part0074

For many traders and investors, price and the price chart itself are the beginning and the end of technical analysis, and this perhaps best describes those traders who classify themselves as price action traders. All they consider is the price and nothing else. However, for myself, and many others, this approach completely ignores the extension of price to its logical association with volume, which together then reveals the truth behind the raw data of price.

The explanation generally given is that technical analysis is based on the underlying philosophy that all market sentiment is contained within a simple price chart. That a price chart encapsulates the views of every market participant at a given moment in time. Moreover, that technical analysis is simply price analysis, and that traders can forecast the future direction of price by analysing and studying where it has been in the past.

And whilst this is undoubtedly true, what it fails to account for is the market manipulation that occurs in all markets and all time frames. And in order to see inside the market, and what the insiders and market makers are doing, we have one tool at our disposal which reveals their activity instantly, and that tool is volume. Volume is the catalyst which when combined with price, provides the foundation stone that is volume price analysis.

But if you think volume price analysis is a new approach, think again.

This approach was first developed by the founding father of technical analysis, Charles Dow, more than a century ago, and then further developed by one of the greatest traders of all time, Richard Wyckoff. Iconic traders such as Jesse Livermore and Richard Ney also used the same approach, and all had one thing in common. They used the ticker tape, reading the prices and associated volumes to interpret and anticipate future direction through the prism of volume and price.

And indeed as Richard Wyckoff wrote in the introduction to his own course in the 1930s ‘ you draw from the tape or from your charts, the comparatively few facts which you require for your purpose.' These facts are…the price movement, the intensity of trading, the relationships between price movement and volume, and the time required for all the movements to run their respective courses.

The concept of this technical approach to trading is very simple. It is based on the idea that every market is manipulated, and in accepting this fact, we can then conclude the market makers, the insiders and the big operators know where they are taking the market next. If so, then all we need to do to succeed as traders it to follow them. In other words, to buy when they buy, to sell when they sell, and to stay out when they are not participating. These are the simple concepts of this approach to technical analysis, and their participation or lack of participation is all revealed through the prism of price and volume, and what we call volume price analysis.

If you are already familiar with these concepts and ideas which I explain fully in ‘A Complete Guide To Volume Price Analysis’ then the worked examples here will provide further insights and explanations which expand on the basic concepts. However, if these are new to you, and perhaps you have been trading the forex markets for some time, but have not applied these ideas before, let me try to provide a brief overview of the terminology and concepts of this methodology.

And the first idea is very simple in that embracing volume price analysis, we are also embracing the concept that every major market is managed by those on the inside. But before we move on, let me address one issue immediately which is the criticism leveled at using volume in the world of spot forex.

We all know there is no currently central exchange in the spot market, and as such we therefore have to turn to an alternative measure of volume, which is tick activity, and is a proxy for volume. My own view, and proven over many years, is that this volume works perfectly well, and in exactly the same way as in other markets. After all, volume is simply a measure of activity or a lack of activity, and if activity is very high or very low, then this signals participation or a lack of participation by the institutional market makers. There have also been many studies over the years which have compared tick activity with the true futures volumes, and the conclusion in every case is that proxy volume is an excellent measure and barometer of ‘true’ volume.

For the spot forex market the insiders here are the institutional market makers, who create the price spreads, and just like the market makers in the world of stocks, can see both sides of the market, and the balance of supply and demand. The analogy I always use is to think of them as wholesalers with a warehouse of stock which is constantly being refilled and then emptied before being restocked once again. The sole purpose of the market maker is to make money from themselves, and as they sit in the privileged position of seeing both sides of the market, this is relatively simple to achieve. After all, as they see both sides of the buy and sell equation, if they themselves are short of stock and wish to replenish their warehouse, all that’s required is to create a panic move in the market, which then shakes investors out of strong positions with the market makers then gratefully stepping in to buy. And the mechanism they use to great effect is the constant stream of news that drives sentiment 24 hours a day.

And whilst the institutional market makers can hide in relatively obscurity at the centre of the market, there is one activity they cannot hide, and that is volume. As the institutional market makers are by nature large in size, their participation, or lack of participation is also very clear, as price moves on large volume signal the market makers are joining the move. Conversely large moves on low volume signal a trap, with the market makers simply moving the price, but with no participation themselves. Their involvement or lack of involvement is clearly signaled through the analysis of one indicator, which is volume, and when combined with an understanding of price, we can then interpret precisely what the market makers are doing and why. And in doing so, we have a clear picture of where the market is heading next.

This methodology was codified by Richard Wyckoff in his three laws. The third law of effort and result, the second law of cause and effect, and the first law of supply and demand.

In the third law, this states that effort and result must be in agreement. In other words the volume which is the effort, must be in agreement with the outcome of the price move, or the result. If there is high volume, then we should expect to see a significant move in the price which matches the effort. If not, then this is an anomaly, and is sending a signal that something is wrong. From this anomaly in price and volume we can then interpret whether the market makers are buying or selling at this point.

Wyckoff’s second law then introduces the concept of time and enshrined in the law of cause and effect. Here the law states that if the cause is large then the effect should also be large if the two are in agreement. In other words, if the time taken to build the next phase of a campaign by the market makers is large, then we should expect to see this reflected in an extended move in the price action as a result. You can think of this as the effect of winding the spring of a clockwork toy. The more the spring is wound, the greater the energy is stored, and the greater the distance the toy will travel, once it is released. This is the basic principle of cause and effect.

Finally we come to Wyckoff’s first law of supply and demand, which states simply that when supply outweighs demand, then prices will fall, and when demand outweighs supply, the prices will rise.

These three laws then combine to explain and describe the constant journey of price, which moves in an endless journey from bearish to bullish and back again in all timeframes. This journey is self similar, and follows the same pattern, whether on a 1 minute chart or a 1 month chart, and a complete cycle is defined as moving from the selling climax to the buying climax and back again. But in volume price analysis we always view volume and price from the market makers perspective, in other words from the inside out. So when we talk of a selling climax, this is when the market makers are selling at the top of a rally higher, and equally a buying climax occurs at the bottom of a move lower. This is the opposite to what traders and investors understand, and is the reason most traders sell at the buying climax and buy at a selling climax.

In the selling climax, the market or stock has been rising very strongly, and those nervous investors and traders can wait no longer. Their fear of missing out is rising constantly, and finally they are drawn in to buy at the top, just at the point the market makers are selling into an increasingly weak market. The climatic price action is then created using volatility and news, which allows the market makers to clear their warehouses in preparation for the next phase of the campaign which will be to move the price lower in due course, but only when they are ready. The emotion that is used here to trigger buying by the weak hands, is the fear of missing out, or FOMO. This is a powerful emotion, and one the market makers and insiders use to great effect.

The buying climax occurs when the market makers wish to restock their empty warehouse, and here the trigger is fear of a loss. The market is moved fast into a price waterfall, generally on news, with traders and investors then selling in panic, with the market makers then stepping in to buy, and stop the stock or market falling further. Again the climax will be characterised by volatile price action and spikes in volume. Once the buying climax is complete and the warehouses are full once more, the next phase of price action begins.

This is also the reason markets fall far more quickly than they rise. The market makers can take their time in the move higher to maximise their profits, and to take these slowly. But in the move lower, they are in a hurry to fill the warehouse and repeat the process, and you can think of this as an old fashioned game of snakes and ladders. Up the ladders slowly, and down the snakes very quickly.

I use the word campaign in many of these examples, as this is precisely how it is planned by the market makers. In other words, just like a military campaign with nothing left to chance. After all, the worst thing that can happen, once a campaign is underway, is for it to be overwhelmed with increased selling or buying, and so bringing the development of the new trend to an abrupt halt. And this is where the test becomes all important.

Once an extended phase of accumulation has come to an end, and before the campaign begins, the market makers and insiders will test in order to ensure all the selling pressure has been absorbed. This ensures the bullish trend can develop slowly and smoothly, with no chance of any lingering sellers then driving the market lower. The test is executed with a move to the downside and close near the open, and is confirmed if volume is low. What we call a test of supply, and if it is a successful test on low volume, then the campaign can be launched.

Equally at the end of a distribution phase, and prior to development of the bearish trend, a test of demand is executed. Here the market makers push the price higher, and if there is little or no demand, then the price closes back near the open on low volume. This confirms the test has been successful and the campaign can begin.

Moving on, if the primary principle for accepting volume price analysis as a valid methodology is that all markets are managed and manipulated from the inside out, the second principle then follows, in that all we are looking to achieve is to identify when the market makers are buying or selling, or simply not participating in any move. And this is done very simply by considering the price action and volume both individually and also over time, and by considering whether the two are in agreement or disagreement. If price and volume are in agreement, then all is well and the market makers are driving the move and participating. If not, then we have disagreement, and from which we can then draw some logical conclusions as to whether they are buying or selling, and if so to what extent, and based on the preceding price action.

And one of the most important areas on the price chart is where a market is in congestion. Markets spend 70% to 80% of their time in such regions, and the remainder of the time trending. The reason for this is very simple. Congestion zones are the areas where trends are born, and where the market makers and insiders are preparing for the next stage of a campaign. They may be major areas, such as the selling or buying climax, or they may be minor where a market has paused in the primary trend, and developed into a second trend reversal before returning to the primary trend.

Understanding congestion phases, as well as support and resistance is a key aspect of volume price analysis, and one which many traders do not understand or simply ignore in the constant search for a trend. Indeed, breakout trading is often condemned as futile and risky by those traders and investors who have not embraced volume as part of their approach. When any breakout occurs, volume will confirm whether the move is genuine or false. It is very clear and very simple.

Traditional support and resistance based on price is a core concept of volume price analysis, and in my own trading and investing, I also incorporate volume using the volume point of control which displays volume on the price axis of the chart, and so describes the volume histogram at the various price regions and price levels. This is based on the concepts of market profile where ‘fair value’ occurs at the highest concentration of volume on the chart, and which also introduces the concept of time to the volume, price relationship. In other words, the longer a currency pair remains at a price level, then the greater the concentration of volume, and price will only continue to move on, once the balance of bearish or bullish sentiment has changed.

I refer to this as the volume point of control because it is the fulcrum point at which a currency pair is balanced. In other words, the bullish and bearish sentiment is equally balanced. At higher and lower levels, high volume and low volume nodes are also created, and these can then be used in the same was as for price resistance and support. In other words, if a low volume node is approached in due course, then we can expect the market to move through relatively quickly as there is little in the way of transacted volume to cause a pause in price action.

In addition, if the market considered this area to be of little significance in the past, then it is unlikely to be of great significance in the present or future. Equally, if we have a high volume node then the opposite is expected, with a pause and move into congestion then likely. Using volume in this way on the Y axis of the price chart, then gives us two perspectives on support and resistance with one based on price, which is the more traditional approach, and the other based on volume using the volume point of control indicator.

And finally, just a word or two about what we mean by volume.

For stocks and ETF’s, this is the volume reported through the physical exchange. For futures, it is the futures volume, and for spot forex, it is the proxy volume of tick activity. All are very different, but all report activity and volume, and if you have a price chart with volume, then you can apply this methodology to any chart and to any timeframe. But volume is always relative, both to the session and time of year. At seasonal periods we see a general decline in volume, which is to be expected. For example when markets are closed for holidays we see low volume.

Volume reveals the truth behind price action. It reveals precisely what the market makers or insiders are planning to do next. And as a trader or investor, there is really only one thing we ever want to know, namely the answer to the question of where is the market going next. And if you can answer this question with some degree of confidence, then you will take your investing and trading to a new and exciting level. But remember, there is nothing new in trading. This approach has been around for over 100 years. It has stood the test of time, and has been adopted by some of the greatest traders of the past and present.

For myself, I have used this approach for over twenty years, and for me, a chart without volume only tells half the story. And even more important, if you have an existing approach which you use currently, there is no need to change. Simply add volume price analysis to your toolkit, and I know it will help you enormously in your own forex trading.