5 Pillars of Volume Spread Analysis
Volume spread analysis is a school of thought that believes volume plays a crucial role in understanding moves of prices in financial markets. This text will highlight 5 core arguments that solidify this basic premise.
1- Technical analysis is not enough.
An argument in favor of technical analysis is the idea that the securities’ prices may not be linked to their fundamentals. The behavior of financial markets is frequently a result of momentum, confidence, and sentiment. In this sense, traders analyze security price chart to know what is the upside and downside potential.
However, reading the market solely from prices is insufficient. Markets move on supply and demand, and so, volumes are also an important part of the equation.
Volume Spread Analysis is a good way to understand how the concepts of supply and demand influence prices. It allows spotting imbalances between buyers and sellers by looking at prices and volumes.
VSA helps traders understand what the major players are doing and benefit from their actions. When a small trader buys or sells a pair, he/she certainly will not influence the price. However, when a big bank trades millions of a certain currency, this will probably move the market up or down. Usually, these big traders have more information and knowledge about the markets, so it is wise to be on their side. Through volume analysis, traders can know if market makers are buying or selling and take advantage of their positions.
2- It’s all about perceived value.
Fundamental analysis states that we can always grasp the intrinsic value of a financial instrument – stocks, currencies, commodities, etc. An assessment of the economy would allow traders to explain oscillations in prices.
On the contrary, volume-based traders say that to fully know what goes on in the markets, we should rely on perceived values instead of intrinsic value. And what does perceived value mean? This is how different professional traders view a financial instrument. And this is always contextual and acquired through an analysis of volume.
Below you can find the evolution of the price to book value since 2000 of the S&P 500. This metric is considered an approximation of the perceived value. It’s possible to see how traders permanently evaluate companies above their book value, taking in mind other analysis besides the fundamental one.
3- Price and volume are inter-related.
Past prices are an important aspect to understand moves in financial markets. However, the analysis of price is not enough.
A lot of technical analysis theories say we can solely rely on the analysis of price to understand the next move. These can take the form of different theories: Dow theory, Elliot wave theory, harmonic theory, candle-based trade, etc. The bottom line for all these traders is that everything is reflected in prices and different patterns.
Volume spread analysts say that the analysis of price is incomplete. We need to understand where the money is and where it will be in the future. Only then we can try to predict what is going to happen in the markets.
4- The cause of moves is volume.
We already dismissed fundamental and technical analysis as the sole explanations for moves in financial markets. Now, let’s look at how volume spread analysts justify these moves.
In their opinion, we need to look at prices in relation to volume. It is only this interconnection between price action and volume that justifies moves in financial markets.
In the chart below you can observe how major moves in prices or price reversions were always accompanied by volumes higher than normal. An analysis of volume in this situation would help traders identify these movements of prices.
5 – It’s all about understanding the role of different traders in the market.
The 5th core idea is that different kinds of traders carry different sorts of information – and we can base our trading strategy on this idea.
Volume spread analysis tends to emphasize three different types of traders: retail, commercial and professional. Retail traders are those who have small accounts and tend to trade erratically. They do not have any particular trading strategy and traditionally tend to buy and sell when the uptrend/downtrend is exhausted.
Commercial traders are investment banks whose function is to place orders in the market to satisfy clients’ needs. They can also function as market makers. These traders have an impact because they often carry large orders, which usually cause volatility. However, they don’t have any strong rationale supporting their trading decisions.
Professional traders are large traders that are in the game to win, and they are behind most trends. These are the types of traders that volume spread analysis tends to be concerned with – the successful volume trader is the one that detects what these traders are doing.
The following chart illustrates the power of large traders in moving the markets. On the left side, large traders reduced their positions, which caused a downside movement in prices. Prices traded sideways while these traders had stable positions and, when they started buying, prices moved upside. A small trader aware of what large traders were doing could follow their steps and take advantage of this information.
Wish to know more? Learn more about volume spread analysis in this article.