Saturday, September 19, 2009

Denominating Charts in Volume Units

I posted several charts yesterday of the ES futures, in which each bar represented a fixed number of contracts traded, not a fixed time period. Years ago, Richard Arms made a comment that stuck out in my mind. He said that the market's clock is expressed in units of volume, not time.

That notion has some deep implications. Concepts such as cycles, for example, take on a different meaning if we are to measure cycle periods in units of volume, not time. (That notion gets even more interesting when we standardize the volume units and express them as a percentage of a stock's float.)

Setting the x-axis of a chart in volume units also untangles the relationship between volume and volatility. Each bar in the Market Delta chart above represents 150,000 contracts traded, so that we can see Friday's action clearly. Note how some bars are quite a bit larger than other ones, despite the fact that all the bars represent the same number of contracts traded. Volatility is no longer a function of volume; we see it purely as a function of the depth of the order book. When we have lots of buyers and sellers around a set of prices, we will chew through volume in a narrow range. When buyers and sellers become unbalanced in the book, that range will expand. That makes breakout trades from bar to bar very interesting.

Finally, however, there is a psychological benefit to denominating charts in volume units. We know that volume forms a kind of smile pattern during the trading day, with volume (and volatility) highest in the first and last hours of trade, lowest in the midday hours. That typically leads active traders to overtrade those midday hours. When we denominate charts in volume, each bar is the same. If we are trading the relationship of one bar to the several preceding (as in a transition pattern), then we will wait as long as needed for that bar to form.

If we click on the chart above, we see that the amount of time it takes to trade 150,000 contracts is highly variable. Our holding period is not measured in time any more; it is measured in bars. As long as we wait for those bars to form, we can't overtrade slow market periods. We will tend to trade most when markets move the most, because that's when we'll have more bars and more setups.

I will be illustrating these and other ideas related to volume-based charts in coming days.