Introduction

Volume is one of the most critical indicators in technical analysis, often considered the fuel that drives price movements. While price action provides direction, volume helps traders confirm the strength behind the movement. Among various volume indicators, the Volume Oscillator (VO) stands out as an effective tool for measuring the momentum of volume itself. It helps traders assess whether buying or selling pressure is increasing or decreasing.

In this guide, we will explore the Volume Oscillator in detail, discuss its calculation, interpret its readings, and uncover various trading strategies to use it effectively in different market conditions.

What is the Volume Oscillator?

The Volume Oscillator (VO) is a technical indicator that measures the difference between two moving averages of volume, expressed as a percentage. It helps traders determine whether volume is expanding or contracting relative to historical levels.

Formula for Volume Oscillator:

VO = [(Short-term Volume MA – Long-term Volume MA) / Long-term Volume MA] * 100

Where:

  • Short-term Volume MA = A moving average of volume over a short period (e.g., 5 or 10 days)
  • Long-term Volume MA = A moving average of volume over a longer period (e.g., 20 or 50 days)

The resulting value oscillates above and below zero, providing insights into volume trends. A positive reading indicates increasing volume in the short term relative to the long term, while a negative reading signals declining volume.

Interpreting the Volume Oscillator

1. Positive Volume Oscillator (Above Zero)

  • When the VO is positive, it suggests that short-term volume is higher than long-term volume, indicating strong buying or selling interest.
  • If price is rising alongside a positive VO, the trend is likely to continue.
  • If price is falling with an increasing VO, it confirms strong selling pressure.

2. Negative Volume Oscillator (Below Zero)

  • When VO is negative, it means volume is lower in the short term compared to the long term.
  • If price is rising but VO is negative, it could indicate a weak rally or potential reversal.
  • If price is falling with a negative VO, the downtrend might be losing momentum.

3. Divergences

  • A bullish divergence occurs when price makes lower lows, but VO starts increasing, signaling potential accumulation.
  • A bearish divergence happens when price makes higher highs, but VO starts declining, hinting at a possible trend reversal.

Trading Strategies Using the Volume Oscillator

1. VO with Trend Confirmation

This strategy helps traders confirm the strength of an ongoing trend using the VO.

Rules:

  • Look for a rising VO along with a strong uptrend to confirm bullish strength.
  • Look for a declining VO along with a strong downtrend to confirm bearish strength.
  • If VO starts falling while the price is still trending up, it may signal a weakening trend and potential reversal.

Example:

  • Stock XYZ is in an uptrend, making higher highs.
  • The VO turns positive and keeps increasing, confirming strong buying interest.
  • Trader enters a long position and holds as long as VO stays positive.
  • When VO starts declining while price is still rising, it may indicate trend exhaustion. The trader can exit or tighten stop-loss levels.

2. VO with Breakouts

Breakouts from key levels are more reliable when accompanied by strong volume. The VO helps traders filter strong breakouts from false ones.

Rules:

  • Identify a key resistance or support level.
  • When price breaks out above resistance, check if the VO is increasing.
  • If VO is rising along with the breakout, it confirms strong participation, and a trader can enter a long trade.
  • If VO is negative or declining, the breakout may lack conviction and could fail.

Example:

  • Stock ABC has resistance at $100.
  • Price breaks out above $100, and VO spikes up.
  • The trader enters a long position with a stop-loss below the breakout level.
  • If VO starts declining after entry, it might be a warning to exit or move the stop-loss.

3. VO with Moving Averages

Combining the VO with price moving averages can create a powerful trend-following strategy.

Rules:

  • Use a 50-day MA for trend direction.
  • Enter long when price is above the 50-day MA and VO is positive.
  • Exit or short when price falls below the 50-day MA and VO turns negative.

Example:

  • Stock DEF is above its 50-day MA.
  • VO turns positive and starts rising.
  • The trader enters a long trade and holds as long as VO stays positive.
  • When VO declines and turns negative, the trader exits the position.

4. VO Divergence Strategy

Divergences between VO and price can signal potential reversals.

Rules:

  • Identify bullish divergence (price making lower lows while VO is rising) for a buying opportunity.
  • Identify bearish divergence (price making higher highs while VO is falling) for a selling opportunity.
  • Enter when the price action confirms the divergence (e.g., bullish candlestick patterns after a bullish divergence).

Example:

  • Stock GHI makes a new low at $50, but VO starts rising.
  • A bullish hammer candlestick forms, confirming potential reversal.
  • The trader enters a long position with a stop-loss below $50.

5. VO with Relative Strength Index (RSI)

Combining VO with RSI helps filter high-probability trades.

Rules:

  • Look for RSI oversold (<30) along with a rising VO for a long setup.
  • Look for RSI overbought (>70) along with a declining VO for a short setup.
  • Enter the trade when price action confirms the signal.

Example:

  • Stock JKL has RSI at 25 (oversold) and VO turning positive.
  • The trader waits for a bullish reversal candle and enters long.

Pros and Cons of the Volume Oscillator

Pros:

  • Helps confirm trends and breakouts.
  • Useful in spotting divergences for early trend reversals.
  • Can be combined with other indicators for higher accuracy.

Cons:

  • May generate false signals in choppy markets.
  • Needs confirmation from price action or other indicators.

Conclusion

The Volume Oscillator is a versatile indicator that provides insights into the strength of volume trends, helping traders confirm price movements, identify breakouts, and spot potential reversals. By using it in combination with other technical tools, traders can increase their accuracy and improve their decision-making process.

To master VO-based trading, practice analyzing past charts, backtest different strategies, and always use risk management techniques. A well-integrated VO strategy can be a valuable addition to any trader’s toolkit, helping to navigate the markets with greater confidence and precision.