Monday, July 7, 2008

Technical Analysis - Volume Oscillator

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VO (Volume Oscillator) is one of the basic volume based indicators used in technical analysis. Such indicators as MVO (MarketVolume Oscillator) and PVO (Percentage Volume Oscillator) are based on the Volume Oscillator and it could be useful to understand the physics behind the Volume Oscillator in order to understand the other volume based technical indicators.

The Volume Oscillator formula is very simple and it is based on two volume moving averages (VMAs):

Volume Oscillator = [Fast VMA] / [Slow VMA]
Fast VMA is shorter-term VMA
Slow VMA is longer-term VMA

From the formula above we may see that the Volume Oscillator show the difference (ratio) between two volume moving averages. Volume moving average is average volume over a specified period of bars. If we set Fast VMA bar period equal 1 and Slow VMA period to 10 then on the daily chart (1bar = 1 day) the Volume oscillator will show how big or small is the current volume bar in relation to the average volume over the last 10 days.

The definition of the Volume oscillator could sound like: "The Volume oscillator shows where the current volume is in relation to the average volume over a longer period of time."

The Volume Oscillator becomes very useful in analysis of the volume surges because it gives mathematical evaluation of the volume surge in relation to the average volume over a longer period of time. That helps to use the mathematical representation of a volume surge in a developing of a trading system or building a trading strategy.

Volume Oscillator is very similar to the PVO (Percentage Volume Oscillator). These two technical indicators basically have the same meaning with the only difference that PVO evaluates volume surge in percentages while Volume Oscillator represents the magnitude of a volume surge as absolute value.

It is common practice to use several indicators in technical analysis. By joining Volume Oscillator with price technical indicators we may separate volume surges (when VO > 1) during the price move down from volume surges during the price move up. The high Volume Oscillator assumes abnormal volume activity and we may classify the volume surge during the price decline as panic selling and volume surge during the price advance as greedy buying:

  • When VO is above 1 and the price of a stock declines it indicates that this decline generates bigger than normal volume over the longer period of time. We have abnormal volume – more traders are in the game – a stock decline generates panic selling. The higher volume oscillator value is during a price decline the stronger panic selling we have on the market;
  •  When VO is above 1 and the price of a stock advances, it indicates that this advance generates bigger than normal volume over a longer period of time. We have abnormal volume – more traders are in the game – a stock advance generates greedy buying. The higher the volume oscillator value is during a price advance the greedier buying we see on the market.
Keep in mind that the volume is always a two sided transaction. Volume = 1 means that we have 1 buyer and 1 seller. When we have high volume surge during the price declines it does not only mean that we have panic selling, that also means that we have somebody who satisfies demands of the panic sellers and that could lead to the changes in the supply/demand balance and as a result we may expect a trend reversal.

The similar logic could be applied to the volume surge during a security price advance. The price of a stock moves up when we have more buyers than sellers. At the moment when we see big volume surge during the price move up we may say that some sellers decided to satisfy the big number of buyers which may lead to the luck of buyers (buying power for further up-move). The bigger a volume surge is during the stock price rise - the bigger number of satisfied buyers do not place trading orders any more (all funds already invested). As a rule that leads to shift in supply/demands balance, reduced number of buyers and as result we may see correction down or even market crash.

The difference between greedy buying and panic selling is that the greedy buying could be spread over time while the panic selling as a rule is a short lived process and that’s why we have bigger and stronger volume surges at the support points than at the resistance levels.

technical analysis has dozens of the various technical indicators in its arsenal. On my opinion, before using any of the technical studies, it is important to spend time and learn about it as much as possible. Only then a trader may analyze mistakes (lost trades) and  only then a trader may correctly adjust a technical indicator to the current market conditions.

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