This is an important post on a topic I rarely see discussed. As background, you might want to check out my posts on tracking large traders in the market and the volume realities that every short-term trader should know. The reason volume analysis is important is because the majority of volume--and the shifts in volume--can be attributed to the participation or non-participation of large market participants. These institutional traders have the resources to move markets, so it is critical to understand when they are relatively active and inactive in the markets you're trading.
I took a look at the last 14 days of trading in the ES (S&P emini) futures contract and found that the volume of each 30-minute period during the day correlated with the size of the high-low price range for that period by .78. That means that about 60% of the variance in volatility can be accounted for simply by knowing the volume traded during that period. When we identify whether volume is high or low for a period, we're also able to make an estimate of likely volatility for that period.
Above we see the median volume for each 30-minute period in ES for the last 14 trading sessions (top chart) and the median high-low percentage price range for those periods. The correlation between volume and volatility is obvious. Also obvious is that volume and volatility shift substantially within the trading day. Indeed, the median volume of the 11:30 AM CT - 12 Noon CT bar is less than half of the median volume for the market's opening 30-minute bar. The median price range per 30-minute period--the total price movement--is 40% smaller for the midday period compared with the opening one.
This changing volume/volatility dynamic within the trading day has important implications for the intraday trader, including the placement of stops and price targets. I recently corresponded with a rookie trader who placed his stops and price targets a fixed number of points from this entry. While this provided the illusion of managing risk, it was ineffectual. The fixed stop point was hit simply by random price movement during the busy periods of the day, taking the trader out of good trades. Conversely, during slow periods, the trader's price targets were never hit, leading to reversals of his paper profits. The trader sought me out for help in dealing with his emotions, but in fact his problem was his failure to adapt to shifts in volatility.
This same problem occurs among even relatively sophisticated traders who bring expectations of price movement from the last day or two to the present trading day. They anticipate more or less movement than the market is actually giving them, leading to premature exits from good trades on busy days and failure to take profits on trades when markets are slow.
So how can we estimate the volatility of the day that we're currently trading, so that we can adapt accordingly? The idea of relative volume is that you compare the volume for the recent time period with the average volume for that same time period over the past X days. For example, I know that the median volume for the time period of 12:30 - 1 PM CT is 113,785 contracts, with a standard deviation of 53,262 contracts. If I see volume for that period exceed 200,000 contracts during the trading day, I know that this is a significant jump in volume relative to the recent past. It alerts me that institutional traders are relatively active in this market, so I will pay particular attention to whether they are buying or selling (by analyzing NYSE TICK and Market Delta for that period). It is out of such surges in participation that breakout moves and trends are often born.
Conversely, if I know that if the opening half hour of trade averages 259,412 contracts with a standard deviation of 66,817 contracts and see that the current opening period has only traded 150,000 contracts, I know right away that large traders are not dominating this market. This will lead to reduced volatility, and it typically leads to a choppier trade, as market makers push the market to and fro to make their scalping profits. A market dominated by market makers trades very differently from a market dominated by prop traders and fund portfolio managers. By recognizing relative volume, you can also identify who is relatively active in the marketplace--and that will provide you with valuable clues as to how much--and what type of--opportunity is present.
Note: If there is sufficient interest, I can post real time relative volume info via Twitter and as part of the indicator updates on the blog. The RSS subscription to Twitter is free of charge; the weekly indicator updates typically appear on Monday prior to the market open.
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