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For centuries, investors have used volume to measure demand and whether a move in the markets or single sector has conviction.
In 1670 enterprising Frenchmen, Medard Groseilliers and Pierre Radisson, used the rising sales volume of beaver skin hats to convince several noblemen to invest in their idea of sailing to North America to obtain beaver pelts to ship back to Europe to meet this hat demand.
The Frenchmen later founded Hudson’s Bay Company, which later become North America’s first joint stock company. While the company no longer trades furs, the Hudson’s Bay Company continues to prosper today, owning retail stores in the United States, Canada, and several other countries.
Volume continues to be monitored and used by stock investors today. Perhaps the most popular way to measure volume is by calculating average volume, which is simply the mathematical average of volume over time. Investors look at the current volume in relation to a simple moving average (SMA) of volume to assess the strength of related price movement. While SMA can be helpful, it’s difficult to spot rising or falling momentum in volume when only using a SMA.
One of the difficulties with this basic methodology is that volume can be volatile, changing dramatically from one day to the next. What’s missing is a measure that takes into consideration the momentum changes around that volume. And that’s where the volume oscillator comes in.
Looking at Figure 1 below, the top section shows the SMA of Lululemon (LULU), while the bottom section shows the volume oscillator of the retail stock LULU during the same period. The volume oscillator makes it easy to see that volume momentum is increasing.
Simply put, if the volume oscillator is moving up, momentum is increasing. If it’s moving down, momentum is decreasing.
The volume oscillator identifies momentum by measuring the difference between the two moving averages of volume (short-term moving average of volume minus the long-term moving average of volume).
This study (see Figure 2) can also be presented as a percentage (short-term moving average of volume minus long-term moving average of volume divided by long-term moving average of volume).
In Figure 2, the top chart illustrates two moving averages of volume; a seven-period simple moving average of volume and a 28-period simple moving average of volume. The white arrows highlight the difference between the two moving averages of volume. The bottom chart is the volume oscillator. It illustrates the same information as the top chart but from a different perspective. The 28-period moving average of volume is represented by a yellow horizontal line at zero. The red line is plotted as the difference between the two moving averages of volume. The math for the red line in the volume oscillator is simply the 7-period simple moving average of volume minus the 28-period moving average of volume.
The volume oscillator is primarily used to confirm the strength and conviction in an existing trend or breakout. It can also be used to signal weakness in an existing trend or recent breakout.
Here are five volume oscillator rules traders can use as a general guide:
1. Increasing price with increasing volume oscillator can indicate a bullish conviction.
2. Increasing volume oscillator with a breakout above resistance can indicate a bullish conviction.
3. Decreasing volume oscillator with an increasing price can indicate a bearish conviction.
4. Decreasing volume oscillator with price moving in a channel can be neutral or indicate a lack of bullish or bearish conviction.
5. Increasing volume oscillator with price moving down can indicate a bearish conviction.
Figure 3 below uses weekly aggregation (each candle represents one week) and covers the time period from January 27 to September 25, 2020. The moving averages used in the calculation and plotting of the volume oscillator are 14 and 28.
Investors use the volume oscillator in conjunction with price patterns to determine entries and exits.
In figure 3 below, there are three examples of the volume oscillator used in conjunction with price patterns to determine potential entry and exits.
1. Note point A on the chart. The volume oscillator has changed direction and started to move up at the same time price has created a bullish bounce (closing above the high of the low day). This combination indicates a potential entry opportunity. The stock followed with 10 weeks of upside movement before the bearish price pattern occurred at point B.
2. Note point B on the chart of the volume oscillator. The volume oscillator has moved down. The following week, price created a bearish engulfing pattern (opening the week above the close of the previous week then closing below the low of the previous week). This bearish combination indicates a potential exit opportunity. The stock followed with seven weeks of sideways movement before the bullish breakout at point C.
3. Note point C on the chart of the volume oscillator. The volume oscillator has changed direction with an uptick. The following week price broke out of the sideways channel. This bullish combination indicates a potential entry into the stock. The stock followed with three weeks of upside movement.
Following volume helps investors interpret what may be irrational movements. The volume oscillator gives investors a window into the momentum of volume and clues as to future price movement. It can also be a useful addition to a trader’s technical indicator toolset when evaluating price movement and the right strategy to implement. To learn more, watch this short “Ask the Coach” video that features more information on using the volume oscillator.
Follow Ken Rose on twitter @KRose_TDA where he posts information on this and other technical analysis concepts.