts include aspects such as the use of 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 profiling also makes the rounds.
One of the major claims of using the volume profile strategy is that it allows you to build the market concept based on the study of volume printed on the y-axis of the price chart.
Volume as an indicator is not uncommon. It is commonly used in the technical analysis of a stock chart. Volume is also widely used in forex trading.
However, in most cases, volume is limited to the x-axis. The volume indicator essentially shows the number of trades made in a session. Depending on whether the price was bullish or bearish, the volume bars are painted accordingly. This is called the volume profile or market profile.
With the 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 environment and that such methods are used by large institutions and banks.
Regardless, the volume profile strategy is an interesting study because it puts the often taken-for-granted volume bars into context and provides unique market insights when trading.
But before we begin, let’s start with the basics, what is volume?
What is volume?
Volume or trading volume indicates the total number or quantity of contracts or shares traded for a specific security. Volume can be measured on any financial security.
Most commonly, volume is used in futures and equities. Because futures and equities are traded on an exchange, one can get an accurate picture of how much of a contract or stock changes hands.
Volume is also used in the foreign exchange markets. However, the major drawback here is that due to the OTC nature of foreign exchange execution, it is difficult to get a complete picture of the actual volume in the foreign exchange markets.
Nevertheless, many brokers offer the volume indicator, plotted as a histogram on the x-axis. In most cases, this volume represents only a small percentage and therefore does not reflect reality. Nevertheless, many traders still prefer to use the volume indicator.
The first chart below shows the basic structure of a stock chart with the volume bars displayed at the bottom.
Volume essentially represents the number of trades made. Volume can also be used to measure the liquidity of the stock in question. Generally, volume is reported once per hour by the exchanges. However, these electronic trading days can report volumes on a tick-by-tick basis. Yet, these volumes that you see in real time are only estimates. The actual, real volume is only displayed the next day for the previous day.
When volumes are high, it means that the security is liquid and active. Higher volume security also tells you that order executions and spreads are better.
What is the volume profile strategy?
The volume profile strategy is essentially a price-based volume study. It’s a little different from the regular volume bars we mentioned in the previous section of the article.
While the regular volume tends to display the total volume of the security for a given session, the volume profile displays the volume of the security for a given price.
As a result, the volume profile is plotted on the y-axis because it is the price. To explain this in simpler terms, the volume profile takes the total volume traded at a specific price level during the specified time period and then divides the total volume.
This is then categorized into buy volume or sell volume and makes this information available visually, as plotted on a histogram on the y-axis.
The following chart shows an example of a chart with the volume profile. For context, we also keep the normal volume bars on the x-axis.
The longer horizontal volume bars are the ones of interest. These bars represent the price where the volume is highest. In other words, the price level represented by the horizontal volume bars indicates the price where most of the activity occurred.
This price is commonly referred to as the control point or PoC. The name comes from the fact that the price in question had the most control over the market at the time.
Volume profile bars can be plotted over different time periods. The horizontal volume bars are updated each time a new order is filled. Each time the volume profile bars are updated, they can change position.
It is common to see the control point or price where most of the activity is occurring, starting at the top of the chart, at the beginning of a new trading session. Over the course of the day, this control point may then shift to a different price level.
In analyzing the market or volume profile, some technical jargon is commonly used. These are defined below.
High Volume Nodes
These are the price levels with the highest activity around a price level. High volume nodes can be viewed as an indicator of price consolidation.
In high volume nodes, you can usually see a high level of buying and selling. The price also stays at this level for a long period of time.
High volume nodes imply fair value for the security in question. As the price approaches a previously established high volume node, you can expect the price to consolidate or move sideways. It is less likely that the market will immediately move past a previous high volume node.
Because of the high amount of activity that occurs at high volume nodes, the price tends to return to these levels. High volume nodes are also seen as levels where a lot of institutional buying and selling is taking place.
Low Volume Nodes
These are the exact opposite of high volume nodes. Low volume nodes mean a drop in volume around a price level. Low volume nodes are created as a result of a price breakout after consolidation.
During a breakout, you can often see that the price breaks with an initial increase in volume and then drops. These declines imply that the price of the stock is at an unfair value.
As the price approaches a previous low-volume node, there is a greater chance that the price will rise above that level due to unfair value. The security price will not necessarily move to this level compared to high volume nodes.
The checkpoint is the price level at which the highest activity occurs. Note that time is not critical here. Therefore, the control point only considers the price level that has experienced the most consolidation.
The checkpoint, from a trading setup perspective, is considered the level where you can place your stop or entry levels for a trade. Price also tends to go back to the previous control point. This tends to act as both support and resistance.
The value zone is essentially the percentage of all volume traded. The default setting for the market profile indicator is 70%. The 70% value is based on the normal distribution curve.
The following chart shows all of the above technical terms in a visual way.
Volume Profile Trade Setup
So far we have explained what volume is and how the volume profile differs from the traditional volume indicator commonly used.
With the Volume Profile indicator plotted on the price chart and the y-axis against the control point, the high and low volume nodes, you can now get a clear picture of what is going on.
One of the most commonly used volume profile patterns is to use the price levels as support and resistance areas.
We have already noted that high volume nodes are areas of consolidation where most trading is taking place, but prices are moving sideways. These areas can be used as support and resistance. Similarly, low-volume nodes that tend to have little activity can also be used as areas where price could either quickly reverse or fall.
One of the main differences in using volume profile patterns is that they are reactive in nature. Common methods of plotting support and resistance levels are essentially trend lines and consolidation zones. Similarly, by using volume profile analysis, a trader can create a reactive market environment by using this strategy.
Volume Profile in Forex
The chart below shows some simple examples.
In the chart above, you can see that we used a 20 and 50 period exponential moving average. The black dotted lines indicate the low volume node areas.
The thick red line indicates the control point. If you trade the chart based on the moving averages alone, you will notice that after the bearish sell signal (right), the price initially falls to the control point and rebounds.
However, a little later, the price breaks the control point. At this point, short positions can be taken after the control point is removed with a strong bearish candlestick. While both EMAs are already signaling a sell-off, a short position can be taken here up to the low value node.
The most amazing thing about this setup is that you entered the trade at the high point of the trend and took profits at the low value node. Following the drop to the low value node area from 1183 to 1175, the price bounces back up.
In the chart above, we simply fast forward the chart keeping the old values. Here you can see that after the initial bounce from the low value node area, you can see a new control point. When we combine the moving averages and the control point, you can see how the price reacts to the control point.
This is the area where you would enter the trade on the long side.
With both EMA periods already in a bullish signal, the long position from the control point targets the previous low node. Notice how the price consolidates in this area and the previously formed low value node turns into a high value node?
By recording your profits here, you are once again showing how you can enter the trade at the best time in the trend.
We currently see in the charts that the price is close to a high value node. Therefore, we could expect to see the price drop and retest the previous high value node around the 1292 – 1285 level.
In conclusion, analysis of the volume profile shows traders the price levels and the amount of volume traded during the session. The volume profile is dynamic in nature and moves with the market. At the same time, the volume profile also creates the market environment.
The trading setups presented here are just one of the many ways in which the volume profile can be incorporated into the development of a trading plan or strategy. Traders can experiment with the volume profile indicator with the understanding and explanation provided in this article.