More accurate market forecasting using volume profile
Why are popular indicators unreliable?
The most popular technical analysis methods such as RSI, MACD and moving averages are price derivative indicators and is really just an abstract of what the price is already telling us - whether the market is moving up, down or sideways. The fallacy of using price derived indicators is that a derivative indicator does not produce new information, hence why the majority of the most popular indicators are unreliable at best. Derivative indicators were developed many moons ago before cheap and fast access to market data was available and using them in this day and age will hand market participants who use non-derivative indicators an advantage.
Why Volume Profiling is more accurate
Volume Profiling is more accurate purely because it treats the market as what it should be, a venue to advertise price. The stock market, for all intents and purposes is basically an auction house, with buyers and sellers advertising price. The market is always continually searching for an equilibrium where a large buyer will meet a large seller and when that equilibrium is found, a transaction will take place. This transaction will show up as volume, where buyers and sellers have agreed the market is at fair value.
Based on the presumption that the market is simply an auction house, we can conclude that the current bid and offer is an advertisement of price and volume is the confirmation of fair value. This means that any move on low volume is simply a search for value and any move on high volume indicates acceptance of price and is significant. By using this information, we can more accurately deduce where the collective market and more importantly, where large participants perceive to see as fair value.
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Volume as a function of price rather than time
Most people who have traded the markets would have seen volume as a function of time, where volume is plotted on the x-axis. However, viewing volume as a function of time does not give us enough information - a market participant may have acted at a specific point in time, but at what price?
Volume profiling sees volume as a function of price and is plotted on the y-axis. By categorising volume at each level of price, we can see what price market participants have deemed as fair value and derive a bell curve from this volume.
By constructing a bell curve from the transacted volume, we can then start to determine areas of high and low probability. Where 70% of the volume (one standard deviation) is transacted, we deem this to be the value area, and the other 30% of the tails is deemed the value area high, and value area low - where volume has indicated are areas which there is minimal participation and potential areas of opportunity.
Technical analysis using volume rather than derivative indicators gives the trader an extra dimension of data and can assist the trader in making better decisions based on probabilities. With volume profiling, we can construct a market profile based on volume and get a better understanding of where market participants perceives as value, with opportunities arising when the advertised price moves away from areas of value.
In the next post, we will discuss how to determine if the market is trending or consolidating using volume profile analysis.
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