Volume Trading Strategy – Does It Matter? (Setup, Rules, Backtest, Returns)

Volume trading strategy is a trading method that involves analyzing the volume of shares or contracts that are being traded in a particular stock or market. The idea behind this strategy is that high trading volume can indicate strong buying or selling pressure, which can be used to make trading decisions.

Successful trading is based on spotting the direction the price is headed. But while the price is the ultimate factor in determining profitability, the volume of transactions can offer a clue to shifting sentiment and how the price might move. This is why a volume trading strategy can be a game-changer for you. What is a volume trading strategy?

In this post, we answer some questions about the volume trading strategy, and we make several backtests (including trading rules) further down in the article.

Introduction to Volume Trading Strategy

In stock and other financial markets, volume is the total number of shares or units of the asset that has changed hands. Volume trading refers to using volume data to identify potential buying and selling opportunities in the markets. It involves analyzing the volume of trades in a particular security or market and using that information to make predictions about future price movements.

The idea behind this strategy is that high trading volume can indicate strong buying or selling pressure, so it is one of the most accurate ways of gauging money flow and, thus, can be used to make trading decisions. There are several ways to analyze volume, such as looking for patterns in the volume data or using technical indicators like the on-balance volume indicator.

Benefits of Volume Trading

The benefits of volume trading are that traders can use volume to:

  • identify potential buying and selling opportunities
  • identify trends, momentum, and potential breakouts
  • confirm or refute other technical indicators and patterns
  • identify significant levels of support and resistance
  • gauge the strength of a move
  • enhance the accuracy of trades
  • provide a better understanding of market sentiment
  • spot potential reversal days
  • look for exhaustion days

Analyzing Volume Indicators

There are several ways to analyze volume indicators when using a volume trading strategy. One popular method is to look for patterns in the volume data, such as increasing or decreasing volume over time. Another method is to use volume indicators, such as On-Balance Volume (OBV), Accumulation/Distribution Index (A/D), Money Flow Index (MFI), and so on.

Volume indicators can be used in conjunction with other technical indicators, such as moving averages or trend lines, to help confirm trading signals. Traders can use volume indicators to analyze the relative strength of a move, which can help them identify potential breakouts or trend reversals.

Applying Volume Trading Strategies

To apply volume trading strategies, traders can learn how to use volume data to identify buying and selling pressure and how those can affect market sentiment. They can look for patterns in the volume data such as increasing or decreasing volume over time.

With that knowledge, they would know the volume indicators to add to their trading strategies and how they can use that to improve their trading success. Volume indicators can be used to analyze the relative strength of a move, which can be helpful in breakout and trend reversal strategies.

Risk Management for Volume Trading

Risk management is an essential part of volume trading. It is important to have a clear understanding of the potential risks associated with trading, as well as strategies in place to manage those risks.

One effective risk management strategy is to use stop-loss orders, which automatically close a trade at a certain price point to limit potential losses. For this to work, the trader must use position sizing to control the amount of risk they are taking on in each trade.

In addition to the above, diversifying one’s portfolio and not putting all eggs in one basket is also a key risk management strategy.

Related reading:

Developing a Volume Trading Strategy

To develop a volume trading strategy, traders can start by analyzing historical volume data to identify patterns and trends. They can use volume indicators, such as OBV, A/D, and MFI, to track price momentum and identify when there is a divergence between price and volume.

Volume indicators are combined with other technical indicators to specify the criteria for trade entry and exit. For example, a mean-reversal strategy could use the Bollinger Band indicator and the MFI, such that a trade setup forms when the price is trading beyond the outer Bollinger bands and the MFI shows a divergence signal.

Understanding the Different Types of Volume

There are several different types of volume that traders can analyze when using a volume trading strategy. These include:

  • Tick volume: This is a measure of the number of trades that have been executed in a given time period.
  • Dollar volume: This refers to the total dollar value of all trades executed in a given time period.
  • Real volume: This is a measure of the actual number of shares that have been traded, as reported by exchanges.
  • Relative volume: This compares the current volume level to the average volume level over a given period of time.
  • On-Balance Volume (OBV): A cumulative indicator that uses both volume and price to measure buying and selling pressure. However, we have not found the on-balance volume trading strategy to be any useful.

How to Use Volume to Spot Trends

To use volume to spot trends, traders can analyze the volume data to identify patterns and trends. For example, a trend with increasing volume over time may indicate a strong bullish trend, while decreasing volume may indicate a potential reversal.

Traders can also use volume indicators in conjunction with other technical indicators, such as moving averages or trend lines, to help confirm the strength of a trend. Traders can use relative volume indicators, such as On-Balance Volume (OBV) and the Volume-Price Trend (VPT), to measure buying and selling pressure, which can help them identify potential trend reversals or breakouts.

Identifying Support and Resistance Levels Using Volume

Traders can use volume profile to identify potential support and resistance levels. Generally, strong support and resistance levels are characterized by price consolidations, which are nothing but mini accumulation or distribution phases.

If you look at a volume profile indicator on the price chart, you would notice that such areas are often associated with more trading volume than any other levels in the price chart. So, by studying the volume data and price movement, you can observe areas that can serve as support or resistance levels.

The Role of Volume in Price Action Analysis

Volume plays an important role in price action analysis, as it can help traders identify buying and selling pressure, which can be used to identify potential changes in market sentiment and trends. By analyzing volume data in conjunction with price action, traders can better identify key levels of support and resistance, confirm breakouts, and spot potential changes in trend.

Some volume indicators that can be used include On-Balance Volume, Volume-Price Trend (VPT), and Accumulation/Distribution volume indicator. They can help traders identify buying and selling pressure and confirm or refute breakouts and trend reversals. This can enhance the accuracy of trades and provide a better understanding of market sentiment.

Common Mistakes Made When Trading with Volume

Some common mistakes when trading with volume include:

  • Over-reliance on volume alone to make trading decisions
  • Not considering the context of the market and other external factors
  • Not considering other technical indicators and analysis in conjunction with volume
  • Not monitoring and adjusting the strategy based on market conditions and performance
  • Not having a well-defined risk management plan
  • Not diversifying the portfolio

Volume Breakouts and How to Trade Them

Traders can use volume to confirm a breakout. When the price genuinely breaks out of a chart pattern or a support/resistance level, there should be a rise in trading volume because of the huge trade orders lying around such levels.

When you are trading a chart pattern, if the breakout happens with low volume, there is a high chance that it is a false breakout. A breakout that happens on an increasing volume is more likely to be profitable.

Identifying Trading Opportunities Using Volume

There are many ways to use volume to identify trading opportunities:

  • Traders can look for volume spikes, which indicate a sudden increase in buying or selling pressure, which can signal a potential trend reversal.
  • Traders can also use volume indicators such as On-Balance Volume (OBV) and the Volume-Price Trend (VPT) to measure buying and selling pressure, which can help them identify potential changes in trends.
  • Traders can also use the Accumulation/Distribution volume indicator to identify the accumulation or distribution of shares by significant market players, which in turn can help identify potential trading opportunities.
  • Using volume indicators, traders can spot divergences from the price, which may signal a potential change in trend direction.

Timing Entries and Exits with Volume

You can use volume changes to time trade entry when using a breakout strategy. If the volume of the breakout candlestick is higher the that of other candlesticks around it, then, the breakout is likely genuine, and you can enter a trade accordingly. If the breakout is on a low volume, you can refuse to trade the setup.

Similarly, you can use volume divergence to exit a trend-following trade. If the volume diverges from the price, it may be a sign of a potential reversal, so it may be time to exit the trade.

Strategies for Trading Low-Volume Markets

Trading in low-volume markets can be challenging, as it can make it harder to identify buying and selling pressure, and to confirm trading signals. Here are a few strategies for trading low-volume markets:

  • Using relative volume indicators to compare the current volume level to the average volume level over a given period of time, which can help them identify potential trading opportunities in low-volume markets.
  • Using a longer timeframe to analyze the market and look for patterns that may not be visible on a shorter time frame.
  • Using a scalping strategy to take advantage of small price movements in a short period of time.
  • Having a long-term trading outlook and making position plays.

Developing a Profitable Volume Trading Plan

To develop a profitable volume trading plan, you should follow these steps:

  • Identify the markets and securities you want to trade
  • Analyze historical volume data to identify patterns and trends
  • Use technical indicators such as on-balance volume, the moving average of volume, etc. to gain more insights.
  • Create your trade entry rules
  • Have a risk management strategy, which can include stop-loss orders, position sizing, and profit targets
  • Backtest your strategy to be sure it can be profitable
  • Regularly monitor and adjust your strategy as needed

Implementing Volume Trading Strategies

To implement a volume trading strategy, you should start by identifying the markets and securities you want to trade. Next, analyze historical volume data to identify patterns and trends and then create your strategy.

After backtesting your strategy, you may forward-test it with a demo account. When you are ready to go live, start with a small amount you can afford to lose and gradually grow your account. You should have a schedule for when to evaluate the performance of the strategy to know when to adjust the parameters.

Tracking Performance of Volume Trading Strategies

It is important to regularly review and evaluate your strategy to see if any adjustments need to be made and to make sure that it’s still in line with your overall trading goals. So, you need to regularly track the performance of your volume trading strategies.

To track the performance of a volume trading strategy, you can use metrics such as profit and loss, risk-reward ratio, win-loss ratio, and percentage of profitable trades. Additionally, you can use a performance tracking tool such as a trading journal or spreadsheet to record and analyze your trades.

Improving Your Volume Trading Performance

You should focus on continuously learning the market and improving your strategy to improve your volume trading performance. This can include researching new ways to apply your strategy, testing them through backtesting, and constantly monitoring the markets to stay up to date with the latest trends.

In addition, you should constantly review and evaluate your current strategy and make adjustments as needed. You should also focus on risk management because you can improve your performance by limiting losses.

Scaling Up Your Volume Trading Strategy

To scale up a volume trading strategy, you can look for ways to automate your strategy using trading software, so that you can make trades faster and more efficiently. Furthermore, you can also diversify your portfolio by adding new markets and securities to trade in. With an automated system, you can easily trade more markets and instruments. Automation is power! We have automated all our trading systems ourselves.

Understanding Volume Spread Analysis

Volume Spread Analysis (VSA) is a method of technical analysis that uses volume data in conjunction with price action to read the action of the smart money or the strong hands by reading the price action with three parameters: the close of the price, the spread, and the volume. Basically, it aims to identify buying and selling pressure in the markets.

VSA is based on the idea that changes in volume can be used to predict changes in price. The practitioners of VSA believe that smart money (professional traders) leave distinctive footprints in the volume data that can be used to identify their actions and anticipate future price movements. The analysis is done by looking at the relationship between volume, price, and spread (the difference between the bid and ask price) to identify potential trends, reversals, and market manipulation.

Using Volume to Measure Market Momentum

Using volume to measure market momentum involves analyzing the volume of shares or contracts that are being traded in a particular stock or market. High trading volume can indicate strong buying or selling pressure, which can be used to measure the market’s momentum.

For example, high buying volume can indicate a strong bullish momentum and high selling volume can indicate bearish momentum. In addition, comparing the volume to historical data can also provide insights into whether the current momentum is likely to continue or if a reversal is likely. Special volume indicators, such as Volume RSI, can also be used to measure momentum by comparing the magnitude of recent gains to recent losses.

Analyzing Volume to Improve Forecasting

Traders can use volume data in conjunction with other analysis tools to make predictions about future market movements. High volume during a price increase can indicate strong buying pressure, which could suggest that the trend will continue. Conversely, low volume during a price increase can indicate low buying pressure, which could suggest that a reversal is imminent.

Choosing the Right Volume Trading Strategy for You

Choosing the right volume trading strategy depends on your individual trading goals, risk tolerance, and experience level. You should consider the condition of the markets and securities you plan to trade, your own personal trading style, and your availability.

While some traders may prefer to focus on short-term trades, others may prefer to hold positions for a longer period of time. Whatever the case, it may be necessary to test and backtest different strategies to see which one aligns with your goals and risk tolerance.

Volume trading strategy backtest – Does volume matter in trading?

Let’s look at some backtests to find out if volume really matters (or not). There’s only one way to find out, and that is by backtesting.

Let’s start with the Turnaround Tuesday trading strategy. We have mentioned this strategy multiple times in the past. The strategy can be traded many ways, but let’s make the following trading rules:

Trading Rules

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The above are the core trading rules, but we also split our backtest into two: we add another variable: does the strategy improve if we add a volume filter?

Let’s backtest the ETF that tracks S&P 500: SPY, the oldest ETF still trading. We filter our trades using the following volume requirement: above and below the 25-day moving average (of the volume).

If we backtest SPY using the trading rules described above we get the following equity charts:

Volume trading strategy

On the left is the Turnaround Tuesday strategy if today’s (Monday’s) volume is lower than the 25-day moving average, and on the right is when the volume is higher:

Clearly, the strategy on the right performs best: 0.81% vs. 0.41% average gain. Mondays with higher volume also return significantly more money (466K vs. 366K) despite having fewer trades (379 vs. 222). Even better, the max drawdown is much less on the high volume Mondays: 27 vs. 23%.

We can only speculate why. Is it capitulation, and the sellers get “washed” out? We are not writing this blog to speculate, so we leave it up to you to judge. To summarize, volume worked well as a filter for the Turnaround Tuesday trading strategy.

Let’s try another backtest: we use the IBS indicator, a mean reversion indicator. The trading rules read like this:

  • When IBS ends below 0.1, we take a long position, and
  • We use the QS exit as a sell trigger.

Below is the performance when the volume is higher (left) and lower (right) than the 25-day average:

Volume trading strategy backtest and trading rules

The average gain is 0.69% vs. 0.56% (almost equal number of trades). Again, a high volume day makes the strategy perform better.

Let’s swap market directions and look at a potential short strategy (for SPY). We don’t want to reveal the strategy because we have it incubation and might publish it for our paying membership later. The chart on the left shows above-average volume, while the right shows below-average volume (25 days):

Volume trading strategy for shorts

The average gain on the left is a pretty good 0.4%. Short is extremly difficult to make money on in the stock market because of the tailwind from inflation and productivity gains, so this is a good result.

Let’s finish this article with a last backtest. This time, we look at our trading strategy #78 which is behind a paywall. This day trading strategy trades SPY from the open to the close. We use a volume filter from the previous day’s price action: if yesterday’s volume was below or above the 25-day moving average.

The two charts below show above-average volume on the left and below on the right:

Does volume matter in day trading?

The average gain per trade is 0.63% if yesterday had a huge volume compared to half the gains if the volume was below average.

Volume trading strategy – does volume matter?

The backtests we did showed that a volume filter paid off, and we believe this is far from any form of curve fitting. That said, you need to backtest yourself to find what works for you. For example, we discovered that volume could be a crucial filter for single stocks.

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