At this point, it is important to define what the volume figures are that you can receive and analyze in the forex market. The volume for forex pairs represents the number of transactions or ticks and not true trade-size activity. Forex does not have actual trade-size information because there is not a central marketplace to tabulate and send the information out to traders. The true definition of volume is the number of trades for all the total contract months of a given futures contract, both long and short, combined. For example, the futures foreign currency markets trade on quarterly expirations the March, June, September, and December contract months. The volume will represent the total for all the trades in each contract month. Most technical analysts believe that volume is an indicator of the strength of a market trend. It is also a relative measure of the dominant behavior of the market. Here is a further explanation; volume is the measurement of the markets acceptance or rejection of price at a specific level and time. There are several theories and so-called rules when using volume analysis on price charts; the first one is that if a market is increasing in price and the volume is increasing, then the market is said to be in a bullish mode and can indicate a continued move in the direction of the trend.

The exact opposite is true for a declining market. However, if a substantial daily market price increase or decrease occurs after a long steady uptrend or downtrend, especially on unusually high daily volume, it is considered to be a blow off top or bottom and can signal a market turning point or trend reversal. Here are some guidelines to use when using volume analysis.

Increasing volume in a rising price environment signals excessive buying pressure and could lead to substantial advances.
Increasing volume in a falling price environment might signal a continual fall in prices or a prolonged bearish trend.
Decreasing volume in a rising price environment may indicate a plateau and can be used to predict a reversal. Especially when prices make a higher high such as occurs with divergence patterns, a decline in volume with a rise in prices is extremely bearish.
Decreasing volume in a weaker price environment shows that fresh sellers are reluctant to enter the market and could be a sign of a trend reversal.
Excessive volume in a high price environment indicates that traders are selling into strength and often creates a price ceiling.
Excessively low volume in a low price environment indicates that traders are buying on weakness and often creates a floor of support.

I want you to study the chart in Figure 1; it shows the trends that occurred in the Japanese yen futures contract. If you recall, earlier in the book, I gave an example of the confusing aspect of the quotation of yen futures contracts versus spot forex contracts. Figure 1 shows what I was referring to. The futures contracts are quoted yen to dollar, FX is quoted dollar to yen. Lets go over how to interpret the data, and then I will explain how you will apply that information to the forex market. Looking at the chart from left to right, the first trend (point A) condition is down. The corresponding volume levels are also trending lower. This indicates that, with the decreasing volume in the weakening price environment, new sellers are reluctant to enter the market and that a reversal is imminent. As the market bottoms in late April (point B), the sharp price increase is followed with a rise in volume, indicating prices can sustain an advance. Finally, when the high of the move has formed (point C), it is made with a large bearish engulfing candle pattern. The trend reverses as sellers enter the market and longs liquidate their positions. Notice that this new downtrend is on increasing or rising volume, which alerts you that a substantial move is in the works.

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FIGURE 1 Japanese Yen Trends (daily bars)

Two Flaws in Volume

As with life or any aspect of trading, nothing is perfect. Collecting and analyzing volume is no exception, especially in the futures markets. The first flaw is that the data is delayed by one day. You can get real-time tick volume, which shows how many times a price level was traded, but not realtime contract size volume; the exchanges do not post this information until the following day. There is a huge difference in the two concepts. The second flaw is that as a futures contract month gets closer to expiration, it converges with spot prices and becomes the cash market. At that point, it no longer is a futures contract. For example, a September futures contract expires around the middle of the month by late August traders moving their positions out of the September and rolling over into the next contract month, which would be a December contract. As this occurs, the volume levels start to artificially decline in one month as the further-out contract month starts to increase. This can be confusing and generate false signals.

Stay ahead of the crowd! I have a solution and can help you possibly beat the system! Remember the section on the currency ETFs? They trade in real time; they track almost identically to the spot currency markets (perhaps even better compared to forex dealers); and because they are listed on the New York Stock Exchange, they report real-time transaction volume! The drawback here is that they only trade during the U.S. equity market session9:30 A.M.(EST) to 4:00 P.M.(EST).

Lets examine this principle of using volume analysis from the euro ETF (FXE) versus the futures market, which is shown in Figure 2. The first thing that should pop out at you is the fact that the ranges of each bar (or, in this chart, the candles) are comparatively smaller than the ones in Figure 3, which is a spot forex euro currency. This is because the euro ETF only trades during the U.S. equity market session. However, if you compare the price points as shown at point A and point B on both charts, you will see that the lows and the highs are almost exactly the same. The volume analysis is easily tracked, and you do not have to account for the rollover effect that exists in the futures markets. This is a continuous market. You can easily see where the market declines in price on declining volume; and as a reversal forms into an uptrend, it is accompanied with an increase in volume. This again is a very healthy sign that the trend may maintain more upward momentum. The increase in volume helps amplify the magnitude of an increase in the value of the euro.

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FIGURE 2 Euro Currency Trust (daily bars)

Armed with this information, you can make better decisions for staying on the long side of the market if you are a day trader. As a swing trader, you may wish to exploit the potential for a serious price advance. If you are a position trader, you can develop a solid trading plan with various choices in strategies or trading vehicles.

Figure 3 shows that at point A, we broke below a previous swing low. Some traders may have looked at that as a sign of continuing weakness in prices. However, with the aid of volume analysis, the price decline was on sharply declining volume. That was indicating that sellers were running out of steam and that a price reversal was imminent. The very low marked by point A shows a very strong reversal engulfing/piercing candle pattern. That was a confirming clue that the price decline had ended. If you have knowledge on the technical analysis theory and combine the use of several indicators, such as price and volume studies, you will increase your probability of success.

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FIGURE 3 Euro/U.S. Dollar (daily bars)

Open Interest

Open interest reveals the total amount of open positions that are outstanding and are not offset or delivered on. Remember that in futures trading, this is a zero-sum game: For every long, there is a short; or for every buyer, there is a seller. The open interest figure represents the longs or the shorts, but not the total of both. So when examining open interest, the general guidelines are that when prices rise and open interest increases, this reveals that more new longs have entered the market and more new money is flowing into the market. This reflects why the price increases. Of course, the exact opposite is true in a declining market. Chartists combine both the price movement and the data from volume and open interest to evaluate the condition of the market. If there is a price increase on strong volume and open interest increases, then this is a signal that there could be a continued trend advance. The opposite is true for a bear market when prices decline. Also, if prices increase, volume stays relatively flat or little changed, and open interest declines; this then reflects a weakening market condition. This is considered to be a bearish situation because if open interest is declining and prices are rising, then this shows that shorts are covering by buying back their positions rather than new longs entering the market. That would give a trader a clue that there is a potential trend reversal coming. Here is a guide as to how to identify an opportunity when there is a major top or bottom in the spot forex markets using this information: When observing a continued long-term trend in a spot forex currency in order to spot a climaxing market condition or reversal of the trend, whether it is in an uptrend or a downtrend, clues to watch for:

Prices start to fluctuate with wider-than-normal daily price swings or ranges, or are in an extremely volatile condition.
Prices move against the trend accompanies unusually strong volume and a decline in open interest.

The market is getting ready to turn or reverse the trend. In Figure 4, the graph is a futures euro contract with the volume and open interest study. The bar graph represents the volume with the open interest overlaid by plotting a line measurement. Notice after the peak in prices, the volume started to dry up (decline).

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FIGURE 4 Euro (daily bars)
Open interest started to decline confirming a top was in place. This was a warning that a trend reversal was forming rather than a small correction. Therefore, spot forex traders would more clearly recognize that selling rallies and/or looking to take sell signals at resistance would be a more fruitful and profitable course of action, due to the bearish volume and open interest signals that the futures markets provided.