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Kira McCaffrey Brecht explains how volume analysis can assist in trading.
www.TraderPlanet.com
By Kira McCaffrey Brecht , Senior Editor, SFO Magazine
Many technical traders will tell you that price is king. After all many technical indicators are simply price massaged, oiled and spit out into a blue or red line at the bottom of one's chart. But, volume is a completely different animal. While you'd have to travel far and wide before you'd likely find a trader who would say that volume readings are more important than price, it is a useful tool to measure the amount of action and psychology of the market players.
In the futures arena, volume measures how many corn contracts or S&P E-mini's changed hands that session. For those who are trading on an intraday basis, 5-minute volume bars can be found, or for traders more comfortable with a longer-term view, weekly or monthly volume data can be called up just as easily.
Why Does Volume Matter?
Remember back to high school physics. Newton's first law of motion reflects the concept underlying volume analysis in the futures markets. Newton's first law says that an object in motion will stay in motion unless acted upon by an unbalanced force.
Think of volume as the fuel behind a market move. Is the gas tank full and providing powerful momentum for that Porsche speeding down the Autobahn? Or is the gas tank nearing empty, which means the engine is likely sputtering, and the old junker is slowing and limping toward the shoulder of the road? For a trader who is looking to put on a stock or futures trade, from the long side, knowing how much gas is likely left in the tank is an important variable. After all, how many smart drivers set off for a long trip, with only a gallon of gas left in the tank?
Rules of Thumb
Generally, volume is used to confirm price action. For example, if price breaks out of a consolidation to the upside, or downside, a pick-up in volume can be a "confirming" indicator. One of the basic rules of thumb for traditional volume analysis is that a healthy uptrend would see expanding volume on up days and contracting volume on down days. Just the opposite would be true for a downtrend. Waning volume during an uptrend could be a red warning flag. Or another subtlety to be on the lookout for is when one identifies heavy volume in an uptrend, but no price progress. The idea is that an unusual change in volume pattern could signify a possible reversal. Bull markets tend to have bigger volume, while bear markets tend to have lighter volume. For traders who may have missed an entry opportunity on a breakout, if a stock posts a retreat on declining volume that may offer a second entry opportunity for a trend move.
Blow-off and Climax
Now, for the exciting stuff: blow-offs and climaxes. No, this doesn't refer to some exotic dating ritual; instead blow-offs tend to occur at major market peaks, while climaxes emerge at market bottoms. These terms simply reflect a huge amount of volume, which emerges late in a market rally (or decline), with a sudden peak. Prices then abruptly reverse.
Confirm Pattern Breakouts
Another usage of volume analysis is to incorporate volume readings along with pattern breakouts. For those schooled in traditional pattern analysis, volume can be a helpful confirming indicator for double bottom or top, flag, triangle or any type of pattern breakout. How does it work?
Combining a price breakout with a volume confirmation simply helps a trader to see if there is conviction behind that a pattern breakout. Let's say that corn futures have been in a downtrend. But, as markets don't ever simply go straight up or down, the bear trend takes a pause and prices consolidate for several weeks and a continuation triangle develops on the daily chart. Then one day, traders wake up and corn breaks out to the downside of that triangle, blasting below the lower triangle line at the final bell. On that day, traders could look for a high volume day, a large and long volume bar, relative to the recent sessions. A high volume day would be viewed as "confirmation" to the downside breakout of that pattern.
On Balance Volume
There are a variety of tools and ratios based on volume, but one of the early volume indicators is known as on-balance volume (OBV), developed by Joe Granville in the early 1960's. This tool can help traders avoid the subjective nature of "eyeballing" those volume bars streaming across the bottom of the chart. The OBV indicator turns the volume data into a line graph, which can be displayed across the bottom of one's chart. Traders can actually draw trendlines on the OBV indicator, just like a price chart. When the OBV turns and breaks that trendline it can signal a potential turning point in price. Also, it can be used like an oscillator to help pinpoint divergences between price highs and volume peaks or price lows and volume troughs. In a bull move, OBV should be moving up.
The calculation behind OBV is simple. The total volume for a session is given a plus or minus value, depending on whether prices closed higher or lower that day. A higher close would result in the volume to be counted as a "plus," while a lower close would result in a "minus" value. Thus, a running total is achieved by simply adding or subtracting volume depending on direction of the market close.
Add Open Interest to the Mix
Traditionally, some futures markets technical analysts have combined volume with the study of open interest, which simply refers to the number of outstanding contracts still open at the end of the trading day in the futures markets. With the advent of 24-hour markets and the rise in popularity of foreign exchange trading among individual traders, the study of open interest appears to have waned. But, for those wanting to understand the basic rules of thumb they still apply.
Traditional Open Interest and Volume Guidelines:
• If prices are rising and volume and open interest are increasing, that represents a strong market;
• If prices are rising, while volume and open interest falls, that reveals a weakening market;
• If prices are falling, while volume and open interest increase, that represents a weak market;
• If prices are falling, while volume and open interest are falling, that represents a strong market.
Timing is Everything
Typically, trading in the stock market (and the futures on the major stock indices) sees the heaviest volume during the first hour and a half of the day and then the last hour and a half of the day. Traders can use this generality to help them in their intraday trading. Often times, major institutional players will execute large portions of orders in the morning, and then wait for heavy volume and renewed trending action late in the day to finish orders.
This can be useful and helpful information for those are trading very short-term on an intraday basis. There may be another opportunity during the second late day wave of action. Otherwise a trader who bought say the S&P E-mini early in the day and saw some profits in that trade, may slowly watch that profit erode during the lunch-time doldrums, as prices simply tick slowly lower. For those who get spooked on pullbacks or don't have the patience to wait for the afternoon move, it may be wise to simply book the profits early on.
Closing Thoughts
One day of volume can't be viewed in a vacuum. Volume analysis is most useful when compared to previous sessions. Some like to say volume is simply a reflection of supply and demand. A high volume day simply reflects more demand in the marketplace. But, overall, traders and analysts note that volume should be used as a confirming indicator. Most still agree that price remains the most important factor to consider while trading. Volume may offer up warning signals, red flags or generate trading ideas. But, use it as a supplementary tool. If you've haven't incorporated volume readings or analysis into your trading, it may be worth exploring.
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