Volume is seldom discussed in forex trading. 

But as a stock trader would tell you, volume provides insights into the underlying market sentiment. 

Here I’ll demonstrate the use of two simple volume filters to improve entry reliability.

Traders have long used volume to gain insights into the markets.

For exchange-traded assets like stocks, volume refers to the number of shares that changed hands over that period. It is usually plotted below prices, and gives a good indication of the level of participation in the market.

Why is Volume Useful?

Volume primarily serves to validate price action. When price action is accompanied by high volume, it is more likely that the movement is a true reflection of the market sentiment, and not just a result of random noise.

In particular, volume can reveal whether trend continuation or reversal is likely to occur.

When prices are trending with high volume, there is likely a fundamental impetus driving the movement, which is causing a large number of participants to jump onboard.

The chart below shows Zoom’s rally in 2020, with the stock closing almost 5x higher by year-end.

Price consolidations occurring on high volume will likely result in reversals. The chart below shows Boeing’s struggles in March 2020.

A few Dojis occurred on high volume, indicating a serious struggle between the bulls and bears. Prices eventually reversed, and that price level became a key support that has yet to be broken.

The following table summarizes how volume validates price action:

Volume can thus be used to improve the reliability of trading signals, much like how customer reviews improve your confidence when shopping for a product.

Is Volume Relevant in Forex Trading?

Forex is decentralized, and there is thus no central reporting of trading volumes. But if you look at your MT4 platform, there is a volume indicator available. What is this?

This volume indicator refers to tick volume, which is the number of price changes that occurred over that period.

A green bar means tick volume is rising, while a red bar means tick volume is falling.

Is tick volume a good substitute for actual trading volume?

Prominent authors such as Anna Coulling, who is a strong proponent of volume price analysis, certainly believe so. It makes good sense after all. You can expect a very strong correlation between market activity and price movement.

The chart below shows the January 2021 US nonfarm payroll release. Notice the sharp increase in tick volume immediately before and after the release.

Each forex broker will report a slightly different tick volume. Nonetheless, if you use an ECN broker that subscribes directly to the interbank liquidity pool, you should get a quality feed. Not perfect, but nothing in trading ever is.

Trading With Volume

We want to make use of tick volume to filter our strategy’s entry signals. Signals that occur together with high volumes tend to be more reliable.

Let’s build a simple trend following strategy that uses volume as an entry filter. We want to take only entry signals that occur on high volume, which increases the probability that the trend will continue.

When making use of volume, I have a couple of recommendations:

1. Use Average Volume

Tick volume should be averaged over a certain number of bars.

There are countless financial transactions occurring around the world, with participants ranging from central banks to retail traders. Any single bar will be contaminated with a certain degree of random noise.

Using average volume will mitigate the effects of noise and improve your signal reliability.

2. Use Volume in a Relative Sense

The volume of any period, when considered in absolute terms, has little value. It should be compared against the market’s recent volume history, to get a better estimate of where price is headed.

Baseline Forex Trend Strategy

I’ll use a popular Bollinger Bands trend strategy to illustrate how tick volume can be used.

The entry conditions are as follows:

Buy when price closes above the 20-period upper Bollinger Band
Sell when price closes below the 20-period lower Bollinger Band

A 100-pip stop loss and trailing stop will be added for trade management.

The chart below shows the simple strategy in action, with the trailing stop already locking in a substantial profit.

Here’s how the AlgoWizard programming looks like:

Let’s first check out the baseline performance without any volume filters.

I’ll use the 4-hour AUDJPY for testing. To get a larger sample size, I’ll use data from November 2003 to February 2021.

The strategy is profitable in the long-term, but there are numerous deep drawdowns. Hopefully the volume filters can mitigate this by improving the 38% win rate.

Adding Volume Entry Filters

In keeping with the recommendations above, I’ll only use average volumes for the entry filters. These are simple moving averages of volume, similar to those used for prices.

MT4 does not contain an average volume indicator by default. Fortunately, Strategyquant’s free custom indicators package contains average volume.

1. Rising Average Volume Filter

The first filter will only allow entries when average volume has been rising. This indicates increasing market participation, and that there’s a genuine impetus behind the price penetration.

Similar to the Bollinger Bands, I’ll use a 20-period lookback for the average volume.

Note that the filter conditions will be identical for both the long and short sides, since we are looking for strong market participation in both cases.

Here’s an example of a trade being triggered:

A lower band penetration occurred after a brief band squeeze, which was validated by rising volumes.

Also notice the somewhat regular pattern of rising and falling volumes. These are a result of the increased volumes during the London and New York sessions.

I coded in the rising volume filter as follows:

The backtest has improved in every area, especially the maximum drawdown, which fell 28%. The deep U-shaped ‘crater’ towards the end of the backtest is now gone.

2. High Recent Volume Filter

Remember I mentioned using volume in a relative sense?

Another way to apply a volume filter is to compare the market’s most recent average volume with a longer-term average.

For the long-term volume, I will use average volume over 100 bars.

With this filter, trades will only be taken if the 20-period average volume exceeds the 100-period average volume. Like the rising volume filter above, this indicates increasing participation in the market.

Here’s an example of a trade being triggered:

Unfortunately, the volume indicator can’t display multiple moving averages. MT4’s data window (Ctrl+D) will come in handy here.

We can see from the data window that the average volume over 20 periods is 13041 ticks, higher than the 100-period average of 12859 ticks.

This relative volume filter condition was added and backtested:

Results are quite similar to those obtained from the rising volume filter.

This filter cut off 38% of trades though, while the rising volume filter only cut off 14%.

A large sample size improves the reliability of your backtest. Generating sufficient trades on the higher timeframes is usually a challenge, even when using over 17 years of historical data.

When adding filters to your strategy, you need to decide whether the performance improvement justifies the loss of trades.

3. Using Both Volume Filters Together

Since both volume filters improve performance, why not use them together?

This should be the most effective at weeding out weak entries.

The win rate has further increased to 42%, boosting both the profit factor and return/maximum drawdown.

Now that we have eliminated most of the deep drawdowns from the original strategy, stagnation has dropped from 2200 to 1300 days.

That’s still a long time, but such statistics are not uncommon if you’re trend trading on the higher timeframes.

Wrapping Up

Volume filters help you focus on entry signals generated when there is strong market participation.

Such entries offer a better reflection of market sentiment and tend to be more reliable.

Like prices, volume feeds are broker-dependent. A reputable ECN broker will probably be your best option.

Have you found a way to use volume in forex trading? Let me know in the comments!