In this entry we will delve into the volume interpretation; but not of the volume data we are used to, but of the Volume Profile. We will delve into the concepts of Acceptance and Rejection; High Volume Node and Low Volume Node; and we will see a simple strategy for trading with Volume Profile.

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Discover how to use the Volume Profile

The Volume Profile is a variant of the Market Profile®, a tool designed by J. Peter Steidlmayer in 1985 for the Chicago Board of Trade (CBOT®).

Steidlmayer was a trader and executive member in this major futures and options market for more than 40 years. This new method of auction representation was initially intended only for CBOT members, although it quickly spread abroad. We can therefore infer that their approach to how the market moves does not seem to be on a bad basis.

Unlike the analysis of the Order Flow, the Volume Profile is totally objective since it does not require any type of interpretation and therefore it provides us with very useful information for our analyzes and scenario approaches.

With the analysis of the Volume Profile we return to treat all the concepts initially presented in the theory of the auction (Auction Market Theory). We do not focus on determining the intention of a particular order cross, but we expand the picture to identify the most relevant trading zones.

Volume Profile is not an indicator. It is simply another way of representing the volume’s data. It clearly and precisely identifies the number of contracts traded at different price levels.

This article is an excerpt from my book:

Wyckoff 2.0: Structures, Volume Profile and Order Flow

in which you will learn…

If you like the content I encourage you to buy the book. You will be able to see the supporting graphics that go with the article and much more!

Auction Theory + Volume Profile

The Volume Profile uses the principles of auction theory to put it into practice and to be able to visualize the areas of interest on the chart. Interest is simply measured by the activity that has been generated in a particular area; and that activity is identified by the volume traded.

In this way, this tool can help us to identify the areas of greatest and least interest and we can use it evaluate the price that interacts with these areas, in order to determine if there is acceptance or rejection.

All of these principles are based on the premise that the market has a memory and tends to repeat behavior. Therefore, it is expected that in the future certain areas will behave in the same way as they did in the past.

One caution to keep in mind is that market memory is mostly short-term. This means that the most recent trading areas are more important than the older ones. If the price initiates an imbalance, the first zone to take into account will be the most immediate previous balance zone.

The longer the price has been away from a certain acceptance area, the less significant it will be. If we do not have another reference, it will still be useful to value it, but it is important to be aware that the most immediate balance zones will most likely be the ones that the market will look for in the first instance, since they are the ones that best represent the value at the present time.

Composition of the Volume Profile

Volume profiles are visually displayed on the chart as a horizontal histogram, whose values are distributed according to the traded volume of each price level.

Depending on the number of contracts that are exchanged at each price level, the shape of the distribution will vary. The more transactions, the greater the length of the horizontal line; while a short horizontal line represents fewer trades.

As a reference we are going to take a normal distribution or Gaussian Bell to understand the most important statistical concepts:

Volume Profile

  • The data is distributed symmetrically about the central point where the mean, median and mode coincide.
  • It has three standard deviations on each side, which are equally spaced apart and measure the amount of variability or spread around an average. It is also a measure of volatility.
  • The first standard deviation comprises 68.2% of the data and up to the second standard deviation 95.4% is reached.

Value Area (VA)

This real example has the form of a normal distribution where the values are distributed above and below around the central point.

value area volume profile

The data is organized by means of a vertical axis in which the price is located and a horizontal axis that represents the volume variable.

The value area is determined between the Value Area High (VAH) and the Value Area Low (VAL), is part of the first standard deviation and represents exactly 68.2% of the total volume traded in that profile. It is the most traded area of the profile and therefore it is considered an acceptance area.

The volume operated outside the value area comprises the remaining 31.8%. It is the least traded zone of the profile and therefore it is considered a rejection area.

The high and low levels of the value area (VAH and VAL) will act as support and resistance areas as some interaction is expected on them.

The breadth of the value area leaves us clues about market conditions. A large Value Area suggests that there is a large participation of all traders, all are buying and selling at the prices they want; while a narrow Value Area is a sign of low activity.

Extremes

This is the highest (High) and lowest (Low) price reached in that profile. These price levels should always be viewed as key reference points.

Depending on the negotiation that is generated at these extremes, we can consider that they represent finished or unfinished auctions.

  • Auction finished. It is visually observed with a decreasing negotiation towards the extreme. It represents a lack of interest as the price reaches price levels further away from the value area, ultimately suggesting a clear market refusal to trade in that zone. By its very nature it is a Low Volume Node.

Prices have reached a point where some traders have seen it as an advantageous opportunity and have entered causing that rejection. The lack of participation of the opposite side is represented by this decrease in volume.

  • Unfinished auction. It appears as a zone of high trading (High Volume Node) on the end of the profile. It implicitly represents an interest in trading in said area and therefore suggests a subsequent visit of the price if it has previously moved away from it. In the future visit, the intention behind it will have to be evaluated, since it could be carried out with the aim of ending the auction and turning around, or with the aim of continuing to negotiate and continue in that direction.

Volume Profile

This concept of a finished or unfinished auction can be very useful since, for example, if we are assessing the possibility that the price will leave an balance zone upwards, we will want to see that in the lower part of said zone there is a finished auction that would suggest a lack of of interest to trade there. In case of observing a possible unfinished auction, it would be convenient to quarantine the scenario since it is most likely that before starting the upward movement there will be a visit of the price in that low part with the aim of testing the interest in that area.

Unfinished Auction

When in doubt as to whether we are in a possible finished or unfinished auction, it is advisable to treat it as finished. Unfinished auctions should be very visual and shouldn’t be shrouded in a lot of subjectivity. Generally we are going to observe them as an abnormal cut in the profile distribution and in many occasions it will coincide with one of the two Value Area limits.

Market Profile

In Market Profile this concept is totally objective: an unfinished auction (Poor High & Poor Low) appears at one extreme where at least two TPOs are observed; or what is the same, a finished auction will be represented with a single TPO in the price level (Single Print).

Volume Point of Control (VPOC)

It is the level of highest volume concentration in that profile. It represents the most accepted price by both buyers and sellers (more fair) and establishes the level from which the value area is calculated.

Since most of the volume comes from large institutions, this is where these large traders have accumulated most of their positions. They generally accumulate contracts in a range of prices, but the VPOC represents a reference point since it identifies where the greatest interest is.

As it is a level that will attract many trades, it is generally advised to avoid trading in its immediate vicinity. The broad consensus among participants will cause fluctuations around that level. Behavior that will be maintained until new information appears that unbalances the perception of the participants.

The VPOC allows us to establish who has control of the market. If the price is above it, we will determine that the buyers will be in control, so it would make more sense to go long; if it is below, the sellers will have it, so going short would be a better option.

Keep in mind that the VPOC, by its very nature, will always be a High Volume Node, but not all High Volume Nodes will be VPOCs.

Volume Weighted Average Price (VWAP)

If there is a level widely used by large institutions, it is the VWAP. Huge transactions seek to be executed at the price level where the VWAP is and that is why it has raised its level of importance.

The VWAP represents the average price of all contracts traded during a specific time period.The formula for obtaining it is as follows:

No. of contracts traded * asset price / total contracts traded

To understand it a little better, we can say that above the VWAP there is the same traded volume as below it, that is, it represents an important balance level. This balance causes that when the price reaches the VWAP there are equal probabilities that the price will go up or down.

It is displayed on the chart as a traditional moving average and its position varies as the transactions are executed. Generally, depending on the trading style, the VWAP of the session, the weekly or the monthly are usually used.

The VWAP is used by institutional traders mainly as a means to determine the value of the asset at that given moment, so they consider that they have bought low if the price is below and that they have bought high if it is above.

The institutions have taken the VWAP as a reference measure with which to judge the quality of their executions, hence its relevance and that we treat it as an important trading level. When they receive an order, they do not execute all the contracts they need at once, but they will try to do it gradually knowing that their work will be judged based on that reference level.

Volume Weighted Average Price (VWAP)

Because it represents an important level of balance or fair price, it is a good measure of whether we are buying too high or selling too low. We can know this by adding one or two standard deviations to the mean. That the price is in some standard deviation does not mean that it cannot continue moving in that direction, we could simply use it as one more mark to add to our analysis.

But be very careful because everything is subject to the valuation of the market at that time. In a balanced market, a price below the VWAP will be considered cheap and a price above it will be considered expensive; but just when the market is unbalanced to one side or the other, the VWAP stops representing efficiency since now the perception of value has changed.

Depending on the time frame we can make use of different VWAP levels. The most commonly used are the session VWAP for day traders and the weekly and monthly VWAP for medium and long-term traders.

High Volume Nodes (HVN)

High volume nodes. They are zones that represent balance and a high level of interest by all market participants since both buyers and sellers have been comfortable making transactions there. It is observed as peaks in the volume profile.

high volume nodes

Although for this example we have used a Composite type profile, the fundamentals are equally valid and applicable to all profiles.

Past balance zones act like magnets attracting price and keeping it there. Since there was some consensus between buyers and sellers in the past, exactly the same is expected to happen in the future. That is why they are very interesting areas for goal setting.

Within the same profile, different High Volume Nodes can be identified.

Low Volume Nodes (LVN)

Low volume nodes. These are areas that represent imbalance/rejection. Neither buyers nor sellers have been comfortable trading and therefore prices are considered somewhat “unfair”. It is observed as valleys in the volume profile.

As there was no consensus in the past, it is expected that in the future there will be no consensus either and they will cause some rejection, so they are interesting areas of support and resistance where to look for potential entries.

It is important to understand that rejection can be represented by price in two ways:

Low Volume Nodes

  • V-turn. The perception of value has not changed with respect to the previous balance zone and there is a refusal to quote at said levels. The market turns completely around to re-enter the previous zone where buyers and sellers feel comfortable trading.

What causes this reaction in the price is in the first instance the placement of passive orders waiting on said zone to block the movement, together with a subsequent aggression that confirms the V-turn and return to the previous value area.

Visually it may be seen in price as prominent wicks at the ends of the candlesticks which will suggest such a rejection.

  • Fast scrolling. The perception of value by participants has changed and is represented in the price by a violent movement. The market, based on the new information, refuses to quote at those levels of the LVN and goes through it quickly.

Technically, what causes this rapid movement is, on the one hand, the execution of protection orders (Stop Loss) of those who are positioned on the opposite side; and the activation of momentum strategies that enter aggressively with market orders.

Visually it will be observed on the chart with wide range candlesticks generally accompanied by high volume.

Like the HVNs, more than one Low Volume Node can be viewed within the same profile.

Profile types

The volume profile is a tool that can be adapted according to the needs of the trader.

The main difference when using one type of profile or another will be determined by the trader’s work schedule and the context he needs to cover in his analysis.

Basically we can differentiate between three types of profiles:

Fixed range

This type is very versatile. What makes it unique is that it allows us to manually launch profiles on any particular price action.

Especially useful for identifying trading zones in two types of contexts: trend movements and ranges.

volume profile rango fijo

If we see a downward trend movement we can launch a profile of all the momentum to identify the interesting areas where the price is likely to make some kind of upward pullback. It is in these trading areas where we want to be prepared to evaluate the possibility of joining in favor of the trend. In the example we see how the price tests the VPOC of the downward momentum and from there a turn is generated that causes the development of a new downward movement.

If what we have is a context of lateralization, a structure that we work under the Wyckoff methodology approach, the profile will come in handy to mainly identify where the VPOC is that determines the control of the market and the value area with its extremes (VAH and VAL). These will be very interesting to take into account in order to search for the test after the structure breaks on them, as in the following example.

Volume Profile fixed range

Unlike the other types of profiles, the fixed range is not updated and only analyzes the volume traded in the area that is determined.

Regardless of whether you are going to work with structures or not under the Wyckoff methodology approach, it is very useful to draw profiles that encompass several sessions in case we see an overlap between their value areas. If we see more than one session generating value over a certain price range, it is best to launch a profile that includes all the price action, since the trading levels that said profile can provide us with will, by their very nature, be more relevant.

Session

This is the profile for the day. Especially useful for intraday operations where the most important trading areas of the session are taken into account. Its range includes from the beginning to the end of the session, so it is updated as the day progresses.

volume profile sesión

Shorter-term traders use both session levels and previous sessions to make their scenario approaches.

If we find ourselves observing an upward movement and a subsequent lateralization of the price, it would be interesting to look for the incorporation in favor of the trend movement on some trading level. As we know, the most important level of the entire profile is the VPOC, so we must take it into account to wait for our entry trigger on it.

developing VPOC

Continuing with this same example, another interesting area to look for a test after breakout could be some trading area from previous sessions. If we are above the value area of the previous session, the first trading level on which to wait for a test to look for the bullish continuation will be the Value Area High of the profile of said previous session.

Composite

Originally profiles were only viewed by sessions and this idea of grouping them was introduced by Donald L. Jones in his book “Value-Based Power Trading” in what he called “The Overlay Demand Curve”. The aim was to try to eliminate the noise of short time frames and thus obtain a better understanding of the condition and context of the market.

This type of profile can be configured in two ways:

  • Fixed. Within the fixed mode we have the possibility to select the range of dates that we want to include in the profile analysis. You may want to know the profile of last week, last month or current year, this mode is designed for this particular requirement.
  • Variable. Characteristically, this variable mode shows the traded volume of all the price levels currently on the chart. It is important to keep this in mind, because if you move the chart, the profile will change.

The best use of this type of profile, regardless of the time frame in which we are trading, is to analyze the general context and identify the trading zones (mainly the high and low volume nodes) that we have both for above and below the current price.

volume profile composite

These zones will serve to point out the bias of the market in a more macro context as well as for the establishment of possible zones where to look for entries and exits.

If, for example, we are working on a structure, it is very interesting to analyze the profile of the Composite to identify the High Volume Nodes of the longest term on which to establish objectives to take profits.

Another use could be to identify a large Low Volume Node in the macro context and encourage a false breakout to develop on it. We could be working on a potential cumulative structure. If, when analyzing the context, we identify an LVN relatively close to the structure, it would be interesting to take into account the possibility that the Spring that generates the imbalance of the structure may occur on it.

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