Interpreting Volume for the Futures Market (2024)

Volume for identifying market trends and reversals

Sustained high volume in the direction of a trend signals strong participation, and it is likely continuing. Meanwhile, a sudden surge in volume after a period of trend movement may indicate exhaustion and a possible trend reversal.

Volume in confirming or invalidating trading signals

A trading signal, such as a technical pattern or indicator, is considered more reliable if there's a corresponding increase in volume. For example, a bullish engulfing pattern with higher than average volume is more likely to result in a successful long position.

Conversely, if a trading signal occurs with low or decreasing volume, it may lack the necessary market support, suggesting the signal might not lead to the expected price movement. Traders might view this as a warning to avoid acting on the signal or to proceed cautiously.

Volume in breakouts

Volume can be very useful in confirming breakouts. A breakout from a trading range with significantly higher volume suggests a new trend is starting, and the high volume validates the breakout's strength.

Volume spikes and drops

A sudden spike in volume could indicate a strong market reaction to news or events. Traders watch for these spikes as they often precede significant price movements. Traders observe the price direction following the volume spike to gauge market sentiment.

Conversely, a significant drop in volume can indicate a lack of interest in the current price level, potentially leading to a consolidated period or a reversal if followed by a volume spike in the opposite direction.

Volume actions precedes price changes

Often, traders observe volume patterns to predict price moves. An increase in volume without a significant price change may suggest that a price jump is imminent since this suggests traders are accumulating positions.

Factors Affecting Volume in Futures Trading

Various factors influence volume in futures trading, each playing a role in the market's liquidity and the depth of trading activity. Here are the most critical ones to know:

• Market news and economic events: Significant news releases, economic reports, and geopolitical events can increase trading activity as market participants react to new information. This includes interest rate decisions, employment reports, gross domestic product figures, and other economic indicators influencing market sentiment and trading strategies.
• Time of day and trading session: Volume tends to be higher at the opening and closing of the trading session because of increased participation from institutional and retail traders. In addition, the overlap of significant market sessions, such as when both the European and American markets are open, can lead to higher volume.
• Expiry dates and rollover periods: In the derivatives and futures markets, volume can vary significantly as contracts approach their expiry dates. Traders may increase their activity to roll over positions to the next contract month, leading to spikes in volume. This is particularly evident in markets with a high amount of speculative trading.
• Price volatility: Increased volatility often leads to higher trading volume as traders capitalize on price moves. Large price swings can attract more participants to the market, including speculators and hedgers, each looking to take advantage of or protect against price changes.
• Market liquidity and access: The ease of access to a particular futures market and its overall liquidity can influence volume. Markets that are more accessible to a broader range of participants, including international traders, tend to have higher volume. Similarly, markets with higher liquidity attract more traders because of the ease of executing large orders without significantly impacting the market price.

When combined with other techniques, volume analysis is a strong tool for assessing the strength of price movements and the potential for future volatility.

Interpreting Volume Patterns with Open Interest

Volume and open interest are used together to gauge futures market sentiment and help forecast future price movements. While volume is the total number of contracts traded within a specific period, open interest refers to the total number of outstanding contracts that have not been settled or closed out.

Open interest provides more context to volume data, giving a better understanding of the flow of capital in or out of the market and the sustainability of a trend. A rise in open interest signals that new money is coming into the market, which means the trend might continue. For example, rising open interest in an uptrend implies that new positions are being opened, which supports the continuation of the uptrend.

The inverse is also true: a decrease in open interest suggests that money is leaving the market, which indicates the trend is concluding. In an uptrend, falling open interest could signal that the trend is losing momentum and might soon reverse.

Combining volume with open interest

When volume and open interest are rising, this could mean that new money is entering the market, which will likely reinforce the trend. This makes it a solid indicator of the market direction being maintained. However, an increase in volume and a decrease in open interest could indicate that traders are closing out positions, leading to a potential trend reversal, especially if the price movement does not align with the increase in volume.

A decrease in volume and an increase in open interest may imply a consolidation phase within a strong trend, where traders are not closing positions but are also not initiating new trades aggressively.

Finally, a decrease in both volume and open interest indicates reduced interest in the trend and could signal a weakening of a period of consolidation before a trend reversal.

Volume Indicators

Traders use several volume-based indicators to analyze market conditions and help them predict future movements. Here are some commonly used indicators in futures trading:

• On-balance volume (OBV): OBV adds volume on up days and subtracts volume on down days, providing a cumulative indicator showing when volume flows in and out of a security. A rising OBV indicates buyer dominance, while a falling OBV suggests sellers are in control.
• Volume oscillator: This indicator measures the difference between two moving averages of volume. It helps identify trends in volume relative to changes in the market price. When the volume oscillator moves above its zero line, this indicates that volume is increasing, signaling the start of a new trend or the continuation of an existing one.
• Volume-weighted average price (VWAP): The VWAP is a trading benchmark commonly used in futures markets. It is the average price of an asset, weighted by volume, over a specific period, usually a single trading day. VWAP is calculated by adding the dollar amount traded for every transaction and dividing it by the total shares traded during the day.
• Accumulation distribution line (ADL): This indicator combines price and volume to show how much of a security is being accumulated or distributed. An upward trend in the ADL suggests buying pressure, while a downward trend indicates selling pressure.

Volume indicators are beneficial in futures trading, offering a unique perspective into the market's underlying strengths and weaknesses. However, like all indicators, volume should be used with other analytical tools for the most accurate market assessment.

Using Volume Analysis in Risk Management

Traders incorporate volume analysis into their risk management to enhance decision-making, reduce exposure to unexpected market moves, and optimize trade entry and exit points. As a measure of market activity and liquidity, volume provides insights that can help traders manage risk more effectively.

First, volume can help identify support and resistance levels with greater reliability. High volume levels at specific price points suggest strong buying or selling interest, indicating that these levels may serve as robust support or resistance in the future. Traders may use these levels to set stop losses or determine entry and exit points, managing their risk exposure.

Also, traders often adjust their positions based on the strength of a trend. They might increase their exposure during strong, high-volume trends and reduce it when volume indicates a weakening trend or potential reversal. This approach helps mitigate the risk of holding positions against the prevailing market direction.

Analyzing volume patterns allows traders to better time when to enter and exit the market. Traders might also use it to avoid trading with low volume, which are often subject to higher spreads and slippage, increasing transaction costs and risk. By focusing on securities or contracts with sufficient volume, traders can ensure more stable and predictable trading conditions, reducing the risk associated with illiquid markets.

In addition, traders can review volume/price divergence. As prices move in one direction and volume in another, this serves as a risk warning signal. For instance, if the price is rising but volume is declining, this could indicate weakening buying pressure, which suggests that the uptrend will soon reverse. Traders might use this information to tighten stop losses, reduce position sizes, or prepare to exit positions, managing potential downside risk.

Example of Using Volume Analysis in Futures Trading

When trading E-mini S&P 500 futures (ES), integrating the VWAP, anchored annually, along with the OBV 20 and 75-period simple moving averages (SMAs), offers a way to identify trading opportunities based on the interplay among these volume indicators. The trading conditions for this strategy are as follows:

• Go long: Traders could take long positions when the VWAP is below the closing price of the E-mini S&P 500 futures and the OBV's 20-SMA is above its 75-SMA. This indicates a bullish sentiment and upward price movement.
• Go short: Conversely, a short position is favored when the VWAP is above the closing price of the E-mini S&P 500 futures and the OBV's 20-SMA crosses below the 75-SMA. This signals bearish sentiment, with volume analysis confirming a potential downward price trajectory.

We can see moments in trading history that seem to confirm this volume analysis approach. For example, on Dec. 27, 2021, a negative crossover between the OBV SMAs heralded a peak-to-trough decline of approximately 27%. Traders utilizing this strategy would have positioned themselves short when the closing price of E-mini S&P 500 futures was below the VWAP while incorporating their other trading strategies and capitalizing on the anticipated downturn.

Another notable instance occurred in December 2022, marked by a positive crossover of the OBV SMAs, which resulted in a trough-to-peak increase of about 22%. At that point, traders could have entered long positions as the closing price exceeded the VWAP, aligning with the expected price appreciation. This would have been in addition to their other trading strategies.

However, there have been times when a negative crossover was observed while the closing price of the E-mini S&P 500 futures remained above the VWAP. In these cases, traders would have sought confirmation before executing traders or waited on the sidelines.

These examples serve as illustrations of incorporating volume analysis into futures trading strategies. Traders typically employ a more comprehensive system, including rigorous backtesting strategies to validate their effectiveness.

The Bottom Line

When analyzed with price action and other market indicators, volume data can help get a more comprehensive view of the futures market and its dynamics. High trading volume often signals strong interest in a contract and can indicate the presence of significant market activity, either confirming a trend or signaling potential reversals.

In addition, understanding the nuances of volume changes helps assess the robustness of price levels and the potential for future volatility. As such, interpreting volume should be in every futures trader's arsenal since it helps identify prospects and manage risk.