This month I decided I’d get He Shuhan back on the show and grill him a bit more on Volume Spread Analysis after his comments in his earlier show left me wondering. August was also a great time for me to sit a back and reflect on the interviews so far while I hit a significant milestone in my life as I turned 40.
To listen to the audio version of this post, you can do so below, or keep reading to grab the highlights!
So, where did I end up after the trading goals I set last month? To recap here they are again:
- Read up on the Volume Spread Analysis book recommendation from Leonardo Barata
(Note, a free link to the PDF version of “Master the Markets” can be found here)
- Find more VSA traders to interview
- Don’t place any live trades!
Well, working backwards through the list above, I am pleased to let you know I achieved goal number 3 (albeit there was temptation)!
However, goal number 2 proved a little more difficult…
“Calling all VSA Traders!”
What I discovered was that VSA traders are quite hard to find and in the minority. A simple search on Twitter revealed just a handful when compared to Elliott Wave where there are plenty.
I was, however, able to get an interview with Nigel Hawkes, a VSA trader from the UK who had a tremendous amount to share and what he said really hit home for me. The key takes out from the interview were ones I’d been ignoring for so many years (because I thought I knew best). Here they are summarized below:
- Trade higher timeframes first (then go shorter if you must)
- Add to your winning positions
- Get trend confirmation on higher timeframes
- Managing your emotions is what will keep you in the trend
- Don’t focus on your profit and loss statement (try and be abstract with your trading)
When I’m ready to trade again I’ll be coming back to this list to make sure I have all these elements in my trading plan.
So, with the lack of VSA traders out there I decided to go back to where I first heard about VSA and dive a little deeper on what He Shuhan said in his interview, simply because it puzzled me and I wanted to know his reasons for the following statement:
“Read up about Volume Spread Analysis, but don’t trade it. It doesn’t work.”
A polarizing statement if ever I heard one.
And since that interview I’ve had Leonardo Barata on the show who is a VSA and Nigel Hawkes. Both these traders use elements of VSA, but there strategies do also use a number of other levers to pick entry and exit points.
I thought, what better way to get to the bottom of He Shuhan’s statement than getting him on the show again, so that’s exactly what I did.
He Shuhan explains his Volume Spread Analysis comment
Here’s an overview of my conversation with He Shuhan. To get the full commentary you’ll need to click play and listen above:
VSA has two components – Volume & Spread. Why would we want to look at the correlation between both? The primary reason is because we want to identify true price breakouts from false ones.
A lot of traders will be using Support & Resistance and they’ll meet up with places where the price is so ambiguous that it could be going up, bouncing off support, or breaking down with support and becoming a complete true breakout.
Even within a breakout, how many pips or how far will it go? Will it go enough to make money or are you just getting into another bad trade because of a false breakout? Volume Spread Analysis answers that question perfectly.
Take the Forex market as an example. There is no centralised volume because it is OTC (Over the Counter) traded by 7-8 large banks and the other 100 liquidity providers. But still volume is one of the key factors to driving price.
Another key factor that drives price is the level of desperation which is reflected in the spread. Here’s an example, if we have 1000 people trying to buy an apple at $1, because of the massive amount of buying volume the price of an apple will naturally go up, right?
But think of it another way. What if one person was desperate enough to buy the apple at $10,000? You will still cause the price of the apple to go up because whenever someone bids a price, someone asks a price to match.
So, in the first one, volume, we’re talking about whether there’s actual buying and selling in the market and number two, the spread, will tell you the level of desperation that is going to happen in the market.
If you have a case where the volume, the actual act of buying and selling, coincides with a case where people are desperate to continually bid for higher prices or lower prices, that will be a very strong move and that will identify you a real breakout.
If you have one out of the two, maybe you’ll get a real breakout, but if you have neither a good volume or a good spread which indicates there is no level of desperation (just normal market noise) most probably you have a false breakout. Avoid that trade.
Why not use VSA?
If you’re trading Forex for example, there’s no centralized/accurate data for volume. Even if you’re using an institutional platform such as EBS or Reuters 3000.
Another problem is that traditional VSA analysis has a few contradictory scenarios, e.g. according to the Richard Wyckoff method, if you see that the distance between the open, high, low, close is huge (a very large spread in the bar) and the volume is high it could mean two things, 1) if it’s a bullish bar, the buying volume has increased or 2) it’s the last bar of buying volume from the last remaining group of buyers before it’s exhausted and comes down.
My experience is that most traders have a hard time understanding this, especially in the field of Forex because they have never worked in a bank before dealt with two way market making or interbank dealing before. So they don’t really know if it’s an exhausted buy (which they should not long) or the start of a buying spurt (that they should long).
Knowing these principles will help you greatly identify the levels at which prices are critical, significant and more importantly “reflexive”. Which comes from the “Theory of Reflexivity” by George Soros where it says (simplified): function of x leads to function of y where x is cognition (how the people look at the market, how they see the prices) and y is reaction (where at certain prices they are more sensitive and they will act on it).
In simplest terms a support and resistance area is a reflexive area, especially a big round number like 1.1, 1.2, stuff like that. Because these are areas that have been heavily contested by both buyers and sellers, the memory still lingers in them and when it comes back to that area there is another competition. When the spread widens and momentum increases most likely it is going to breakout in a direction.
So, you don’t need to apply the VSA strictly as per the Richard Wyckoff method but if you understand the principles of it you’ll understand which levels you want to be trading off for a buy or a sell.
Is support and resistance key to having success with that sort of trading?
I wouldn’t say support and resistance. Support and resistance is classically defined by two points that have been bounced off, either a bottom or a top.
So, what I’m talking about is heavily contested areas and when you become experienced you can see visually. Or if you’re not experienced enough you can use a concept called Markovian Chains. It’s basically a Stochastical process that says: if a price is not transient it is recurrent. Think of it like a random data plot on graph paper, so you curve fit (liner regression) you have one line. Then that is the recurrence zone where price keeps touching and keeps going. It can be a support and resistance, but it can also not be a support and resistance zone. It doesn’t matter. So, you don’t need two points to connect to them.
Then if the price were to go out of that zone, which usually is shown by a strong volume spread move with momentum, then it’s actually going into what we call a transient zone. A transient zone is where price is transient and usually does not come back to the recurrence zone again. Also known as a breakout and the start of a trend.
What you were talking about there, what that related to the Accumulation/Deccumulation phase of Volume Spread Analysis?
No, not at all. I’m not talking about Accumulation/Deccumulation because we are not talking about the stock market.
Let’s say you were looking at the Forex market where the market does not stop at all. There are certain points that have recurred, been competed, over and over again at a price. You may see it as being a support and resistance sometimes, but if the range is rather huge you may not be able to see it. If you want to see it visually you’ll want someone to train you because it takes some time. Or if you’re mathematically inclined you’ll need to program something called a Markov Chain, also known as Stochastical Brownian motion.
It’s a statistical tool. Usually I analyse that alot on met lab and statistical software like IBM SPSS. It can be pretty useful in conjunction with one of the topics that I talked about before: ARIMA (which is really just variancy).
So, the essence of how I use VSA is just like that. I start by collecting data from a recent market window of say 2-3 hours. Let’s say you’re using 15 minute charts you would probably collect half a day and then you need to plot out linear regression of where the market is going generally. Then the Markov Chains will actually tell you that there are certain places that are recurrent and there are certain places that are not recurrent. So when ARIMA points in one directions, in/at a recurring area, goes beyond the recurring area and the spread widens up (spread of the bar) together with increase in momentum also known as “Rate of change”. Then the chance of a real breakout is extremely high. Of course after you enter the trade you will still need very sound solid money management; you could still lose of course. So you need very good money management to reduce your loses and net an edge over time.
Would you say you use this sort of theory in most of your trading systems, if not all of them?
You should really not apply Markov Chains on a long term basis, like a daily, weekly or monthly chart because stochasitcal processes are like… Imagine there’s a paper box. You put in a particle gun and you shoot a stream of particles onto the box. Some of them will reflect, some of them will refract (that means some of them will bonce off at different angles along the boxes non stop). So the Markov Chains Stochastical process only tells you there’s a short term repeatable pattern that’s going to occur. In the long run nobody knows exactly what’s going on so that’s actually the random walk theory, the Brownian motion. But in the very short term the stochasitcal process actually tells you that there’s a very high probability that certain small patterns will repeat. And these patterns will just occur on the start of a breakout.
So our job is to identify which one has the highest probability and then trade on those real breakouts which is before the price move. So when the market is consolidating we may lose a bit or take a small profit. If the market is starting to trend, you’re in for a very good ride!
Have you incorporated any of this theory into any custom indicators or tools that you use with your trading?
I do not program these into custom indicators. I have some tools that can help you identify those. My focus when I’m training people from University or anyone that comes to me. I want to ingrain this philosophy so they have a complete understanding of these mechanics and be able to visually identify.
Why do I not want to put it into an indicator alone is because platforms change all the time, technology changes all the time. And one more reason, what if one day I’m dead? And nobody can update the software anymore. My students must have the skill to carry on this for the rest of their lives.
If traders wanted to get a head start and start looking into this stuff, what should be their first port of call?
Read about Markov Chains. Read about Path Dependency. And read about Stochastical Processes.
What are your thoughts on Order Flow and how it’s related to VSA?
Order Flow is one of the most superb tools if you wanted to trade the futures or stock market. It’s a tool of a dying breed. Coming from it as an S&P trader myself. It’s very hard to find people who are good at that. But it does share similarities to VSA except for the fact that VSA is much more visual because you do need to look at the length of the spread. Where Order Flow is looking for large orders (what we call block trades) being triggered at certain prices and trying to piggy back on the big orders while the market moves.
So I’d say Order Flow is an even shorter term variation of VSA and a less visual way of doing VSA.
The system you gave me to trade last month was that based on VSA theory, Markov Chains and the things you discussed today?
The indicators I sent you was actually a simplified version of what I do. That indicator actually measures DIDX which is known as Rate of change. And Rate of change is a much more reliable divergence indicator that say Stochastic, RSI, CCI, MACD, etc… So, it’s a simplified version of that but it’s part and parcel of my technical trading system which I would say VSA derived theories takes about 60% of the weight-age at least.
Thanks for sharing again He Shuhan. If anyone has any questions are you happy to answer them if they leave a comment below?