Volume Zone Oscillator (VZO) – Rules, Strategy, Settings, Returns, Performance

In the fast-paced world of financial markets, leading indicators that can predict market movements and show where to buy or sell are hard to come by, which is what makes the Volume Zone Oscillator (VZO) a very special tool in the hands of those who know how to use it. What do you know about this indicator?

The Volume Zone Oscillator (VZO) is a momentum indicator that uses volume changes to predict extended price levels where there can be price reversals. It is a leading indicator that can spot where there may be buying or selling opportunities in a trending market. So, it can help to time trade entries if used in the right market direction and condition. In this post, we will take a look at most of the questions you may have about the Volume Zone Oscillator: what it is, how it works, and how you can use it to improve your trading strategies. Let’s dive in!

Key takeaways

• Definition and Purpose:
• The Volume Zone Oscillator (VZO) is a momentum indicator that uses volume changes to identify potential price reversals.
• It is a leading indicator designed to spot buying or selling opportunities in trending markets.
• Can assist in timing trade entries when aligned with the market’s direction and condition.
• Construction:
• Built using two exponential moving averages (EMAs) of volume:
  • Volume Position EMA: Similar to On-Balance Volume (OBV), assigns positive or negative values based on whether the price closed higher or lower than the previous bar.
  • Total Volume EMA: A standard EMA of the volume over the same number of periods.
• The indicator calculates a percentage ratio of the Volume Position to the Total Volume and plots it.
• Key Levels and Zones:
• Lines mark specific levels in the indicator window: 5%, 20%, 40%, 60%, and their negative counterparts (-5%, -20%, -40%, -60%).
• Zones:
• We show you a complete Volume Zone Oscillator (VZO) trading strategy complete with trading rules.
• If you want to look at other indicators, please read our take on the top 20 trading indicators.

What is the Volume Zone Oscillator (VZO)?

The Volume Zone Oscillator (VZO) is a momentum indicator that uses volume changes to predict extended price zones where there can be price reversals. It is a leading indicator that can spot where there may be buying or selling opportunities in a trending market. So, it can help to time trade entries if used in the right market direction and condition.

The indicator is constructed from two exponential moving averages (EMAs) of volume — an OBV-like volume EMA and a normal volume EMA. The OBV-like volume EMA, called Volume Position, considers whether there is a price gain or loss relative to the previous price bar’s close in assigning a positive or negative value respectively to the volume — that is, the volume is considered positive if the price closed higher than the previous bar and negative if it closed lower.

The total volume EMA (named Total volume) just calculates an EMA of the volume using the same number of periods. Then, a percentage ratio of the Volume Position to the Total Volume is calculated and plotted on the indicator window.

Lines are drawn in the indicator box to mark certain levels, including the 5%, 20%, 40%, 60%, and their negative counterparts (-5%, -20%, -40%, -60%). Between the 40% and 60% levels is considered an overbought zone, and beyond the 60% level is extremely overbought. Likewise, between the -40% and -60% levels is considered an oversold zone, and beyond the -60% level is extremely oversold.

For example, the indicator might look like this in a chart:

Volume Zone Oscillator (VZO) trading strategy – rules, backtest, returns, and performance

Let’s backtest a Volume Zone Oscillator (VZO) trading strategy that is complete with trading rules.

We make the following trading rules:

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This strategy works best for stock indices. Below is the equity curve for S&P 500 (SPY) from its inception until today:

Trading statistics, returns, and performance:

• Number of trades: 104
• Average gain per trade: 1.9%
• Annual returns (CAGR): 6.1%
• Win rate: 82%
• Time spent in the market: 33%
• Risk-adjusted return: 18.5%
• Max drawdown: 26%

This is the code we used for the backtest (Amibroker):

THIS SECTION IS FOR MEMBERS ONLY. _________________ BECOME A MEBER TO GET ACCESS TO TRADING RULES IN ALL ARTICLES CLICK HERE TO SEE ALL 400 ARTICLES WITH BACKTESTS & TRADING RULES

How does the Volume Zone Oscillator (VZO) work?

The Volume Zone Oscillator (VZO) works by using the percentage ratio of Volume Position to Total Volume to estimate overbought and oversold zones in the market where traders can look for selling and buying opportunities respectively.

Traders can look for buy setups when the VZO is at oversold and extremely oversold zones but only when the market is in an uptrend. Similarly, they look for sell setups when the VZO is at overbought zones but only when the market is in a downtrend. This is why the authors of the indicator recommend combining it with a 14-period ADX and 60-period EMA for identifying and marking the direction of the trend.

A trend exists if the ADX value is higher than 18, otherwise there is no trend. If the market is trending, the EMA is used to spot the trend direction — the price staying above the EMA indicates an uptrend, and the price staying below the EMA suggests a downtrend. In an uptrend, the VZO rising above the -40% level from the oversold zone is a buy signal. Likewise, in a downtrend, the price falling below the 40% level from the overbought zone is a sell signal.

Who developed the Volume Zone Oscillator (VZO)?

The Volume Zone Oscillator (VZO) was developed by Walid Khalil and David Steckler. It was Walid Khalil who first introduced it to the trading public in the 2009 International Federation of Technical Analysis Journal. However, in a follow-up article that appeared in Technical Analysis of Stocks and Commodities magazine in May 2011, he was joined by David Steckler.

The VZO has gained traction since then, with many charting packages now including it in their platforms. The indicator uses the on-balance volume (OBV) concept of positive and negative volume based on the direction of price compared to the previous bar.

What is the formula for calculating the VZO?

The formula for calculating the VZO is given as follows:

VZO = 100 x (VP/TV)

Where:

TV (Total Volume) = n-days EMA (Volume)

and

VP (Volume Position) = n-days EMA (± Volume)

In calculating the VP, the volume is treated like in the on-balance volume, such that, if today’s closing price is higher than yesterday’s, then the volume will have a positive value. Otherwise, it will have a negative value.

How do traders interpret VZO signals?

Traders interpret VZO signals in different ways, but the general interpretation is this: When the VZO rises and stays above the 5% level, the price is likely making an upswing, as the area between the 5% and 40% levels is considered a bullish trend zone. Conversely, when the indicator falls and stays below the -5% level, the price is making a downswing, as the area between -5% and -40% is considered a bearish trend zone.

However, values above 40% suggest an overbought market condition, and beyond the 60% level indicate an extremely overbought condition. On the flip side, values below -40% suggest an oversold condition, and below -60% is considered extremely oversold.

What are the key VZO levels to watch?

The key VZO levels to watch include:

• The 40% level: This marks the beginning of the overbought zone. The market is considered bullish but once it crosses this level, the bullish move may be unsustainable. But in a strong uptrend, the market can stay above this level for a long time.
• The 60% level: Beyond this level, the market is considered extremely overbought. The indicator rarely reaches this level but may do so if the uptrend is very strong.
• The -40% level: This marks the beginning of the oversold zone where a bearish move may be considered unsustainable. But in a strong downtrend, the market can stay below this level for a long time.
• The -60% level: The indicator reaching this level suggests that the market is extremely oversold. The indicator rarely reaches this level but may do so in a very strong downtrend.

How does the VZO indicate overbought and oversold conditions?

The VZO indicates overbought and oversold conditions when it crosses the 40% and -40% levels respectively. Before reaching the 40% level, the market is bullish if it is rising. But once the indicator, crosses this level, the bullish move may be unsustainable. However, in a strong uptrend, the market can stay above the 40% level for a long time and even go beyond the 60% level, which indicates an extremely overbought condition.

On the opposite side, the market may be bearish if the indicator is falling. But once the indicator, crosses below the -40% level, the bearish move may be unsustainable. However, in a strong downtrend, the market can stay below this level for a long time and even go beyond the -60% level, which indicates an extremely oversold condition.

Can the VZO be used in all market conditions?

No, the VZO may not be used in all market conditions, as it may not perform well in a tightly consolidating market without clear price swings. The indicator works best in a trending market, which is why the authors recommend combining it with a 14-period ADX and 60-period EMA for identifying and marking the direction of the trend.

In an uptrend, it is best to look for buy signals only after a pullback triggers an oversold condition. Conversely, in a downtrend, look for only sell signals after a rally triggers an overbought condition.

What is the significance of VZO crossing zero?

The significance of VZO crossing zero is that it shows a change in the polarity of the market. When the indicator crosses from below to above the zero line, it means that the market is more disposed to the bullish side, as the indicator is now recording bullish volume.

On the other hand, when the indicator crosses from above to below the zero line, it means that the market is more disposed to the bearish side, as the indicator is now recording bearish volume.

How does the VZO compare to other volume-based indicators?

Compared to other volume-based indicators, the VZO does not just gauge the amount of volume behind a price move or check whether the market is accumulating or distributing, but rather, provides entry and exit signals by estimating extended price levels using the direction of volume changes.

This is unlike the OBV and accumulation/distribution line and other volume indicators that are used to estimate the buying and selling pressure in the market. The VZO can be used to know when to buy and when to sell a stock based on its trading zones.

How does the VZO respond to price trends?

The VZO responds to price trends by moving in the direction of the trend. When the trend is to the upside, the VZO will start rising. It rises until it gets to the 40% level, where the market is considered overbought. If the trend is not strong, the price may at least pull back from there, but if the trend is very strong, the market may keep going up.

On the flip side, when the trend is to the downside, the VZO will start falling until it gets to the -40% level, where the market is considered oversold. If the trend is not strong, the price may at least pull back from there, but if the trend is very strong, the market may keep going down.

How do you set up the VZO on a trading platform?

To set up the VZO on a trading platform, search the indicator session of the trading platform to see whether the indicator is among the built-in indicators. Being a relatively new indicator, the VZO may not be preinstalled in many trading platforms.

If it is not on your platform, you will have to get a custom-made version for the trading platform and install it yourself. After the installation, go to the indicator section and double-click on it to attach it to your chart. When you do that, a box will appear for you to put your preferred level settings.

The timeframes that work best with the VZO will depend on your trading style, trading strategy, and backtesting results. If you are a day trader, you may want to trade on the 1-hour, 30-minute, or 15-minute timeframe. A swing trader, on the other hand, may focus on the 4-hour or daily timeframe.

Whichever style you use, to know the timeframe that works best for your trading strategy, you have to backtest your system on different trading timeframes suitable for your trading style to see the one that offers the best performance.

How can the VZO improve trading strategy accuracy?

The VZO can improve trading strategy accuracy by showing the precise levels to enter and exit the market if the right market conditions are met. Although it provides entry and exit points, the signals must be used in the right market context.

For instance, the 14-period ADX must show that there is a trend and the 60-period EMA must show the trend direction before you can use the VZO to find the right signal in the trend direction. If the market is in an uptrend, you trade only the buy signals.

Is the VZO useful for day trading?

Yes, the VZO can be useful for day trading if used on a suitable timeframe. The best timeframes to consider for day trading are intraday timeframes like the hourly, 30-minute, 15-minute, and 5-minute timeframes.

You will have to backtest your strategy on these timeframes to know the one that offers the best performance and then trade on that timeframe.

How does the VZO help identify trend reversals?

The VZO helps identify trend reversals by showing when the market is in overbought and oversold conditions, as well as extremely overbought/oversold conditions. When the indicator is in the overbought or extremely overbought zone, it means that the upswing is no longer sustainable and may soon reverse or at least pull back to the downside.

On the opposite side, the indicator reaching the oversold or extremely oversold zone means that the downswing is no longer sustainable and can reverse soon. The indicator’s divergence from price may also signal a potential reversal.

What is the role of volume in the VZO calculation?

The role of volume in the VZO calculation is that it is the only data used in the calculation. The Volume Position only used the price gain or loss to assign positive or negative signs to the volume — all the calculations are based on the volume data.

This is why the indicator cannot be used in markets that don’t post reliable volume data.

How do traders combine the VZO with other indicators?

To combine the VZO with other indicators, traders look for indicators that will complement it. Since it is an oscillator that can provide entry and exit points, they combine it with trend indicators.

The authors of the indicator recommend a 14-period ADX for identifying the presence of a trend (when it rises above the 18 value) and a 60-period EMA for identifying the trend direction (based on whether the price is above or below it). The VZO’s buy signals are to be taken in an uptrend, while the sell signals are to be taken in a downtrend.

What are common mistakes traders make using the VZO?

The common mistakes traders make using the VZO are as follows:

• They may trade without using the ADX and EMA to first identify whether there is a trend and establish its direction.
• They trade the buy and sell signals in any market condition, ignoring the direction of the trend
• They do not have a trade plan before entering the market.

How can the VZO help manage trading risk?

The VZO cannot directly help you manage trading risk, as it does not show you where to place your stop-loss orders or how much position size to enter in a trade. However, by providing clear entry and exit points, you can plan your trades in time so that you check where to place your stop loss and use that to calculate your position size.

The exit points also help you to secure your profits in time before a market reversal.

Is the VZO suitable for all asset classes?

No, the VZO is not suitable for all asset classes as it is derived from the volume data, which is not available in all asset classes. For example, the spot forex market is traded over the counter and does not have a way of getting the overall trading volume since there is no centralized exchange to keep the record.

Without reliable volume data, the VZO cannot be calculated for the spot forex market.

How can the VZO confirm breakout trades?

The VZO may be used to confirm breakout trades, as it shows the volume momentum behind price moves. When the price breaks out to the upside, the VZO is expected to rise above the zero level but without reaching the 40% level. If it doesn’t, the breakout may not be valid. Similarly, a downward breakout should be accompanied by a fall in the VZO below the zero level but without reaching the -40% level.

Can the VZO be used for short-selling strategies?

Yes, the VZO can be used for short-selling strategies if the market is shown to be trending downward. A 14-period ADX must be reading above 18 and a 60-period EMA should be sloping downward with the price trading below it.

If these two conditions are met, the market is in a downtrend, so you can trade the sell signals in the VZO when the indicator falls below the 40% mark from overbought zones.

What are the pros and cons of the VZO?

The pros and cons of the VZO are many. Here are some of the pros:

• The indicator offers precise entry and exit signals
• It gives the conditions under which to use the buy and sell signals

These are some of the cons:

• It cannot be used in all types of markets — doesn’t work in forex
• It does not work in non-trending markets

How do you optimize VZO settings for different market conditions?

To optimize VZO settings for different market conditions, you have to backtest your strategy under different market conditions using different settings. This way, you know the settings that work for each market condition.

Also, as you trade the live market, you should periodically evaluate your trading result to know when you need to adjust the VZO settings for better performance.