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Written by:
John McDowellWhat Is
Volume Profile?
A Volume Profile
is a volume-by-price trading indicator that shows the total trading activity or
volume traded at each price level over a specified period. This contrasts the
traditional and commonly used volume-by-time indicator that displays trading
volume over a specified period instead of price level. Using the Volume Profile
while trading can significantly improve your performance as you get a detailed
and insightful view of the trading activity at different price levels.
In this post, we will learn how the Volume Profile indicator works and how to
apply advanced trading strategies, which can take your trading to the next
level.
How Volume
Profile Indicator Works
The
Volume-by-Price, or Volume Profile indicator, plots a histogram on the price
chart using user-defined parameters such as range of time, number of rows, or
any other custom range. However, depending on the platform you use, the Volume
Profile data may be plotted based on the period visible on the available screen
space. This version of the Volume Profile Indicator is called the Volume
Profile for Visible Range (VPVR).
The
histogram is plotted on the chart after the system divides the total volume at
a particular price level over the specified time into up-volume trades or
down-volume trades. The trader can then easily visualize significant price
levels by analyzing the histogram created on the chart. For example, the length
of histogram bars indicates the trading volume at each price level over a
specified range of time; the longer the bars, the higher the trading volume at
that price level and vice versa.
How to Use
Volume Profile Indicator?
To use the
Volume Profile Indicator, you need to be aware of the significant levels or the
components of the histogram displayed on the chart. Here we list and describe
some of those:
Low Volume Node: As indicated by the name, a low volume node indicates the
price level where the trading activity or volume is low. In other words, the
price level at the low-volume node is of little interest to buyers and sellers,
resulting in thin trading volume.
High Volume Node: The high volume node represents a high volume of trades at
the particular price level on the chart. It means that the price level bears
significance, which is why there is a high level of buying and selling
transactions taking place.
Point of Control: This price level shows the highest trading volume, even above
the high-volume node. The point of control area is the most significant as this
price level draws the most interest from the buyers and sellers, resulting in
peak trading activity.
Value Area: The value area represents the price range where a specified
percentage of the total trading activity took place during a period. The
percentage is typically set to 70%; however, a trader can set it to any value.
The value area is used to determine significant price levels and support and
resistance levels.
Depending on the trading platform, you can configure the Volume Profile
indicator in various ways. For example, you can either choose to plot it at the
bottom of the candlestick chart on the x-axis, or you can plot it
right over the candlestick chart. Some platforms also allow you to plot the
volume profile indicator horizontally on one side of the main price
chart.
Advanced
Volume Profile Strategies
Here are
some advanced trading strategies you should consider when implementing the
Volume Profile indicator:
1. High
Volume Node (HVN) Retracements
As discussed
in the previous section, there is a high volume of trading activity at
high-volume nodes. When most of the high-volume nodes are in the Value Area
(usually 70%), the price level is significant and you can then look for price
retracements, providing opportunities for trade setups.
For example, if the price enters the high volume node, you can expect the price
to retrace from there as one party – either buyers or sellers – will prevail,
which will move the price in their direction. Traders mostly look at the high
volume node retracements at past price levels to predict future price movement.
If the price indeed retraces, you can then consider setting up your trade at
that point.
High-volume
nodes are usually a resistance level when the price trades below it, while it
acts as a support level when the price trades above it. Suppose, there is an
uptrend and the price retraces to the HVN, it may be a buying opportunity as
the HVN at this price level might act as a support level, from where the price
usually bounces off.
The strategy
could also work in reverse. For example, if there is a downtrend and the price
moves up to the HVN, you can expect it to retrace as the HVN level at this
point might act as a resistance, providing an opportunity to sell short.
Risk
Management
You can set
your stop loss just above or below the HVN, depending on
whether you want to go long or short. If you want to go short, the stop loss
would be placed just above the HVN, while it would be placed below the HVN if
you want to go long and expect the price to bounce up the HVN after dropping.
However, you should give your trade enough breathing room and not place the
stop loss too close to the HVN so that you are not stopped from the trade too
soon.
If the market is trading in a range and you observe the price continuously
retracing between HVNs, you can use the distance between the next HVN as your
take-profit point in such cases.
2. Low
Volume Node (LVN) Breakouts
Low Volume
Node is the zone where the trading volume has been low compared to the nearby
areas. The LVN signifies a lack of interest from buyers and sellers which means
that price moves rapidly at these price levels.
Because of low trading activity at the LVN price levels, the price doesn’t stay
there for long, unlike the price at the high volume node levels. Resultantly,
there is no resistance or support at LVN price levels and the price mostly
slips from there until it gets support or faces resistance at some other price
level. The LVN breakout strategy focuses on such low-volume areas to identify
trading opportunities.
When the price nears LVN, it can present traders with a breakout trading opportunity as there is less volume
to arrest the price movement at this level. So when the price breaks out the
LVN, this could be an indication of the start of a new trend or a change in
market sentiment.
Risk
Management
You can
enter the trade as soon as the price goes past or breaks out the LVN. For long
trades, your stop loss would be just below the LVN, while for short trades, the
stop loss should be placed above the LVN so that you don’t fall prey to a false
breakout where the price bounces back.
While the LVN breakout strategy is quite effective, which can be verified by
studying historical charts, it is best to combine it with some other technical
indicators to increase your chances of making successful trades. These could be
momentum indicators, RSIs, and moving averages. Since the price breakouts at LVN levels
are quick yet significant, the strategy is particularly popular among short-term,
day traders and scalpers looking for quick high-risk/high-reward setups.
3.
Determining Market Trends
The Volume
Profile indicator is also used to determine trends in the market. This is done by analyzing the shape
and structure of volume distribution over a period across different price
levels, which gives vital clues about the current state of the market.
For example, if the histogram has a bell-shaped or normal distribution
structure, the market is usually in an equilibrium or a range-bound state. In a
balanced or choppy market, the price is centered around the Point of Control
and Value Area of the Volume Profile chart.
If the market is trending, the distribution is skewed towards one side,
indicating the shifting of the Point of Control and increased trading activity
at the price level. The skewed volume profile distributions are classified into
two types: P-shaped and b-shaped. The P-shaped volume profile distribution is
wider at the top and thin at the bottom, signaling that the volume is
increasing at a higher price level – a potentially bullish signal, or bearish
signal if at a market top. In contrast, the b-shaped volume profile distribution
is thin at the top while wider at the bottom. It shows an increase in trading
activity at a lower price, which can be a bearish signal or a bullish signal at
the start of a new trend.
However,
before entering the trade, you should confirm the signal by using other trend
indicators to increase your chances of making a successful trade.
4. Finding
Support and Resistance Levels
Volume
Profile helps traders identify key support
and resistance levels. These are price levels where there has been
increased buying or selling activity, with the price consolidating and finally
reversing the ongoing trend.
For example, in an upward trend, when the price stops moving up due to
increased selling activity at a particular price level, it is called a
resistance level. Conversely, in a downtrend, when the price stops going
further down and ultimately bounces back due to a sudden buying activity by
buyers, we term this price level a support level.
The High Volumen Nodes (HVN) in the Volume Profile indicator mostly act as
support and resistance levels since those price levels were marked by
heightened trading volume. Because of the high trading activity at such price
levels, breaking through these levels takes significant effort, due to which
price retraces most often from there.
The Low Volume Nodes (LVN) in contrast are areas where trading volume is low,
and hence the price doesn’t stay there for long. This makes LVN price levels a
breakout or breakdown point – the price level where there is no support or
resistance from either buyers or sellers. Such price areas provide
opportunities for trading breakouts and breakdowns.
As discussed
in the article previously, the Value Area also holds significance since it
covers around 70% area of the total trading volume during a period. In a
range-bound market, the Value Area High (VAH) on the VA often acts as a
resistance level while the Value Area Low (VAL) acts as a support level.
5. Improving
R-Multiple
Volume
Profile analysis can help traders improve their risk-reward
ratio by strategically placing their stop loss and take-profit points.
For example,
based on your analysis of the Volume profile, you can enter trades at High
Volume Nodes or Low Volume Nodes as these usually act as strong support and
resistance points. To minimize your losses in case the trade goes against you,
you can strategically put your stop loss below the HVN (in case of a long
trade) and above the LVN (in case of a short trade).
By keeping
your risk small relative to the profit potential, you can significantly improve
your risk-reward multiple, even if some of your trades hit the stop loss.
Risk
Management
No matter
how confident you are about your trading strategy or the trade set-up, having a
risk management strategy is the key to achieving long-term success in trading.
One important element of risk management is the optimal trade size. If
your trade size is too large, you might end up losing too much in case the stop
loss is hit. In contrast, if your trade size is too small, you’ll be taken out
of the trade too often as your stop loss would be hit frequently.
Backtesting the Volume Profile and playing with the historical data in
different scenarios can make you feel confident while executing your strategy.
You’ll instantly spot familiar setups once you apply the lessons learned from
the guide. There's no better place to do this than in the TradingSim simulator.
Volume
Profile Summary
Volume
Profile trading indicator gives you a wealth of important information about the
price and the trading volume driving the price. To successfully apply a Volume
profile in your trading, you need to understand the important components of a
volume profile, such as High Volume Nodes, Low Volume Nodes, Point of Control,
Value Area, etc. These components reveal vital information that you can use to
gauge the market sentiment and trade the market accordingly.
In comparison with the traditional volume-by-time indicator, the Volume Profile
indicator is a handy tool that you should master. The indicator can be easier
to interpret, and you can identify crucial price levels along with the support
and resistance levels marked by heightened trading activity. It also helps you
find low-volume price levels, where scalpers and day traders can find trading
opportunities or to identify whether the market is trending or moving
sideways.
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