In one of my earlier Weekly Report posts, I mentioned that I would try to add a post on an indicator that I devised, so here’s the first, which applies to equities (and futures if you like). Keep in mind that this was created only recently, and it has not been tested too thoroughly, so it is up for scrutiny and hopefully can be utilized in some way (we’ll call it Version 1.0):
One of the major types of trading is Momentum Trading, which makes use of changes in volatility to predict price breakouts and ensuing trends (whether they be long term or short term). My idea was to look at the volume of the day (or period) and compare it to the range traded for that time [ volume/range]. Intuitively, I can conclude that if the volume is simply divided by the range, it would create a ratio that could tell me how the range is behaving relative to the number of shares being traded. So, I would look for this ratio to raise significantly, which could mean only one of three things: 1) the volume increased significantly 2) the range decreased significantly 3) both the volume increased and the range decreased. The third option is significant because it means that many shares are trading hands, but the price is not moving, which, in turn, would lead to low momentum / low volatility (an opportunity to trade a breakout in either direction). Obviously, as with any indicator, this is not perfect. There are times where the ratio gets distorted by exorbitant price movements or amounts of volume, and I’m sure there are many instances in which the analysis that I look for simply does not work. However, I will show some set-ups that did work out.
As with anytime you trade, you want to tilt the odds in your favor as much as possible to maximize the reward potential while the risk is minimized, so I’ve included support and resistance levels to back up the high VPR instances.
The following is a daily chart of DryShips Inc. (DRYS), which exchanges roughly 16M shares per day (click for larger view):
The VolumePerRange study that I created takes 4 parameters: 1) VPR length (the moving average of the VPR), 2) VPRMA length (the moving average of the VPR length) [these two create a delayed indication of reversals much like that used in Stochastics], 3) the ATR length (the lookback period for the Average True Range 4) the ATRMA (the moving average period of the ATR) [these two form the orange line on the chart, which basically provides the moving average of the Volume/ATR, providing a benchmark to compare the VPR]. I used the following inputs: 5 (smoothing out the VPR per the length of a trading week), 3 (keeping the MA of the MA close to the actual), 10 (averaging the range for the previous 2 weeks), and 20 (flattening out the benchmark for the previous 4 weeks). I will use the same inputs for the rest of my charts as well. As you can see, the price broke below the ascending channel, and at the same time, the VPR and the VPRMA crossed each other forming a peak that was significantly above the Volume/ATR benchmark, telling us that buyers and sellers were fighting it out to make a new direction for the price of this security. The VPR confirmed the breakout from low volatility as is made its peak, creating a good opportunity to get short (the price ended up dropping nearly 42%). Obviously, I am going to pick the best case scenario, but I think this can be a useful tool.
The next chart shows Intel (INTC) in the daily timeframe. This time, we use a different charting pattern (double bottom) to signify a bullish reversal, which is then confirmed by the VPR:
As the price formed a double bottom, it proceeded to break through the resistance level shown. At the same time, we had another set-up where the VPR crossed below the VPRMA creating a peak and an opportunity to seize the opportunity as the ranges increased, resulting in a breakout to the upside. As of right now, I have not seen a pattern that shows an exit sign with the VPR, but I have noticed that strong trends seem to gravitate closely to the Volume/ATR line (orange). In this case, if you noticed, there is another peak that formed about 3 weeks prior to the highlighted one. In this case, I wasn’t able to find support and resistance levels to break out from, so it did not provide as nice of a trading opportunity. This one could have potentially led to an gain of 15% as no clear peaks have formed since, although it looks as though today could possibly provide a selling opportunity.
This can be utilized for any timeframe or price target, but it is important to define that clearly before entering a trade. Here is Baidu (BIDU) on the hourly timeframe:
Peaks were formed once again, this time paired with the moving average cross between the 5-period open and the 5-period close to signal trend reversal. In this instance you would have caught the trade at the high and the low for this entire period (30 days).
Finally, I used the VPR in conjunction with the Bollinger Band Width (which shows low volatility as price fluctuation slows down and the bands pinch). Here’s Dell (DELL) again on the hourly timeframe:
We have a break out below the ascending support, coupled with small BBWidth and a peak that formed in the VPR. In this case, the move is not entirely dramatic, but it still provided an opportunity to profit on the short side.
I’ve talked about peaks and what they mean quite a bit, so what about troughs on the VPR? Well, intuitively, I know that low VPR could mean one of three things (the opposites of those mentioned before). Again, I can deduce the most from the third scenario: low volume and high range. This tells me that indecision is entering the market, either in the form of choppy trading, or more interestingly, weakening of a current trend. Either way, at the moment, it does not seem like a good scenario to enter a trade.
Like I said, this isn’t perfect, and it will never be perfect. But I am not looking for perfect, I am looking for an edge to make my trading more consistently profitable. I know this was a pretty long-winded post, so hopefully you made it through the whole thing. I welcome any comments or questions, as I realize writing all of these technicalities can get pretty tricky.