The Volume Oscillator, An Awesome Weapon

Volume analysis can really tip the scales in your favor when looking to open a trade.  The volume oscillator measures momentum.  With it, you can discern a few very important things; increased activity, the short term trend of this activity and the exhaustion point of the traders it represents.  These things are not as easily seen on a volume histogram.

Not all volume oscillators are created equal or work the same though.  Many oscillators simply compare a number of periods to the same number of periods in the past, with no reference point to make them relevant, at least not without careful scrutiny.  Like RSI for example, a 14 period RSI compares two contiguous four-teen periods.  Volume however, is more erratic in nature, and if you are interested in short term profits, like swing trading, then an excellent method is to compare the last five days with the last twenty days.  Why you ask?  Well, if you are trading swings, then for the most part, your trades will be from two to five days (bars) long, very short term.  So you are only looking for a short burst of support.  So you want a short time frame of volume to look at, like five days (bars).

You will compare it to twenty days (bars) of activity for a few reasons.  First of all, it provides you with a point of reference as to what constitutes a short burst of activity, by starting your measurement from this point.  Second, it gives you an overall picture of where the crowd is headed, like looking at a larger time frame.  Third, because of the erratic nature of volume, a twenty day average will better remove misleading spikes. 

In the event something is about to change, it will become more apparent in the five day average before it will in the twenty day average.  This five day average could be considered the leaders of the crowd.  If the five day average makes a significant enough move, the crowd will follow.

It also serves notice as to when the leaders are getting exhausted, because the leaders can not pull too far away from the crowd for any length of time without becoming exhausted, just like the runners in a long distance race.  When they do, either the crowd will catch up, or they will fall back into the crowd, the result is the same.  Lets see how this looks.

Volume Oscillator vs Moving averages

The chart above (MTW) has three windows.  The top is of course the price.  The middle windows contain two moving averages for volume.  The green line is a five day exponential moving average, the blue line is a twenty day moving exponential moving average.  As you can see, the twenty day blue line has a sluggish movement, much to slow to be of use for swing trading.  The five day green line, while much more responsive, is erratic and hard to make relevant to the price movement.  That's where the oscillator comes in handy.

The bottom window with the red line is the oscillator you will use.  It is the twenty day average subtracted from the five day average.  Think of the flat horizontal line as being the twenty day average stretched out.  Now the line which moves up and down represents the difference between the twenty day average and the five day average.

This combination gives us responsiveness and relevancy.  It's responsive because when the five day moving average changes, it is reflected in the oscillator.  It is relevant because its' height is measured from the twenty day moving average.  When It is above the center zero line, the five day volume is faster that the twenty day crowd.  When it is less than the zero line, the five day volume is slower than the twenty day crowd.

Notice how this can benefit you.  Look at the two peaks in the chart above on January 23rd and February 13th.  When the second peak occurs, the twenty day average (blue line) is still moving strong in an upward direction.  The five day average (green line), while lower than the previous peak, is still not a long way off.  Now look at the oscillator (red line).  There is a huge difference between its height when measured at the two price peaks.  Why is this?  Because it is more relevant to recent activity.  By flattening out the twenty day average with the oscillator, the five day average becomes relevant from one peak to the next.

This of course will not be the sole criteria for entering a trade, also sound money management, as well as an exit strategy is required for profitable trading, but I have found it to be a great addition to several strategies I use to confirm an entry.  If you would like to learn another robust method for profiting in the market, then follow the link below;

Profitable entry & exit techniques

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