How does the Volume Profile work? – Tutorial

Introduction and explanation:

The Volume Profile in trading describes the traded volume in an underlying instrument at a specific price. Usually, the volume is plotted on the time axis so that a certain value is displayed per candle and per time. With the volume profile, the price axis is used to calculate a specific number of contracts traded per price, for example, in E-Mini S&P Future.

A typical chart with a volume profile could then look like this:

Chart and Volume Profile

This allows you to see which brands have a lot of trading activity and which have little trading activity. The point of greatest trading activity, that is, the highest volume traded per day, is called the point of control (POC). In addition, two further areas are often shown, which are defined as ValueArea (VA). Within this range, 70% of the daily volume is traded, if you take the default setting. Above the POC and below the POC, the ValueArea-Top (VAT) and the ValueArea-Bottom (VAB) can be plotted.

The Volume Profile explained:

  • Point of Control = POC: The price with the highest traded volume in the selected period. The POC (in red) has the longest horizontal bar of the observation period and thus represents the price with the highest trading activity of the day. The POC represents the “fair value” = the fair price of the day, because this is the price at which most purchases and sales have taken place. During the trading day, the POC meanders dynamically through the evolving Volume Profile.
  • Naked POC: A POC that has not yet been touched/traded on the following day/periods.
  • Value Area: This is the dark blue area in the charts. Based on the standard normal distribution, this is 1 standard deviation (= 1 σ) of the traded volume around the POC. Usually, 70% is set in the chart tool (exactly 68.3%).
  • Value Area High = VAH: The upper edge of the Value Area.
  • Value Area Low = VAL: The lower edge of the Value Area.
  • VAAH = Value Area Absolute High = Daily High
  • VAAL = Value Area Absolute Low = Day Low
  • Price Range: Total trading range of the day.
  • Low Volume Node = LVN: A price with very little volume, whereby clear volume clusters must be formed above and below it. The price in such a volume node was rejected by the market participants (rejection) because it was traded quickly.
  • High Volume Node = HVN: These are the volume clusters with high volume, but less volume than at the POC. This price was accepted by many market participants and indicates a consolidation.
  • Close: The closing price of the day. As a reference for the following day, has a special meaning with regard to the question: Has the sentiment changed?

See the picture with description:

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Statistical evaluations for the Volume Profile

In order to develop an automatic trading system or a trading strategy from this data, a statistical evaluation of the volume is required. Only then can you see whether it makes sense to develop a trading system and whether it is worth implementing it. In the following, the respective price levels of POC, VAB, and VAT from the last day are used. The position of the opening price of the following day in relation to these values is considered.

The current day cannot be considered because the volume develops over the course of the day and the POC and ValueArea are therefore constantly shifted until these values are fixed at the end of the day.

Trading approach from the volume profile for your trading

The following points (positions) of the opening price are considered:

A: Open of the day > POC, but Open below VAT

B: Open of the day < POC, but Open above VAB

C: Open of the day > VAT

D: Open of the day < VAB

The evaluations were carried out from 2013-2017, i.e. over 5 years, in order to ensure certain timeliness. Evaluations 10 or 15 years back are of course also possible, but in my experience, the significance for today’s market is lower.

A total of 1249 trading days were considered in which the POC of the previous day was reached in more than 63% of the cases, i.e. was restarted. The ValueArea-Top was reached in just under 60% of cases and the VAB was reached in just over 54% of the days. This is in line with expectations, as we were in an upward trend during the period under review.

Here now the described cases A-D and the historical probabilities for them. The evaluations were created with ATAS.

Volume Profile Patterns explained:

D Profiles:

This pattern has the shape of a large “D”. With a D-profile, the market is balanced, it is in balance, the POC is approximately in the middle of the trading range and a relatively ideal Gaussian bell curve has been formed around it. Buyers and sellers acted in balance, neither side tried to dominate the other or started aggressive actions. With a D-profile, it can be assumed that institutional investors accumulated without attracting much attention.

The three important zones in a D-Profile are:

  • The high of the D-Profile
  • The depth of the D-profile and
  • The POC

In a D profile, prices around the high and low of the profile are strong support and/or resistance zones. Often aggressive buyers at the low and aggressive sellers at the high of the profile occur the following day. This is because: the buyers want their long positions accumulated on the previous day and the sellers want their short positions accumulated on the previous day to be profitable.

Countertrend traders can shorten the previous day’s high and lunge the previous day’s low. Take Profit is recommended for D-Profile at the POC.

P-Profiles:

This pattern has the shape of a large “P”. With a P-profile, aggressive buyers are at work and sellers are weak. Usually, bullish candles are trained. The POC is trained at the upper end of the trading range. Such a P-profile is usually formed when

  • the market is in an upward trend, or
  • at the end of a downward trend and a trend reversal could be imminent.

If the market rises on the following day or days, the POC from the P-Profile provides good support. Often the POC is retested (from above) so that long positions can be reopened or increased.

Volume clusters in the thin area of the profile are often signs of aggressive buyers who have bought the market massively upwards at these prices … but also short-sellers have closed their positions. If prices (from above) return to these levels, buyers will defend this support and buy the market back up.

b-Profile:

This pattern has the shape of a small “b”. With a b-profile, aggressive sellers are at work and buyers are weak. Usually, bearish candles are trained. The POC is trained at the lower end of the trading range. Such a b-profile is usually formed when

  • the market is in a downward trend or
  • could be at the end of an upward trend and a trend reversal could be imminent.

If the market falls the following day or days, the POC from the b-profile will provide good resistance. Often the POC is retested (from below) so that short positions can be reopened or increased.

Volume clusters in the thin area of the profile are often signs of aggressive sellers who have sold the market down massively at these prices … but also “longies” have closed their positions. If the prices (from below) return to these levels, the sellers will defend these resistances and sell the market again.

I-Profiles or Thin-Profiles:

A “thin” I-Profile is usually formed in a strong uptrend or strong downtrend. The profile is thin because the market has either been bought very aggressively upwards or sold downwards. This leaves little time for volume accumulation because the market is virtually “running” in one direction. Some volume clusters are formed but without a significant POC. In these more or less equal volume clusters have accumulated. Buyers increase their long positions or sellers increase their short positions. These volume clusters offer support on the following days (coming from above) because the buyers will defend their long positions, or (coming from below) resistance, because the sellers will defend their short positions.

Interpretation of the Volume Profile:

Assuming we are working with a Daily Volume Profile (regardless of the time unit in which the candlestick chart is set), the POC, VAH and VAL etc. from the previous day are always used for the trading decision. Today’s Volume Profile is highly dynamic and the brands change according to the trading activity.

It is not without reason that Charles Dow wrote over 100 years ago that volume is a secondary but important factor in confirming buy or sell signals. Volume must go with the trend!

Or to put it in a slightly different way: Volume is the truth behind price action!

The classic method of displaying the volume per time unit as a bar chart in a separate indicator window provides only a rough overview of the behavior of the relevant market participants. We see, for example, that on the expiration date or at the hour of an interest rate decision by a central bank, a great deal was traded – which is to be expected – but no more than that.

With the Volume Profile, on the other hand, we can see which price was traded with much or little volume – like an X-ray view that shows exactly at which price it was accumulated or distributed.

The price areas with high volume are the POC and the HVNs. The market participants “accepted” these prices, considered them fair at that time and traded accordingly. This implies that positions were built up or even reduced. These act as relevant support and/or resistance zones the following day. The bulls will defend the supports and the bears will defend the resistances.

The price areas with low volume are the LVNs. These prices were considered unfair by market participants, they were rejected and quickly negotiated. These rejected prices = LVNs can be used as potential entry zone, with price target accepted price = HVN.

Because:

  • the prices rejected in the past (LVNs) have the tendency to be rejected again – they are again traded through quickly and
  • the prices accepted in the past (HVN) have the tendency to be accepted again – the market stops its movement and consolidates

The Value Area also provides support/resistance and can be used for trading strategies.

The Value Area contains about 70% of the volume traded around the POC. The POC is the center of the feel-good zone for buyers and sellers. On a D-Day the market is in balance, buyer and seller have formed a pattern that corresponds to an ideal Gaussian bell curve

The following rules apply to the Value Area:

  • If the market opens in the Value Area from the previous day, the market participants agree on the price range and the market tends to form a range.
  • If the market opens above the previous day’s VAH, the bulls have an advantage. If the market opens below the VAL, the bears are at an advantage.

A prerequisite for the strategy presented here is that the market is in a consolidation phase, i.e. it is drifting along without any trend. If the market opens on the following trading day between POC and VAH, the short strategy is triggered: a stop sell is placed at the VAH of the previous day, the stop loss is placed just above the previous day’s high, and the take profit is placed at the VAL of the previous day. Then it is a matter of waiting …

For the long strategy vice versa: The market consolidates and then opens between the POC and the VAL of the previous day. A stop buy is placed at the VAL, the stop loss is placed just below the previous day’s low and the take profit is placed at the previous day’s VAH.

Trading strategy for Volume Profile trading

Strong numbers that require implementation. However, the following points still need to be considered and this makes it difficult to find a systematic approach here. The evaluations do not yet say anything about a possible range of points or the points gap at the opening.

Often it will be similar to the E-Mini S&P500 Future gap analysis that the margins to the respective levels are quite small. Most of the time these are 1-2 points, which can hardly be exploited with an automatic trading system. In manual trading, however, a reversal pattern or the confirmation of a strong candle could be waited for, so that a much better risk/reward ratio underlies here.

See the example in the E-Mini S&P500 Future:

Volume Profile Gap Strategy

In the picture above you a typical gap close with the Volume Profile. The market opened higher after the weekend and closed the gap. Directly after the open people started to sell on the VAH (value area high) from the day before.

The volume is very high on this price and you see the point of control (maximum volume) is forming there. That means there is a hard resistance. Several times the market hit that price and dropped again. Then the full gap close appeared for this time.

From our experience, you can search for a short entry if you see such a situation. The high volume means that there are new selling orders or people are closing their position. Combined with the chart you see that the price does not move higher.

The right trading software for the Volume Profile:

Not every charting software can display the Volume Profile. In most cases, you have to pay for the software and its data. Sometimes you may find a broker that displays the Volume Profile for free but from our experience, there are not all functions included.

Our tip: use a professional software for futures trading

We recommend to use the software ATAS (advanced time and sales) for trading with futures.

  • Free test version
  • Orderbook (smart DOM & tape)
  • Footprint Charts
  • Market Profiles
  • Customized indicators
  • All chart types
  • Perfect for order flow reading
  • Our review: 5 out of 5 stars (5 / 5)

Read the full ATAS review

Conclusion on the volume profile in trading

The Volume Profile shows the two driving forces of a market movement:

  • Price
  • Volume

At the POC the market is in balance, in equilibrium, it is the comfort zone of the dominant buyers and sellers because at this price there was the most turnover. Outside the Value Area, the market is in “imbalance” (in imbalance) and unfair. Too expensive for the buyers and too cheap for the sellers. The goal of the market participants is to trade in the comfort zone again. However, if the framework conditions change, a new feel-good zone is sought – and usually found.

The ready-made Volume Profiles of the previous day/periods form supports and resistances to which the major market participants orient themselves. With the Volume Profiles, the opening and closing of positions can be better timed.

The Volume Profile is a Market Profile® supplemented by the Volume. The driving force behind a movement – the volume – is displayed as a horizontal bar chart. With the Volume Profile, the volume is anchored to the price, providing a unique view into trading activity.

With the Volume Profile, you can see which of the major market participants (bulls or bears) are currently at the trigger, whether the market is more likely to move sideways, or whether a breakout is imminent.

Not every chart software offers the Volume Profile. When selecting the price supply, make sure that tick data is available. With aggregated volume data, the Volume Profile is inaccurate, if not incorrect.


Read my other articles about futures:

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