The volume reflects the trading activity. For an OTC market such as forex, there is no aggregate volume data. However, existing market sentiment can often be ascertained by looking at other asset classes.

The listed and highly liquid equity market is often seen as a point of reference. Increased demand for equities can be expected to lead to their appreciation, and investment outflows – to their depreciation.

In practice, a stock (a share of a company) is influenced by a variety of factors – corporate reports, macro data, etc. For this reason, their performance is seen as a composite image of the entire economy.

For the US market, such an image is the S&P 500, reflecting the performance of 500 of the largest publicly traded companies in the United States. A rise in this index signals optimism among investment community. In such an environment, currency pairs such as AUD/JPY are expected to appreciate. A decline in the S&P signals pessimism in financial markets – accordingly safe-haven currencies such as the USD should increase in value.

Chart1: Amazon daily volumes. Chart: Barchart.com

Chart 1: Amazon daily volumes. Chart: Barchart.com

The above chart of Amazon clearly shows that on days with higher trading volumes there is also a high price activity, which often results in larger and sharper movements than usual, reversal patterns, market openings with a gap, etc. With a high probability, it can be assumed that on these days important data have been released for the company (financial statements) or for the financial markets in general (developments in the trade negotiations between the US and China, for example).

Stock traders usually focus their attention on such moments of overactivity. To identify them, actual volumes are most often compared to average levels over a certain period. For example, if an average of 3 million AMZN shares traded daily over the last year, and 10 million shares exchanged in the last trading session, it is easy to conclude that important new information has become public.

Volume data can be interpreted in different ways. In the example above, we see how many times high volume has triggered a sharper movement – be it in the direction of the main trend or a correction.

In the most general sense, high volumes should be accompanied by significant movement in the stock. If the volume is high but the quotes are unresponsive, the situation should be considered with caution.

High volumes coincide with turning points in the chart. Often on these days some classic reversal price patterns are formed. Of course, in these situations it is most important to analyze the information behind this investment activity.

Another scenario is also common – a sensitive price change realized at low volumes. This plot is common when entering a correction against the main trend. Towards the end of the correction, an accumulation of trading activity begins, resulting in the stock being pushed in the main direction.

Let’s look at the volumes on the SPDR S&P500 (SPY). This is an ETF that aims to replicate the returns of the S&P index. This ETF exceeds USD 300 billion in assets, is extremely liquid, and is actively traded by institutional and retail investors. Let’s see how the prices have reacted on days and periods of higher volumes.

Chart 2: SPY ETF Volume Chart. Chart: Marketwatch.com

Chart 2: SPY ETF Volume Chart. Chart: Marketwatch.com

The movement in the S&P in recent years has been upward. In 2019, the trend has remained valid. It is noteworthy that some of the days of more active trading have also led to some more interesting price patterns. August, a month of increased trading activity, is particularly curious. High volumes have supported the prices in individual attempts to break the main upward trend. Its final recovery came at the beginning of October, when a breakthrough was realized in the US-China trade talks.

This opportunity has been used by more aggressive long traders. They have technical and fundamental arguments to open long positions – trendline support, high volumes, support from previous lows and fundamental news (political negotiations breakthrough).

That comes to show how important it is to analyze the root cause of high volumes. Because, for example, the 20th of December, the day with the highest volumes for that month, does not result in a significant change in price. At the end of the year, some market participants often rebalance their portfolios (for accounting, tax or other reasons). That is, in this case there was no fundamental information to surprise the market.

How can volume analysis be transferred from equities to foreign exchange trading?

The general logic is that the rise in equities reflects positive expectations for the economy. Investors believe that the outlook is good and risk appetite is high. In such an environment risky assets should appreciate.

The opposite is true when equities fall – risk appetite is low and investors seek safety. For example, the above trend, which started in October, would be expected to be accompanied by an appreciation of pairs such as AUD/USD.

Chart 3: S&P500 vs AUDUSD. Chart: Investing.com

Chart 3: S&P500 vs AUDUSD. Chart: Investing.com

The above chart shows that AUD/USD (purple line) is rising marginally against the S&P movement. A deeper analysis is needed. First of all, it is worth noting that the high correlation between the S&P and AUD/USD has long been a memory. In recent years, interest rates in Australia have been similar to those in the US, with the Australian dollar losing its “carry trade” currency status. So, expecting the AUD to appreciate along with the S&P is inherently misleading.

This comes to show how important it is to interpret volumes in the context of events. In the above example, the S&P is entering a steady upward trend following the breakthrough in the US-China trade talks. In the midst of the conflict, the Chinese authorities reacted to the imposed tariffs by devaluing the yuan. In this sense, information about an imminent deal implied a reversal in the highly controlled depreciation of the local currency. Let’s take a look at USD/CHN.

Chart 4: USDCNH Before and After US-China Trade Deal. Chart: MetaTrader4

Chart 4: USDCNH Before and After US-China Trade Deal. Chart: MetaTrader4

The appreciation of the Chinese yuan after the optimistic information is evident from the chart. The above example just comes to show how important it is to analyze and view the situation from a different angle. Because the correct interpretation of events can also lead to a more accurate selection of a currency pair to trade. In the above case, USD/CNH is the pair directly dependent on the trade relationship between the two largest economies. In this sense, it may be more suitable for making trades compared to, for example, AUD/USD.

High volumes in equity markets in the United States, China and the major world exchanges, would provide further confirmation of increased investment activity and signal the emergence of a new trend.

Not every event is on the scale of a conflict between the two economic colossi. For example, regional events such as Brexit have a direct impact on the British pound and local stock exchanges. In this case, the trading volumes of British companies will be of interest. FTSE 250 price data will be an object of analysis.

The EURO STOXX 600 or the German DAX 40 is often considered a benchmark of the state of the European economy. For Japan, attention is focused on the Nikkei 225 or Topix 100.

There are of course countless other indices that reflect investment sentiment. Even countries operating in more exotic currencies offer public information on volumes.

Volume indicators

Volume indicators mathematically manipulate data on trading activity. The final result comes in graphical form, which helps to visually compare between the indicator and prices of the analyzed instrument. When the change in volumes (the indicator) is consistent with price changes, investors are more confident in the veracity of the existing market movement. The lack of sync raises doubts. This situation from another angle represents an opportunity.

On Balance Volume (OBV)

OBV is a momentum indicator based on volume data. Basically, it investigates if price changes are well supported by trading activity.

When the price of a financial instrument rises, OBV adds the volume for the period to the existing indicator value. On days of falling prices, volumes are subtracted.

For example, if an ABC stock closes higher at the end of the day, and the volume traded is 1,000 shares, that volume will be added to the value of the indicator from the previous day. If the next closing price is lower and 500 shares are traded, then that value of 500 will be subtracted.

OBV can be considered as a type of momentum indicator because it can confirm or question the price activity.

A rise in prices should be accompanied by a symmetric rise in OBV. A fall in prices should be accompanied by a symmetrical fall in the indicator. In the presence of such a pattern, there is a confirmation of the trend.

Of particular interest are the so-called periods of divergence in which the price continues to move in the existing direction and the indicator does not follow it.

Let us imagine the existence of an upward trend. As long as it is accompanied by purchases by the so-called “smart money” (institutional investors), prices and OBV will be in sync. Gradually, the big players start to close positions and even build exposure against the trend (sell). The small traders are the counterparty to the trades, believing that the existing trend will continue. Prices continue to rise for some time, but volumes are relatively low, thereby forming a divergence. The selling interests of the big players gradually prevail and the trend reverses. Confirmation of the start of a downturn will give a rise in volumes – institutional investors are adding to their position in anticipation of the new wave.

History repeats itself towards the end of the downward trend when the smart money will start buying while small traders will still sell.

Chart 5: DJIA ETF OBV. Chart: Investing.com

Chart 5: SPDR DJIA ETF (DIA) On Balance Volumes. Chart: Investing.com

OBV should be enjoyed with an understanding of its limitations. Its current values are the result of a cumulative accumulation of data from periods preceding the chart.

In addition, on some individual days, volumes may be unusually high or low for a number of reasons, impacting the indicator going forward. The data itself may also not be entirely representative – for example, volumes that are only realized by a given broker.

At the same time, OBV offers another perspective of analysis based on information about actual trading activity.

Accumulation/Distribution

Accumulation/Distribution is also a momentum indicator that compares price changes with volume changes. Accordingly, a rise in prices implies an accumulation of volumes and a fall – a distribution of volumes. Compared to OBV, this indicator takes a step forward as it takes into account not only the closing price of the asset under consideration, but also the highest and lowest price.

When changes in Accumulation/Distribution are in sync with price changes, the trend is confirmed. If the price rises but the indicator lags, the potential for a reversal increases. Similarly, a reversal can be expected when the price is falling and the indicator is rising. In such cases, the formation of divergence reflects the mismatch between prices and volumes.

There are a number of other volume indicators or oscillators such as Chaikin Money Flow or Klinger Oscillator. It is important that these are understood purely mathematically, that their limitations are accounted for, and that adequate judgement is exercised about the data on which they are based. Their main strength is that they reflect real trading activity, which provides an alternative assessment of the market sentiment.

Next: Conclusion Sentiment Analysis

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