August 31, 2005

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On August 31, 2005, Buff Dormeier, CMT, made a presentation to the Chicago Chapter of the CMT Association.

Buff has written about extensively about this idea, and his work on Price & Volume, Digging Deeper was recognized with the Dow Award in 2007, click here to view. In that paper, he wrote, “When securities change hands on a securities auction market, the volume of shares bought always matches the volume sold on executed orders. When the price rises, the upward movement reflects demand exceeds supply or that buyers are in control. Likewise, when the price falls it implies supply exceeds demand or that sellers are in control. Over time, these trends of supply and demand form accumulation and distribution patterns. What if there was a way to look deep inside price and volume trends to determine if current prices were supported by volume. This is the objective of the Volume Price Confirmation Indicator (VPCI), a methodology that measures the intrinsic relationship between price and volume.” This video presentation is an excellent supplement to the paper. In addition, the VPCI is available in many software packages, making it easy for technicians to implement and test the concepts.

Volume should be used, Buff notes in the beginning of his talk, because it increases what he calls the “Four R’s” which means that it is Responsive (provides earlier signals); Reliable (or at least helps generate more reliable trading signals); Reduces Risk (as part of a comprehensive investment strategy); and enhances Returns.

Generally, increasing responsiveness tends to decrease reliability. In other words, quicker signals tend to result in more losing trades. Buff demonstrates in his testing that volume helps to overcome this problem.

Price is defined as an agreement to disagree in Buff’s mind. As a buyer, he feels price is too low, but needs to find someone who is bearish in order to execute a trade. Volume is synonymous with the force of the convictions that investors hold, and volume tends to lead price. Technicians have long noted that volume typically leads and confirms price action, and divergences between price and volume often presage changes in the trend of the price. VPCI is built on these basic technical concepts.

In the 1990s, Buff developed volume-weighted moving averages, first presenting the concept in his CMT paper. The formula for this indicator is:

volume-weighted average = sum {closing price (I) * [volume (I)/(total range)]} where I = given day’s action
The VWMA tends to be more responsive to price trends. This is logical based upon the idea that volume measures the conviction of trader’s beliefs.

Calculating the VPCI is slightly more complex. From his paper, “The VPCI involves three calculations:
1) volume-price confirmation/ contradiction (VPC+/-),
2) volume-price ratio (VPR), and
3) volume multiplier (VM).

The VPC is calculated by subtracting a long-term SMA from the same time frame’s VWMA. In essence, this calculation is the otherwise unseen nexus between price and price proportionally weighted to volume. This difference, when positive, is the VPC+ (volume-price confirmation) and, when negative, the VPC- (volume price contradiction).

The next step is to calculate the volume price ratio (VPR). VPR accentuates the VPC+/- relative to the short-term price-volume relationship. The VPR is calculated by dividing the short-term VWMA by the short-term SMA.

The third and final step is to calculate the volume multiplier (VM). The VM’s objective is to overweight the VPCI when volume is increasing and underweight the VPCI when volume is decreasing. This is done by dividing the short-term average volume by the long-term average volume.

Finally, the VPC+/- is multiplied by the VPR which is multiplied by the VM. The interpretation of VCPI requires considering the recent price trend and the recent levels of the indicator itself. In general terms, if price and VPCI are both rising, it would be bullish.

Related to interpretation of the indicator, in a recent email note, Buff updated his work and noted, “…that I had a change in my opinion regarding some of the VPCI indications since then. At the time, I believed a falling trend and falling VPCI was bearish, it is in fact a bullish indication. I also may have stated a falling trend and a rising VPCI was bullish, however it is a bearish indication. Everything else should be OK.”

Additional signals can come from VCPI crossing its own moving average, and even the indicator itself crossing above and below zero can offer useful signals to traders. The indicator can be used over any timeframe with varying inputs.

As in the Dow Award winning paper, Buff fully discloses how to calculate VPCI and demonstrates how it can be used. The test results are impressive and do demonstrate that the VCPI can increase trade reliability. He also wisely notes that this is a tool that can help improve your performance but it is not the Holy Grail.