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Volume Spread Analysis

Within the forex community, not much is talked about volume. The reason for this is because within retail FX we only really have tick volume to go with which is a different thing all together to real trade volume. It is therefore possible for 100 ticks to be the same traded volume as 1 larger order, which makes tick volume less reliable as a trading tool.

On exchange traded instruments such as stocks and futures we are able to access level 2 information quite easily, because the exchange is able to keep tabs of trade numbers and sizes and offer that back to the trader as real volume information. This means that it is possible to know exactly how big each order is that enters the market (or is about to enter the market via the limit order book) and also exactly how many contracts or shares have been traded for a particular amount of time, which gives the trader an idea of numerous aspects of market sentiment that are not price based.

Tick volume represents the number of transactions for the particular data feed, but since the FX market is not an exchange traded instrument but traded between numerous parties at an interbank level and via liquidity pools, clearing houses and ECNs, it makes it much harder to centralise the information about the total volume traded for the entire FX trading system.

There is however a reasonably good correlation between tick volume and real volume so we are often able to use tick volume as a proxy for real volume so long as we understand its limitations and this in turn allows us to borrow some volume analysis techniques from stock traders.

Volume Spread Analysis is a method of comparing the spread of a candle ie. The price high – price low for that period of time and comparing that with the volume traded during that time. Although this does not provide a signal, it does warn the trader that the current situation may be about to change, which makes it possible to sometimes extrapolate what is going on, however it is also not immune to false signals.

For example, if we are in a well-established up trend on an hourly chart, and we begin to get not very much movement in price but high tick volume, then we know that there is a lot of trading activity but the price is still not continuing within the uptrend. The likely deductions in this scenario are that there is either an increase in sellers entering the market or that the people who drove the prices higher in the first place are now taking profit and selling their positions to people trying to enter long for a trend continuation. Chances are both of these things will be happening.

Fig 1) Hourly chart with high volume to candle spread ratios highlighted in green

As seen in figure 1, we can simply use an indicator to show when high volume to spread ratio candles occur, which provides some useful clues as a leading indicator before price has even moved. These candles are called high churn candles.

We start off with the tail end of a downtrend, which then gives a high churn signal close to the bottom. We then rally higher and observe a weekly opening gap. Traditionally gaps have a tendency to close before they continue with trend or reverse, so it would be likely that shorts would enter the market here, however we can see that another churn signal is showing that bulls are meeting bears completely and the gap rallies higher again without closing.

At the top of the rally (save for the spike higher) we have a series of three candles which are all high churn signals. This means that volume was continually high for three hours although price did almost nothing in that time. As mentioned before, this is a subtle clue that there is a possibility of a trend change soon. Sure enough, this is the beginning of the down trend.

The next churn signal is also very telling. We have come back down close to support, which would typically be where bulls would enter for trend continuation, but this is being met with bears entering the market and eventually breaking the pair lower.

As can be seen, these signals do not tell you anything about direction or even offer a definite signal in the same way as a break of support does, but they do provide useful information that ‘something’ might happen which can then be used alongside other analysis to combine into something that can be very useful.

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