When Price and Volume Disagree, Part Three

NOTE: If you missed parts one and two of the series, it might be helpful to read them first. Don’t worry, I’ll still be here when you get back.

If you are old enough to remember Schoolhouse Rock, then you already know that three is the magic number. Well, so it is with this post. I think that number three in the series may be the most thought-provoking to date. But it is kind of long, and there is no reader’s digest version. For some, it’s so technical that it might be cracklin’ dry. I apologize. The next post will be more entertaining, I promise. But if you’re the kind who is really interested in the how and why, I think it’ll be worth your time.

Today again I’m going to talk about one of my favorite trading edges, and that is the ability I’ve developed to gauge the harmony or discord between price and volume in the order flow. And one of my favorite tools with which to measure that harmony or discord is the Acme Volume Breakdown (AVB).

The AVB uses a less orthodox strategy of measuring and accumulating buying and selling pressure, so I thought it’d be useful to lay out a day-by-day, apples-to-apples comparison of the way the AVB does it against the more traditional strategy of breaking down and accumulating only volume traded at the bid or the ask.

But first some background. Philosophically speaking, I don’t think you can be the best craftsman (trader) you can be without really understanding why your tools were made they way they were and when to use which tool for what job. So with that said, here is the essential rationale for the Acme Volume Breakdown’s strategy:

  1. On most days the overwhelming amount of volume in the most-traded futures contracts is transacted at the bid and ask in small lots. You’ll see hard evidence of this below, and there’s more here too.
  2. So you have to ask yourself, as a trader looking to better his or her results, if almost all volume is traded at the bid and ask, why is this kind of volume considered to be so special? I say it may have actually been special at one time, but in the light of today’s market mechanics (near-ubiquity of market orders) it just doesn’t have the caché it used to.
  3. Most all market data streams do not feed data the way that most traders (who have given it any thought at all) assume they do. Curious? Keep reading.
  4. The stream of actual transactions (ticks) is separate from the stream of bid and ask quotes. Even though you might assume each tick is reported to your trading software with a price, size, a time stamp and the bid and ask prices that were in effect at the time of the sale, that’s generally not the way it works. The bid prices, ask prices and last sale data (ticks) are all fed from the exchanges more or less independently. Your software – from your data provider’s systems all the way up to your charts and DOM – correlates these feeds for you in whatever manner the engineers who wrote each link in this software chain saw fit.
  5. Said another way, only a loose and circumstantial synchronization exists between tick (last) prices and the bid/ask prices. And during heavy volume and/or fast price movement, it’s possible for the bid/ask prices to lag ticks from the exchanges. If you think about it, this makes both common and engineering sense. If the exchanges have to slow down one stream of data to keep another as fast and time-accurate as possible… which stream do you figure they’d favor? The actual transaction stream or the bid-ask stream?
  6. What’s more, your software can be implemented in such a way that causes the bid/ask and last prints to become out of sync, even if only for a short period of time.

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Before I get further into it, I’d like to point out that the approach the Acme Volume Breakdown uses is available in other software as well. At least two of the most popular futures charting packages give you a choice between bid and ask and uptick/downtick evaluation strategies. I’m not claiming anything revolutionary,  I’m simply showing you why I think it’s the best fit for listening in on the price-volume conversation.[/box]

Bottom Line

If your volume breakdown/cumulative delta relies on the kinds of non-deterministic factors described above for quantifying buy and sell pressure, it’s a virtual certainty that you’re not getting all the right information at all times.

On the other hand, using upticks and downticks is completely deterministic.

Unless the ticks themselves are fed wildly out of order from the exchanges (and they are are time-stamped to the millisecond or less so they can be properly re-ordered at any step along the path), or the reported volume is incorrect, there is no theoretical way for buy or sell pressure to be incorrectly quantified.

The rules of the strategy rely only on information available in the tick stream itself, and are about as simple and as robust they come:

  • If this tick’s price is higher relative to the last tick, then the willingness to pay higher prices must (for any reason) be present. This is buying pressure.
  • If this tick is lower than the last then the willingness to sell at prices lower than the previous price must (again for any reason) be present. This is selling pressure.
  • Volume, then, tells us how strong each of those desires are relative to each other.
  • There is a visual example in the FAQs.

Now, finally, on to the comparison I promised. Below I’ll compare some of the more interesting aspects of ES RTH sessions from last week, August 29 – September 1, 2011.

Methdology

  • I downloaded NinjaTrader market replay data for each of the above days. I believe this is Zen-Fire data, and on most accounts this is accepted as high quality for the ES.
  • I created a 5000 volume bar chart using the RTH session template, and I added 2 instances of the Acme Volume Breakdown indicator to the chart.
  • The upper indicator panel in images below is the up/downtick breakdown. This is the same version you can download right now, and it breaks down all volume, as (exhaustively) described above.
  • The lower indicator panel is an unreleased bid/ask breakdown version, and it’s identical in every way to the up/down tick version except it uses the tick price vs the bid or ask to evaluate buying or selling pressure. And as is the common practice, it ignores ticks not traded at/above the ask, or at/below the bid.
  • I ran the replay for all of the sessions.
  • I made each day’s screenshot really big so you can widen up your browser to examine details in place, or download and zoom in as you like.
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Monday 8/29:

Monday was a relatively tame (by recent comparison) ~20 point up-trend day. Here’s the visual:

Acme Breakdown Showdown - Monday

Monday’s interesting way points:

  • The overall trends and undulations of the two breakdowns are very similar.
  • The bid-ask breakdown (lower panel) near the 8:00am hour dips into negative territory. However, the up/down tick version remained positive and correctly confirmed the higher low around 8:35am.
  • Both strategies nicely confirmed the uptrend, though the up/down tick strategy appeared a bit more confident in its trend confirmation from the 11:15am to 1:00pm window.

Commentary
To my eyes, the up/downtick strategy gave a more prescient view of the day as it developed. If you paid attention to the zero line and and the bid/ask’s interpretation of the price-volume conversation around 8:30am (the Pacific time European close is a common head-fake point), you might have gotten short. And that would have been the wrong choice.

On this day both strategies finished with a positive delta. 65.5K for the up/down tick version and 51K for the bid/ask version. Less than 15K difference between versions on a day which traded about 1.6 million contracts. That’s a difference of about .9% of the volume of the day. Further testament to the assertion that almost all volume on this day was traded at the bid or ask. If it was otherwise, the differences in overall shape and the final delta (on this day at least) between the two approaches should be substantial. But they’re not. So again, if it’s almost all traded at the bid/ask why treat it as special?

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Tuesday, 8/30:

Tuesday, another up-trend day, saw a ~25 point move up on about 2.2 million contracts:

Acme Breakdown Showdown - Tuesday

Tuesday’s interesting way points:

  • Again, the overall shape and trend of both breakdowns is quite similar.
  • The up/downtick version was geometrically accurate at confirming price’s uptrend, where the bid/ask version was more geometrically approximate. See the resumption of the uptrend just after 10:00am.
  • Both the up/downtick and bid/ask breakdowns dipped into negative territory by 7:05am, though the up/downtick breakdown only remained there for about 3 minutes. The bid/ask version went as low as about -16K, and remained negative for over 30 minutes with another negative dip just before 8:00am.
  • A bit of selling commenced about 10 minutes after the European close, around 8:40am. And this kind of selling is shows that there are real differences between the two approaches. The bid/ask version nicely confirmed the selling where the up/downtick version very clearly disagreed with the price action. One of the breakdowns provided valuable information about what was really happening under the surface of the price action and gave clues as to what was likely to come. Guess which one?
  • The difference of the deltas on this day was more substantial, about 60K contracts, though once again the general shape of the breakdowns is very, very similar.

Commentary
On Tuesday the bid/ask version displayed greater potential to mislead if you are a trader who pays attention to the zero line. The sub-zero dip may have suggested weakness – a classic ES head fake tactic – when the real intention was further buying.

And again, the up/downtick breakdown gave you valuable insight during the 8:40 – 9:30am selling. Had you been watching the bid/ask breakdown, you might reasonably expect further selling. However, the up/downtick version’s price-volume disagreement alerted you to the strong possibility of underlying strength and revealed an imbalance of intent. Had you listened to the discordant conversation, it could have kept you short small, or not at all, and kept you stalking another long at a level where the price-volume conversation became harmonious once again.

Lastly, while the delta difference between the breakdowns seems substantial at about 60K, that’s really only about 2.6% of the day’s volume.

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Wednesday, 8/31:

Wednesday was a neutral day which saw trading of approximately 2.8 million contracts on a range of 22.25 points:

Acme Breakdown Showdown - WednesdayWednesday’s interesting way points:

  • The most interesting thing about Wednesday’s breakdowns is that they are very, very similar in shape, trend and character.
  • The bid/ask’s final delta was about -34K contracts, while the up/downtick’s final delta was ~1400. Most interesting here was the basically unchanged close, at about 1219.00, and the up/downtick breakdown agreed with a near-zero final delta.

Commentary
Frankly, this was one of those rare days when absolutely every technical measure was singing the same tune. What does this mean? Well, typically it means there was genuine price discovery occurring. Both buyers and sellers were present, active and had real, dissenting ideas about fair value. Most importantly, neither were dominant enough to engage in head fakes of any kind. Wednesday was exceptional for it’s lack of exceptions, if you see what I mean.

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Thursday, 9/1

Thursday was a solid, steady down-trend day with 2.3 million contracts traded in a 28 point range:

Acme Breakdown Showdown - Thursday

Thursday’s interesting way points:

  • Like Wednesday, Thursday was pretty remarkable if only for the unremarkableness of the price-volume conversation. Except for the BIG head fake stop run after the 7:00am econ numbers, it was controlled selling all day long.
  • Today the final deltas of both breakdowns were actually within about 500 contracts of each other. The bid/ask finished at negative 66K, and the up/downtick version finished at negative 65.5K.

Commentary
The take-home (dead horse?) message here is that closeness of the final deltas again confirms essentially all volume on that day was in fact traded on the bid or ask. So, again, why treat it as special?

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The Wrap-Up

I hope this head-to-head comparison has given you some insight into why the Acme Volume Balance and Breakdown Pack and the Acme Volume Impression Pack use the strategy they do, and perhaps even challenged your thinking a bit on what is the “best way” to view and interpret price-volume action.

Moreover, hopefully I’ve laid out an understandable rationale and provided something of a fresh perspective. It’d be great if you agreed with my assertions, but it’s OK if you don’t. There are many, many ways to view a market. Eventually you have to find your own. And maybe I didn’t say anything you didn’t already know.

But if you did learn something you didn’t know before… how will you use it improve your trading?

What’s in a Name?

Depends. Sometimes not much.

Though if you are a registered trademark owner the stakes can be higher. Why am I telling you this now? A few days ago when I released a new Acme pack I inadvertently named it something that I should not have.

We’re talking about the pack formerly known as the Acme Volume F00tprint. I was contacted today by the CEO of MarketDelta LLC and was advised that the term Footprint® is a registered trademark of MarketDelta.

I have no interest in creating confusion between Rancho Dinero/Acme and MarketDelta, nor in infringing on their trademark, so from here forward the software in question will be known as the Acme Volume Impression Pack.

The name may have changed, but the song remains the same.

Trade ’em well, amigos.