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Here's how to use volume spread analysis to track market activity of the professionals.
AS traders, we have different methods with which to analyze the market and on which to base our trading decisions; the two most commonly used are fundamental analysis and technical analysis. Each approach offers varying insights into market activity. Fundamental analysis is often used to help determine the balance of supply and demand, in which reports of crop yields or crude oil inventories, for example, are studied to gain a better knowledge of an underlying cause for the price of a given futures contract to move in a particular direction.

Fundamental analysis attempts to answer why a price will move, but not when. Technical analysis, on the other hand, is often used to answer when the price is ready to move on any given contract with no regard as to why.

A third approach can be used to analyze a market that will answer why and when simultaneously; this methodology is called volume spread analysis (VSA). I will show you how the VSA approach can track professional activity (also known as the smart money), compare this to both fundamental and technical analysis approaches, and show examples of VSA being used to confirm technical analysis indicators to make better trading decisions.

WHAT IS VOLUME SPREAD ANALYSIS?

Volume spread analysis seeks to establish the cause of price movement, the result of the imbalances of supply/demand created by professional operators. Who are these professional operators? In any business where money is involved, there are professionals at work. Some examples are art dealers, diamond merchants, and car dealers; all these professionals need to profit from a price difference to stay in business.

For example, in the car business, when a customer buys a new car and trades in his or her old one, two transactions take place. The first is the sale of the new car at the retail price; that car was purchased by the dealer at a wholesale price, and thus the dealer profits from the difference in price between wholesale and retail. The second transaction is the purchase of the trade-in at a wholesale price, and then the dealer sells the used car at a retail price. Again, the dealer profits from the retail sale purchased at a wholesale price.

What does this have to do with the futures markets or, for that matter, any market? All markets work the same way, and market professionals specialize in specific instruments that they trade and the time frames in which they trade. The market professional can buy the market at low prices (wholesale) and then sell at high prices (retail) and profit from the difference; or they can sell (go short) at high prices and buy back their positions at low prices and profit from the difference. The actual market mechanics are similar to other professional operations once the activity is distilled to the lowest common denominator.

...Continued in the October 2006 issue of Technical Analysis of STOCKS & COMMODITIES