Volume Oscillator – Strategy, Rules, Returns
There are many types of volume indicators traders can use to navigate the complex world of market analysis, and one of the best indicators to assess volume changes is the volume oscillator. What do you know about this indicator?
The Volume Oscillator is a volume indicator that shows the changes in trading volume by displaying the difference between two moving averages of the trading volume expressed as a percentage. It works on the basis that it is the recent trend in volume that matters, not the absolute volume. Thus, a rising volume oscillator indicates a strong trend in volume, while a falling volume oscillator shows weakness in volume.
In this post, we will take a look at most of the questions you may have about this indicator: what it is, how it works, and how you can improve your trading strategies with it. Read along!
Key takeaways
- The Volume Oscillator is a volume indicator that shows the changes in trading volume by displaying the difference between two moving averages of the trading volume expressed as a percentage.
- Please click on the link for a full list of all trading indicators.
What is a Volume Oscillator?
The Volume Oscillator is a volume indicator that shows the changes in trading volume by displaying the difference between two moving averages of the trading volume expressed as a percentage. It works on the basis that it is the recent trend in volume that matters, not the absolute volume.
Since the indicator displays the difference between a faster and slower moving average (MA) of volume, when the fast volume MA is above the slow volume MA, the indicator will be positive, and when the fast volume MA is below the slow volume MA, the indicator will be negative. When the volume MAs cross each other, the oscillator will be zero.
Thus, the indicator oscillates around a zero centerline, with a rising volume oscillator indicating a strong trend in volume, and a falling volume oscillator signifying a weakness in volume. Since volume in financial trading is a measure of market activity, traders use this indicator to know when there is strength in a price move. It is very useful in validating potential breakouts and market reversals.
However, unlike price oscillators, which identify the direction and momentum of price movements, the volume oscillator doesn’t indicate the market direction — it only shows whether a price move is supported by a high volume.
Volume Oscillator Indicator strategy – trading rules, settings, backtest, returns, and performance
Let’s test the indicator. The only way to determine whether it has predictive power is to make quantified trading rules and backtest it.
We did, and it seems the indicator has little predictive use for stocks, bonds, and commoditites. We tried many different settings for each of the assets with no luck.
Thus, it works better for Bitcoin. We made the following trading rules and backtested Bitcoin (USD) from 2014 until today:
THIS SECTION IS FOR MEMBERS ONLY. _________________ BECOME A MEBER TO GET ACCESS TO TRADING RULES IN ALL ARTICLES
CLICK HERE TO SEE ALL 350 ARTICLES WITH TRADING RULES
When we apply the trading rules above on both SPY (S&P 500) and TLT (Treasury Bonds) we get decent results. Below is the equity curve for SPY since its inception until today:
Trading performance metrics and statistics from Bitcoin’s inception until today (including 0.03% commissions per trade):
- Number of trades: 147
- Average gain per trade: 0.49%
- Annual returns: 2%
- Win rate: 60%
- Time spent in the market: 21%
- Risk-adjusted return: 9%
- Max drawdown: 17%
The code of the strategy reads like this (Amibroker):
THIS SECTION IS FOR MEMBERS ONLY. _________________ BECOME A MEBER TO GET ACCESS TO TRADING RULES IN ALL ARTICLES
CLICK HERE TO SEE ALL 350 ARTICLES WITH TRADING RULES
How does the Volume Oscillator work?
The volume oscillator works by showing the recent trend in volume, which can tell if a price move is supported by a huge volume change. It does this by displaying the difference between two moving averages of volume to show whether the recent volume trend is increasing or decreasing.
If the indicator rises above the zero line, it means that the shorter-term volume moving average has crossed above the longer-period volume moving average, so the short-term volume trend is up. On the other hand, when the indicator falls below the zero line, it means that the shorter-term volume moving average has crossed below the longer-period volume moving average, so the short-term volume trend is down.
Why use a Volume Oscillator in trading?
You use a volume oscillator in trading because it tells you the volume strength behind a price move. The indicator uses the difference between two moving averages of volume to show the short-term trend in volume, which can inform you about the underlying market activity behind price action.
You can use the volume oscillator to know whether a price breakout of a support/resistance or even a price reversal is valid or not. When a breakout occurs on increasing volume, it indicates a stronger move than a breakout on low volume — a breakout on a low volume can turn out to be a false breakout. Likewise, a swing low on high volume could indicate a selling climax or capitulation, which could suggest a potential reversal.
What are the components of a Volume Oscillator?
The components of a Volume Oscillator are the shorter-period moving average and longer-period moving average of the volume data. The shorter-period moving average can be any length, but the default setting is often 5 periods. So, if it is a daily timeframe, it will be a 5-day moving average of volume.
The second component, the longer-period moving average, is often set at 20 periods, but you can use any setting you want. A 20-period setting on the daily timeframe will be a 20-day moving average of volume.
How is the Volume Oscillator calculated?
The volume oscillator is calculated as follows:
- Choose the length of the shorter-period moving average, say 5 days
- Calculate the shorter-period moving average of volume: (Sum of the volume data over 5 days/5)
- Choose the length of the longer-period moving average, say 20 days
- Calculate the shorter-period moving average of volume: (Sum of the volume data 20 days/20)
- Calculate the volume oscillator:
Volume Oscillator = (shorter-period MA of volume – Longer period MA of volume)*100/Longer period MA of volume
What is the formula for the Volume Oscillator?
The formula for the Volume Oscillator can be given as follows:
Volume Oscillator = (shorter-period MA of volume – Longer period MA of volume)*100/Longer period MA of volume
In other words, it is the difference between a shorter-period moving average of volume and a longer-period moving average of volume expressed as a percentage of the longer-period moving average by multiplying it by 100 and dividing the product by the longer-period moving average.
How to interpret the Volume Oscillator?
To interpret the volume oscillator, you need to understand that the indicator only shows the volume trend behind a price move — it does not show the direction of the price move, unlike price-based oscillators. However, since volume in financial trading is a measure of market activity, the indicator can tell when there is strength in a price move.
When the indicator rises above the zero line, it means that the shorter-term volume moving average has crossed above the longer-period volume moving average, so the short-term volume trend is up. Likewise, when the indicator falls below the zero line, it means that the shorter-term volume moving average has crossed below the longer-period volume moving average, so the short-term volume trend is down.
What do different Volume Oscillator values indicate?
What different volume oscillator values indicate depends on whether the value is above or below zero. Values above zero signify a positive short-term volume trend, which means that the volume is rising at least in the short term. In indicator terms, it means that the short-period moving average of volume is above the longer-period moving average.
Conversely, values below zero signify a negative short-term volume trend, which means that the volume is falling at least in the short term. In indicator terms, it means that the short-period moving average of volume is below the longer-period moving average.
When should you use the Volume Oscillator?
You can use the volume oscillator when you want to know the volume strength behind a price move — for instance, during a breakout or a price reversal. It can tell you whether a price breakout of a support/resistance or even a price reversal is valid or not — when a breakout occurs on increasing volume, it indicates a stronger move than a breakout on low volume, and when a breakout occurs on a low volume, it may turn out to be a false breakout.
Similarly, a swing low on high volume could indicate a selling climax or capitulation, which could suggest a potential reversal.
How can the Volume Oscillator signal a trend?
The volume oscillator can only signal a trend in volume, not a price trend. The indicator does not show the direction of price movements or the trend. It only shows the trend in volume changes, which traders can use to interpret price action to know the strength behind important price movements, such as a breakout.
When the volume oscillator rises above the zero line, it implies that the short-term volume trend is up. Likewise, when the indicator falls below the zero line, it means that the short-term volume trend is down.
What are common Volume Oscillator strategies?
The common volume oscillator strategies include the following:
- Breakout strategies: These are strategies that aim to trade when the price breaks out of a chart pattern or support/resistance level. Volume changes can help validate a breakout, and the volume oscillator shows such volume changes clearly. When trading a breakout strategy with the volume oscillator, the indicator must display a positive value when the breakout occurs; if not, it could suggest a false breakout.
- Pullback reversal strategies: These are strategies that want to trade in the direction of the trend when a pullback ends. Normal pullbacks in a healthy trend tend to happen on low volume. So, the volume oscillator will often show a declining volume during a pullback.
How does the Volume Oscillator compare to other indicators?
Compared to other indicators, the volume oscillator is a helpful indicator in a market where reliable volume data is available. But the indicator is only as useful as how well it is used. You cannot use it to identify price trends unlike the RSI and stochastic, which you can use to gauge the price momentum. So, trying to use it for that would be meaningless.
When used properly, the indicator can help you see the trend in volume changes over the short term, and you can then use that information to interpret the price action. The indicator is very useful in identifying temporary pullbacks and validating price breakouts.
Can the Volume Oscillator predict market reversals?
No, the volume oscillator cannot predict market reversals on its own, as it doesn’t tell you the direction of price trends. However, you can use it to analyze price action at potential reversal points that may suggest the end of a price swing and the beginning of another swing in the opposite direction.
For instance, if a swing low forms on high volume, it could indicate a selling climax or capitulation, which could suggest that the price may reverse at that level. What matters is how you use the volume oscillator to interpret the price action.
How to set up a Volume Oscillator on a trading platform?
To set up a volume oscillator on a trading platform, you have to first find out whether the platform has a built-in volume oscillator. If it doesn’t, you will have to source a custom volume oscillator for the platform and install it. After that, you can go to the indicator section of the platform to pick the indicator and attach it to your chart — you either double-click on it or grab and drag it to your chart. When you do that, a box opens up for you to input your preferred settings.
What are the benefits of using the Volume Oscillator?
The benefits of using the Volume Oscillator include:
- The indicator shows the trend in volume changes, which can be vital information in analyzing price action.
- It is very useful in confirming if a breakout is valid or not, depending on whether it happened on a positive volume change.
- It can tell you if a price movement against a trend is just a temporary pullback or a potential change in trend direction.
- It can tell the strength behind a price movement.
What are the limitations of the Volume Oscillator?
The limitations of the Volume Oscillator include:
- The indicator is based on volume data and cannot be used in markets, such as the spot forex market where the volume data is not available.
- It does not give direct price information, so you can’t use it to know where the price is moving
- It is based on historical volume data, so it can lag behind the price action.
- It is prone to whipsaws, especially during periods of accumulation or distribution by smart money.
- It cannot be used as a standalone trading strategy
How to combine the Volume Oscillator with other indicators?
To combine the Volume Oscillator with other indicators, you have to understand how the indicator works so you know the other indicators that can complement it. Since the volume oscillator is a volume-based indicator, you can combine it with most price-based indicators to gain valuable insight into the strength of price action.
The key is to use the indicator, alongside other indicators, to create a reliable strategy with clear entry and exit criteria. For instance, the volume oscillator can tell you when there is a pullback in a trending market, and you can use the stochastic or RSI to know when the price has reversed to continue the trend.
What are common mistakes when using the Volume Oscillator?
The common mistakes when using the Volume Oscillator include:
- Not having a robust trading strategy with clear entry and exit criteria
- Using the indicator alone to predict how the price will move
- Poorly analyzing the price action before entering a trade
- Not considering market conditions before trading
- Not having a risk management plan
How to backtest the Volume Oscillator in a trading strategy?
To backtest the volume oscillator in a trading strategy, you have to keep all the other variables in the strategy constant and vary the settings of the volume oscillator. Here are the steps to follow for your backtesting:
- Identify the market to test
- Source the data for the test and divide them into in-sample and out-of-sample data
- Formulate your strategy using the indicator and other indicators or analysis tools — the strategy must have clear entry and exit criteria and proper risk management parameters.
- Convert the strategy into a trading algorithm
- Run your backtesting on the in-sample data
- Optimize the strategy on the out-of-sample data
- Evaluate your results
What time frames work best with the Volume Oscillator?
The time frames that work best with the volume oscillator will depend on your trading style and the market you want to trade. If you are a day trader, you may have to focus on the hourly, 30-minute, and 15-minute time frames. But if you are a swing trader, the 4-hourly and daily time frames may be your best options to get a better view of the market.
To know the time frame that works best for your trading style and the market you’re trading, you will have to backtest the different timeframes for that style.
How does market volume affect the Volume Oscillator?
How market volume affects the Volume Oscillator will depend on how the market volume changed in recent periods relative to the former period. For instance, if the market volume is higher in recent periods than that of the former periods, the volume oscillator will be rising because the shorter-period moving average of volume will reflect the increase in market volume in recent periods more than the longer-period moving average of volume.
Can the Volume Oscillator be used in all markets?
No, the volume oscillator cannot be used in all markets because the indicator is based on volume data, which may not be available in markets that do not have a central exchange. For instance, the spot forex market trades over the counter and, as such, does not have a central exchange. So, its total trading volume is not readily available to calculate the volume oscillator.
How do you adjust the Volume Oscillator settings for better accuracy?
To adjust the Volume Oscillator settings for better accuracy, you have to backtest the indicator. But first, you have to create a trading strategy with the indicator and code it into a trading algorithm. Then, you backtest the strategy adjusting the settings of the volume oscillator in each test. This way, you will find the volume oscillator settings that offer you the best accuracy.
What are real-world examples of Volume Oscillator use?
Here are a few real-world examples of volume oscillator use:
Example 1: Buy signal on Apple Inc. chart
In the chart below, you can see that the price was trending up, as shown by the blue up-trend line. When the price was pulling back, the volume oscillator was declining. When the price reversed to continue the trend, the volume oscillator turned up. Meanwhile, the stochastic RSI indicator confirmed the pullback reversal by rising from an oversold level.
Example 2: Sell signal on Apple Inc. chart
In the chart below, you can see the price struggling to break below a support level. When it finally did, it happened on rising volume, as shown by the volume oscillator. Meanwhile, the stochastic RSI was descending from an overbought level.
How can beginners start using the Volume Oscillator effectively?
Beginners can start using the Volume Oscillator effectively by studying the indicator to understand how it works. When they learn that, they will know the other indicators they can combine with the volume oscillator to create a simple strategy with clear entry and exit criteria, as well as a proper risk management plan. If their strategy is simple and robust enough, they can effectively implement it.