Volume and open interest are momentum indicators – that is, rather than helping you directly determine the direction of a market, they are designed to help you gauge the strength or weakness of a market move. This is the reason we have developed our own very own Strike Momentum Indicator to guide our trades. Therefore, they are secondary indicators of future market direction. I would never recommend using volume and/or open interest numbers as your sole reason for entering a trade. These are strictly secondary indicators or trade “filters”, and should only and always be utilized as such. Factors like volume are useful to confirm your market analysis, but should never form the foundational basis for that analysis. I’ve seen markets go through dramatic, extended price changes with barely a blip of change in either volume or open interest. And I’ve also seen significant changes in volume and open interest that signaled absolutely nothing – that is, that occurred in a market that was stuck in a relatively small trading range and basically going nowhere fast.
In short, volume and open interest can be notoriously unreliable market indicators, especially in short-term trading. However, they can still be utilized to confirm an existing hypothesis that one has about the near-term, or even long-term, direction of a market. One particular situation in which they can be helpful is when a market has been in a trend, up or down, for quite some time, and you have doubts as to whether it will continue its current direction or begin to fail at current price levels and reverse direction. In such an instance, a significant drop in volume and open interest can serve as an early warning indicator that a market has just about “run its course”. Likewise, if volume and open interest remain relatively steady, or even increase, while the market pauses and catches it breath, odds are better that the market will resume its existing trend once it gets moving again.
Volume and open interest are nearly always mentioned together for a very good reason. Whenever using them as market indicators, they are more reliable when both indicators are in agreement with each other. The basic combinations of volume and open interest are as follows:
More reliable indications
– Volume AND open interest both increasing favors higher prices or current trend continuation
– Volume AND open interest both decreasing favors lower prices or upcoming trend reversal
Less reliable indications
– Volume up, but open interest down, signals a changing market
– Volume down, but open interest up, usually signals a market gathering momentum to move higher (however, it’s good to keep in mind that if such a push upward fails, then the market is likely to reverse sharply to the downside as all of those newly opened interests get stopped out or dive for cover)
Volume and open interest numbers tend to diverge when a market’s direction is uncertain, or when there simply is no overall or long term direction (that is, when the market is simply a “trading range market“). By the way, there’s nothing wrong with a trading range market, as long as you can accurately identify the trading range. I’ve seen traders make a lot of money just selling near the top and buying near the bottom of a narrow trading range that stays in place for several hours, or even several days or weeks.
From this point forward, I’m just going to talk about volume, because in forex trading in the major pairs, that indicator fluctuates significantly more than open interest does. Let’s take a look at some volume readings and how you might apply them in an actual trading situation. Consider the Aud/Usd chart below (oh, ignore my note on the chart, “Entered here” – that’s got nothing to do with this discussion):
Starting with the left hand side of the chart, note how after price has been flatlined and volume relatively low, volume increases markedly as soon as the market begins a significant move to higher price levels. But then note how, 3 or 4 candles later, although the market continues to push higher in price, volume begins to steadily drop off. This is a potential clue that buying interest is drying up at the higher price levels. Then just as price falls below the 10 EMA, and just before the 5 EMA crosses to the downside of the 10 EMA, volume begins to pick up. So there’s another indication that the market is spent at the higher price levels and will likely turn lower. Finally, looking at the far right hand side of the chart now, note the sudden sharp increase in volume that tends to confirm the change back to the upside just as the 5 EMA crosses back over the 10 EMA (and, looking back to the left, you can see that price has again moved above the price level where the previous move to higher prices started).
Ah, but let’s keep looking a bit further (the chart below shows the end of the previous one, and then more action moving forward).
Okay, nice 15-minute candle up, 5 EMA crosses over the 10 EMA and both cross above the 50 EMA, and all with increasing volume. Buy it, right? Well, yes, I likely would…but it doesn’t work out. Both price and the lower EMAs almost immediately cross back to the downside of the 50 EMA, and as you can see moving to the middle of the chart, price falls back down even lower than before. So what did we miss? – Not necessarily anything. I just wanted to illustrate that indicators, even several indicators together, do not always accurately predict future market direction. There’s no such thing as a sure thing in trading the markets (well, except buying sugar at the 3-cent level…but that’s another story). The one clue that the temporary move back up might fail is the fact that after that first big 15-minute candle up, there was no follow through as there was in the previous move up – price almost immediately turned back to the downside, and just 3 candles later price was back down near the recent lows and all the moving averages had turned back to the downside as well. Again, the lesson to be learned here is that no matter how good a trade might look in the beginning, it still may not work out as anticipated (that’s what stop-loss orders are for).
Hmm…I guess I should have gone over this in the beginning – following are basic definitions of volume and open interest:
Open Interest is a measure of how many total positions, short or long, are currently held in a market. Are there a lot of positions currently held, or relatively few? – i.e., how much overall current interest is there by traders in trading this market?
Volume is the measure of total buying and selling activity in the market. Is there a lot of trading going on back and forth, or relatively little?
I do believe that volume can be a very helpful indicator, although, as noted above, only a secondary one. One of the advantages of floor traders on the exchanges over those of us sitting behind our desks at home, is that floor traders can actually see the momentum in an increase in volume, can see the suddenly frenzied buying and selling taking place in a market that’s making a significant move (or conversely they can see that while price may be moving a bit, trading is lackadaisical, routine, lacks conviction). This fact has been recognized by nearly all the legendary traders you’ve read about or heard of – that there was an advantage inherent in being able to watch not merely price changes, but the actual level of intensity in trading. Well, floor traders are almost a thing of the past now – nearly everyone is just sitting behind a computer somewhere. Nonetheless, volume readings can provide some sense of the true nature of the action going on.
One cautionary note: It’s difficult to accurately assess volume in the forex markets, simply because there is so much trading in currencies that occurs in so many different markets worldwide. It’s not like, for example, trading wheat, which is overwhelmingly traded in the CBOT market in the U.S. Some people even say you can’t use volume numbers in forex trading. Well, I’d say they’re probably about half right – the volume numbers for forex probably aren’t exactly accurate; nonetheless, I think they’re a good enough estimate of trading activity that they can be helpfully utilized.
Uh, okay, one more cautionary note: There is often a dramatic increase in volume at market tops or bottoms. It’s basically the market blowing out, or exhausting, its remaining interest in price at that level. Therefore, volume can be a useful indicator to help detect market reversals, significant changes in direction, up or down. Just keep an eye out for that.
To sum up:
– Volume and open interest are secondary indicators which may be utilized to confirm one’s market analysis based on other factors.
– Volume and open interest are most reliable when both are in agreement, i.e., both increasing or both decreasing.
There are a variety of volume indicators available for charting, but personally I just use the basic “volume” one.
All right then – go trade, make lots of money, have fun. Me, I’ll try to do the same, and I’ll be back here later in the week with an update on the “Zero to a Million” forex journey account.
Best wishes always, in all things.
Jack Maverick is a writer and forex trader. Find him on Google+ at https://plus.google.com/u/0/103534926809963693894/?rel=author and check out his novel, the psychological thriller “A Cross of Hearts”, on Amazon at http://www.amazon.com/Cross-Hearts-J-B-Maverick-ebook/dp/B006GHJ0ZC/