Why don’t we see algorithmic systems that use volume? It seems that all of them use price, sometimes as spreads as in pairs trading or sometimes as the term structure of futures (often eurodollar rates or crude oil). Rarely does volume enter into the decision, except when selecting the most liquid equities or futures contacts. Yet volume provides a plethora of information for the trader, and incorporating it into a strategy offers benefits in diversification.

Classic chart analysis says that increasing volume confirms the trend, while rising prices on declining volume is an opportunity to sell. That makes sense, but day-to-day volume is erratic. Averaging it helps, but that introduces lag, which makes the volume reading less timely. Volume in most markets declines in the summer, when many investors take time off. It also varies during the day, reading highest on the (traditional) open and close, and lowest around midday when traders break for lunch. That can result in unreliable trading signals.

You get the point. Volume isn’t easy to use. But there are cases where we all seem to agree on its importance: when it spikes way above the normal level of trading. It consistently indicates a change of direction—trader exhaustion.

To implement this volume-based trading idea, we need the following:

1. A measure of extreme volume,
2. A way to decide the current direction of the price move,
3. A profit-taking rule because we don’t expect a reversal to be sustained,
4. The maximum number of days we’ll hold the trade,
5. A large set of markets on which to test the strategy.

Let’s discuss each briefly.

Defining extreme

Using equities, we will average the volume over a reasonably long period, 60 trading days, then find the spike ratio of today’s volume to the average volume.

Sometimes a volume spike is followed by another volume spike. If we use the 60-day average at the time of publication, then a number of spikes in a row will cause the average to increase sharply and we may not get a second volume spike signal. To avoid that, we lag the average volume, so today’s ratio is today’s volume divided by the average 30 days ago. You also could take the average over more days, but lagging it still helps.

How large should the spike be to generate a trade? Because equities are biased to the upside, the thresholds for buying and selling won’t be symmetric. We’ll buy when the price direction is down and the spike ratio is 1.5, or 50% larger than normal. We’ll be more demanding for the short sale and require the spike ratio to be 2.0, twice as large. There’s a trade-off between lower ratios that produce less reliable signals and higher ratios that don’t generate enough signals. 

Maximum holding time

We don’t think reversals indicated by volume spikes have a long memory, so we arbitrarily set the maximum holding time at five days. That gives us a day or two after entry for the price to move the wrong way, but if there is no recovery within five days, we’re out. 

There is not going to be a stop-loss because this is mean reversion trade—that is, we are trading against the direction of the price move, so we fully expect to have a loss for the first day. If we wait for a reversal before entering, we can miss the biggest part of the profit. You may know that the profile of this type of trading is a lot of smaller profits with an occasional large loss.

Profit-taking

We may not have a stop-loss, but we can capture profits and get out early. Again, we’ll want that to be asymmetric. It’s interesting that price moves in equities are very different for long and short sales. Prices move higher slowly but fall quickly. So our profit-taking is only 75 basis points for long positions and 100 basis points (1%) for shorts.

Price direction

We’re not looking for a long-term trend or an investment. If we can identify a spike based on a recent move, we can generate a lot of trades. We’ll choose to use a five-day moving average to determine the direction of prices. If today’s moving average value is greater than the previous day, the trend is up; if it’s lower, the trend is down. There are many ways to determine the trend, and this is one of the simplest.

Execution

Whenever we get a trading signal, we enter on the next open. That reduces the loss if prices continue to move against us. It’s also practical because you may not have good volume numbers until after the close. For the exit, we either get out on profit-taking or Day 5. Because we know it’s going to be Day 5, we can get out on the close of the last day.