Three Volume-Based Technical Indicators to use with CFD trading
While most technical indicators study changes in price behaviour in an attempt to predict future price movements of CFDs, there is another subset of indicators that study changes in the trading volumes that are believed to precede a reversal in the current trend. As such these indicators are at their most useful when a major trend enters its last days.
The underlying principle behind volume indicators is that high trading volumes imply that the current trend will remain in effect for the foreseeable future while lower than normal trading volumes could be an indication that the market is about to turn around, i.e. a trend reversal is on the cards.
Interpretation of volume
During an uptrend, when prices are increasing and trading volumes are also strong at the same time, this indicates that the majority of traders believe that the current trend will continue – hence the strong volume. The moment trading volume starts tapering off in the direction of the current trend, it most likely indicates that traders are not willing to commit their trading funds at current prices because they fear a trend reversal is imminent.
One of the most widely used applications of volume indicators is when traders search for divergence between them and one or more price-based technical indicators. If prices are still moving strongly in any particular direction, but volume is tapering off, this is for many traders an indication that a major price reversal can be expected.
Three of the most popular volume indicators are the Money Flow Index, the Accumulation/Distribution Index and the On Balance Volume.
Money Flow Index
The Money Flow Index is derived by first calculating the ‘typical price’ for a given day using the formula: (High for the day + low for the day + closing price)/3.
The Money Flow is then calculated by multiplying the typical price calculated above with the trading volume. This is usually done for a number of consecutive periods to calculate an index.
A positive figure indicates that a bullish trend will continue, while a negative money flow indicates that a bear trend could be on the horizon.
Fig. 10.23(a) shows a typical money flow Index chart for the Euro (below the price chart).
This indicator also measures the cumulative inflow of money into or out of a specific trading asset, although the methodology differs somewhat from that of the Money Flow Index.
A Money Flow Multiplier is first calculated using the following formula:
[(Close - Low) - (High - Close)] /(High - Low)
The next step is to calculate the Money Flow Volume, which is equal to the Money Flow Multiplier calculated above x the trading volume for the period being studied.
Finally a new ADL is calculated by adding the Money Flow Volume to the previous ADL.
Fig. 10.23(b) shows a typical Accumulation/Distribution chart for the Euro/USD.
On Balance Volume
Of the 3 volume indicators discussed in this article, the On Balance Volume is the simplest to calculate. It simply assigns a positive or negative value to the day’s trading volume based on whether the price went up or down that day. If prices go up, On Balance Volume should therefore also go up and when they are going down, On Balance Volume should follow suit.
Fig. 10.23(d) shows a typical On Balance Volume chart for the Euro/USD