Walid Khalil and David Steckler introduced the volume zone oscillator (VZO) in the 2009 IFTA (International Federation of Technical Analysis) Journal and followed up in Technical Analysis of Stocks and Commodities magazine in May 2011. Those articles outline a money flow indicator with simple trade triggers and close ties to on-balance volume (OBV). This new tool has gained traction since that time and is now included in many charting packages, but it will take more testing and experience to fully evaluate its potential.

The oscillator breaks up daily volume activity into positive and negative categories. It's positive when the current closing price is greater than the prior closing price and negative when it's lower than the prior closing price. The resulting curve plots through relative percentage levels that yield a series of buy and sell signals, depending on level and indicator direction. (See also: An Introduction to Oscillators.)

Formula

The basic formula for VZO is follows:

VZO=100×VPTVwhere:VP=volume position=Xperiod EMA(± volume)TV=total volume=Xperiod EMA (volume)\begin{aligned} &VZO = 100 \times \frac{VP}{TV}\\ &\textbf{where:}\\ &VP=\text{volume position} = X - \text{period EMA} (\pm \text{ volume})\\ &TV=\text{total volume} = X - \text{period EMA (volume)}\\ \end{aligned}VZO=100×TVVPwhere:VP=volume position=Xperiod EMA(± volume)TV=total volume=Xperiod EMA (volume)

The default period is 14 but can be adjusted after backtesting.

The calculation creates a daily variable "R" that contains an up or down volume reading, depending on that session or price bar. VP and TV results are smoothed with exponential moving averages, and final numbers are multiplied by 100 to create a percentage scale on the indicator panel. The oscillator moves higher when the cumulative R has a positive value and lowers when it has a negative value.

[The volume zone oscillator is one of many chart analysis tools that you can use as a guide for your trading decisions. If you'd like to learn more, check out the Technical Analysis course on the Investopedia Academy.]

Interpretation

The VZO points to a positive trend when it rises above and maintains the 5% level, and a negative trend when it falls below the 5% level and fails to turn higher. Oscillations between the 5% and 40% levels mark a bullish trend zone, while oscillations between -40% and 5% mark a bearish trend zone. Meanwhile, readings above 40% signal an overbought condition, while readings above 60% signal an extremely overbought condition. Alternatively, readings below -40% indicate an oversold condition, which becomes extremely oversold below -60%.

The indicator panel shows horizontal lines that correspond with relative percentage levels that trigger buy and sell signals when crossed:

  • BUY OR COVER SIGNAL - cross from below to above the -40% line.
  • SELL OR SELL SHORT SIGNAL - cross from above to below the 40% line.
  • LESSER BUY OR COVER SIGNAL – cross from below to above the 5% line, but any subsequent violation adds a 7.5% buffer zone before the next buy signal.

A 14-period average directional index (ADX) can be used with the VZO, with values greater than 18 pointing to a trending market. A 60-period exponential moving average (EMA) is examined when ADX signals a trend, with price crossing above the moving average denoting a positive trend, while a downward crossover points to a bearish trend. These values should be tweaked and optimized by backtesting specific securities.

Price pattern and other indicators can be examined to confirm VZO buy or sell signals. Volume bars common on most price charts provides useful information in this regard, adding to signal reliability when bullish and bearish crosses align with two times or greater average volume. In addition, look for OBV to tick higher when the VZO has pushed above 50% and lower when it falls below that level. (For more, see: How to Use Volume to Improve Your Trading.)

An Example

PENN VZO Analysis

Penn National Gaming, Inc. (PENN) ground through a choppy uptrend in the first half of the year shown on the chart above, finally breaking out to a significant new high in July. VZO issued two major buy signals during this period, in December and in June. Both preceded strong uptrends that would have booked excellent profits. The period generates two valid sell signals, in February and April, but additional signals in January, May and June lower credibility because they occur at the same time as do higher prices.

The Bottom Line

The volume zone oscillator offers a fresh approach to volume-based trend signals, taking its cues from the classic on-balance volume Indicator and adding smoothing averages to elicit buy and sell signals at different levels of trend movement. (For additional reading, check out: Exploring Oscillators and Indicators.)