Trade Using VSA (Volume Spread Analysis)

Only a fraction of the orders that reach the market are executed. Executed
orders create transactions between a buyer and a seller. The buyer’s and
the seller’s respective buy and sell orders are mutually filled. If you only
study the transactions, it is very difficult to see the direction of these transactions.
Because for each transaction there is a buyer and a seller, it is
impossible to tell if sellers are stronger than buyers.
The direction of the trade is indicated by the small price change that occurs
on the transaction: If the price increased on the transaction, the buyer
was stronger (pushed the price up). Otherwise, the seller was stronger. Because
institutions split up large orders into numerous small orders, studying
the transaction size does not help in figuring out whether the transaction
was generated by an institution. What we therefore need to do is study
all the aggregated transactions within regular time intervals of one minute.
The idea is to reconstruct the size of the original order by adding up all the
transactions that occurred within one minute and to compare that number
to the price variation.
Let’s study this idea in one example: a large buyer. Let us suppose that
an institution wants to buy 100,000 shares on the market of a stock that
is trading 500,000 shares per day. The institution will probably have to use
one of the following four tactics:

Place a large buy order at the bid. This is a passive strategy, since the
institution has to wait for sellers to come to it. But, since regular buyers
are still active, these players would need to bid the price up to get their
shares. As a result, the institution will also have to raise its large bid,
with the risk of starting a new uptrend. This method is ineffective for
accumulating shares. It is easily detectable, since the large bid signals
to the market that a large player is accumulating.

Place regular small buy orders at the bid. This is also a passive strategy,
but the institution will not be easily detected. As we will see in
Chapter 4, this strategy does not allow large players to take a signifi-
cant position, and is therefore probably not often used.

Place regular small buy orders at the ask. This strategy is more active,
because the institution is actively buying shares. This method requires
that the institution have patience in its accumulation, to avoid price
spikes that could trigger a new uptrend. However, because the buying
is regular during a short period of time, the supply of shares will
momentarily dry up and the price will momentarily increase. The institution
needs to monitor these small price increases. If the small price
increases trigger a change of key technical patterns, they could attract
more buyers while the institution has not met its targeted number of
shares. On small price increases, the institution must therefore either
(1) wait for new sellers to come and push the price back down or (2)
push the price back down by itself with a small sell order. Because
of the statistical significance of the repetitive buying pattern, even distanced
buy orders placed at the ask form a pattern using the Effective
Volume, which I explain in the next section. The visible pattern is that
large volume will be more often linked to price increases than to price
decreases.

Place a large buy order at the ask. This very active strategy is used
only when several institutions are competing to get shares, or when an
institution wants to trigger a price increase by signaling to the market
that it is buying shares. This is easily detectable through the monitoring
of the price trend.
It should now be clear to the reader that what we need to analyze is not the situation at one point in time, but the regularity of the pattern during a set of consecutive, identical time intervals.