Can You Hear It? Hidden Market Activity with Volume Profile

Learn how using the Volume Profile indicator can help identify potential price trends.

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4 min read

Traders are known for having their own language, and their own set of assorted proverbs and adages. On the topics of price and volume, many traders would say:

  • Price is king
  • Volume confirms price

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Volume, at its most basic level, can provide extremely valuable information. For example, watching for volume on a breakout above resistance or below support can indicate a continuation or reversal of a trend. It may also indicate institutional buying. On a specific day, a stock might experience high volume, which may imply that there's interest in that stock, but volume alone doesn’t indicate the specific price or prices at which traders were most interested.

So if you're interested in some volume amplification, consider the Volume Profile, available on the thinkorswim® platform from TD Ameritrade. The Volume Profile indicator is volume based on price, and it allows traders to see the exact price levels where demand was highest and lowest.

The indicator doesn't show when volume occurred, but at what price volume occurred. Depending on the settings, you can see volume at each price level traded throughout a day, month, year, or longer. The price level that has the highest volume is considered the Point of Control (POC), which identifies the price level where most trades took place and the level where there was a balance between buyers and sellers. Let’s look at an example. In Figure 1, the shaded area around the POC is called the value area, which encompasses one standard deviation of all the volume traded for the time frame. The area above and below the value area shows the remaining range for the day. Generally the levels outside the value area do not experience much volume. 

Volume profile with point of control, value area, range

FIGURE 1: VOLUME PROFILE.

This profile illustrates point of control, value area, and range. Source: TD Ameritrade. For illustrative purposes only.

The Frequency Modulation Dial

When price trades in a symmetrical fashion around a center point, it’s considered standard distribution and shows a bell curve similar to the one shown in Figure 1. The high volume price, or POC, is generally near the midpoint, and there's light volume near the high and low range of the day. This would indicate a balanced market. Some traders interpret this scenario as having an established "fair price" with activity that may fluctuate around this level. With this scenario, one strategy employed by traders is to attempt to sell the top 15% of the range or buy the bottom 15%, with the expectation of price returning to the POC.

When prices trade in a skewed or asymmetrical pattern, the POC will be either high or low in the range, creating an imbalanced market. When the market becomes imbalanced, it often indicates a trending market. When the POC and value area are at the top of the range, creating a P-type pattern, it usually indicates a bullish trend. If the POC and value area are toward the bottom, creating a B-type pattern, it usually indicates a bearish trend.

If a P-type pattern appears, some traders might look for an opportunity to buy near the bottom of the value area and trade the top or higher, taking advantage of the potentially emerging trend. Figure 2 is an example of an equity that created a P-type pattern during an imbalanced market. Each day after the pattern was established, traders might’ve looked at the value area low as a price level to buy on the dip for the next day’s trading, or they might’ve looked for a break above the value area high as the trend continues.

P type patterns indicate bullish trend

FIGURE 2: P-TYPE PATTERNS.

This bullish trend, indicated by a P-type pattern, usually emerges during an imbalanced market. Source: TD Ameritrade. For illustrative purposes only.

The B-type pattern in Figure 3 is similar to the P-type pattern, only bearish. The skew is bearish and near the lower end of the trading range, establishing a bearish trend. Some traders may look to sell near the value area high or on a break below the value area low to short the instrument or take a bearish options trade. 

In either a balanced or skewed market, opening or closing outside of the value area can also indicate a new emerging trend.

The risk of loss on a short sale is potentially unlimited since there is no limit to the price increase of a security. There is also no guarantee the brokerage firm can continue to maintain a short position for an unlimited time period. Your position may be closed out by the firm without regard to your profit or loss.

B-type pattern indicates bearish trend

FIGURE 3: B-TYPE PATTERNS.

A bearish skew in volume creates a B-type pattern, which is usually found in a balanced market. Source: TD Ameritrade. For illustrative purposes only.

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