Price by Volume Chart (PBV): what is Volume Profile and what does it mean?

The volume profile, depicted on a Price by Volume Chart (PBV) is a common tool in technical analysis. In this article, we explain what volume profile is, what it means, and how to use it to optimise your trading strategy.

volume profile indicator

What is Volume Profile?


Volume Profile in trading is a tool used to show the volume of trades at different price levels over a selected period. It's displayed as a histogram on the side of a price chart. Each bar on the histogram represents the amount of trading that has occurred at a specific price level.

The main purpose of the Volume Profile is to help traders understand at what prices there's more trading activity. This can give insights into where the market finds value or where significant buying or selling occurred.

In this way, the Volume Profile is a key indicator for understanding price dynamics and volume in the context of technical analysis. Specifically, it facilitates the identification of support and resistance levels and helps traders enter and exit the market.

Volume Profile has gained followers in recent years. Mainly, due to the ability of trading platforms to collect information and display it visually in the form of a horizontal histogram on a chart. In the following image, we can see an example of this indicator:

volume profile trading

Although the visualisation of trading volume differs among platforms, it is generally shown as bars. In the picture above, the price with the highest trading volume is highlighted. This level is then used to anticipate future support.

Finally, and before continuing, we should not confuse the Volume Profile with the Market Profile. Market Profile concentrates on price movements and time, along with volume. It's more about understanding the price distribution during the trading session.

History of Volume Profile

The concept of Volume Profile developed from the broader field of volume analysis and represents a specialised application within this domain. It has undergone various modifications and enhancements over time to suit the evolving needs of traders.

The creation of Volume Profile is not attributed to a single individual but is rather a natural progression from Market Profile, a tool developed by J. Peter Steidlmeyer.

Steidlmeyer, who began his work in this area in the early 1980s, is recognised for his contribution to trading analysis while at the Chicago Board of Trade (CBOT). He introduced the Market Profile as a way to analyse and visualise the dynamics of price, time, and volume during a trading session.

Market Profile was innovative in its approach to understanding the market's behaviour through the lens of an ‘auction process' and its emphasis on the distribution of prices over time. As traders and analysts began to explore the concepts introduced by Market Profile, they increasingly focused on the volume aspect of the data. This focus on volume led to the evolution of Volume Profile as a distinct analytical tool.

Volume Profile, therefore, while related to Market Profile, emerged as its specific aspect, concentrating solely on volume distribution at different price levels. This tool has become popular among traders for identifying key areas of support and resistance based on trading volume.

The Auction Market Theory and the Volume Profile

Volume Profile is closely related to Auction Market Theory, which is the underlying principle of Market Profile. Auction Market Theory is based on the idea that financial markets are continuous auction processes where buyers and sellers interact to determine prices.

Volume Profile helps to visualise where the most trading activity (volume) occurs, indicating areas where the market participants see the most value. This is a key aspect of price discovery in the auction process.

A clear example is the one we have seen at the beginning of the article – the price at which the highest volume has been traded. According to Auction Market Theory, prices tend to move away from areas of high volume (value) and towards areas of low volume. Volume Profile can help identify these potential turning points by showing where volume drops off, which can act as natural support or resistance levels.

How does the Volume Profile work? Practical example

To understand how the Volume Profile works, we must understand several key concepts that are fundamental to correctly interpret the information provided by this tool.

Auction Market Theory posits that markets move between states of balance (where prices are fair and there's agreement between buyers and sellers) and imbalance (where prices are moving to find a new balance). Volume Profile helps traders identify these states by showing where the volume is concentrated (balance) and where it is not (imbalance).

In a balanced market, supply and demand coexist in a state of relative equilibrium, which is reflected in a narrow and consolidated price range, and in a more symmetrical and uniform Volume Profile. This balance is broken in an unbalanced market, where the significant disparity between supply and demand causes directional trends and more abrupt price movements, showing notably high and low volume zones.

The Volume Point of Control (VPOC) is the price level with the highest volume in the profile. It is often considered a point of fair value and can act as a strong support or resistance level.

High volume areas are levels where a lot of trading took place. They are often seen as important support or resistance areas. The logic is that many traders have interests at these levels, so they might act as turning points in the future.

Low volume areas are levels where less trading occurred. They can indicate prices that the market moved through quickly, either due to a lack of interest or rapid price changes. These areas might offer less support or resistance.

Advantages and Disadvantages of Volume Profile

Among the main advantages of Volume Profile, we can highlight the following:

  • Identification of support and resistance levels: The Volume Profile facilitates the identification of key support and resistance levels, offering strategic entry and exit points.
  • Facilitates volume visualisation: Provides an intuitive visual representation of the volume traded at different price levels, facilitating its interpretation.
  • Reveals control zones: Allows to identify the control zones where the highest volume has been traded.
  • Liquidity analysis: Helps investors identify areas of high and low liquidity, allowing them to anticipate possible price reactions.

However, it also has certain disadvantages that we mention below:

  • Complexity of interpretation: It can be complex for newly initiated traders. This is because correctly interpreting the Volume Profile may require more advanced learning and practice. This you can learn in our trading guide.
  • It is not infallible: Of course, like any technical analysis tool, it does not guarantee success and should be used together with other tools and analyses to confirm signals.
  • Requires advanced platforms: To visualise and analyse the Volume Profile effectively, trading platforms that support this indicator are needed and it is not usually available on websites that offer chart visualisation for free.
  • Limited volume data: In markets where volume data is limited or not available, the use of the Volume Profile is significantly restricted. For example, in the case of OTC markets like forex, there are no fully real official volume data, so this can affect the interpretation of the data.

Learn more about trading and technical analysis

Summary

The Volume Profile is a technical analysis indicator that shows the distribution of traded volume at different price levels, helping to identify areas of high and low liquidity and support and resistance levels. It is essential to understand the dynamics of price and volume to get insights for trading decisions. Although it is a valuable tool, its interpretation can be complex and requires advanced platforms for effective analysis.

FAQs

Can Volume Profile be used for all types of trading instruments?

Yes, the Volume Profile can be applied to various trading instruments like stocks, futures, forex, and cryptocurrencies, as long as sufficient volume data is available.

Is Volume Profile suitable for short-term trading?

Yes, the Volume Profile can be beneficial for short-term trading, as it provides insights into immediate support and resistance levels and can indicate short-term market sentiment.

How does the Volume Profile differ from traditional volume bars?

Traditional volume bars show the total volume traded during a specific time period, while Volume Profile displays how much volume was traded at each specific price level during that period.

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