How to Use Volume Bars to Identify Trends

08/27/2010 12:01 am EST

Focus: COMMODITIES

One of the problems with reading the volume bar charts directly is the difficulty in doing so. When attempted, it is soon discovered that reading volume bars is quite time consuming, to say the least.

Fortunately, there are other methods of interpreting the volume bars, and many indicators have been created to make it easier to understand what these bars are saying. Basically, there are two types of volume indicators. One involves combining price and volume, and these types of indicators accumulate volume based upon price action. These types of volume indicators include, but are not limited to, the on-balance volume (OBV) indicator, and the accumulation/distribution (A/D) indicator. The other type is called volume oscillator, which also comes in two types. Some volume oscillators are derivatives of the OBV and A/D indicators, while others are derived directly from the volume bars themselves.

While I am not a big fan of the OBV, the A/D, or other indicators that accumulate volume based upon price movement, I do use them from time to time. I am also not a big fan of volume oscillators derived from these types of volume indicators because these types of indicators and oscillators all contain errors. These errors come from trying to separate up volume from down volume based upon total volume and price action. While these approaches are fairly good approximations of what is up volume and what is down volume, they are not completely accurate, and therefore, contain errors.

The only way to create an accurate volume indicator based upon accumulation of up and down volume is to use actual up- and down-volume data obtained from a data feed. Unfortunately, this information is not readily available to traders for all stocks or stock indexes. The main difficulty I have with these types of volume indicators is that from time to time, they will continue to move higher, indicating that volume continues to expand, while at the same time, the actual volume bars are contracting. Despite this inherent error, these types of volume indicators and their derivative oscillators tend to work reasonably well most of the time.

The approach I prefer in analyzing volume is to convert the volume bar chart to a line chart, as shown in the lower panel of Figure 1. Viewing lines instead of bars seems to make it easier on the eyes to decipher the volume peaks, valleys, and when volume is increasing and decreasing. In addition, I add a 200-day simple moving average to represent the average of volume. When the volume line is above the moving average, it tells me volume is expanding, and when the volume line is below the moving average, it tells me volume is contracting.

To help in the analysis of volume and how it helps interpret the price trend, I have shown the daily price bars in green when the volume line is above its 200-day simple moving average, and I have shown the price bars in red when the volume line is below its 200-day simple moving average (see upper panel of Figure 1). When the price bars are green, they tell me that volume is expanding, and when the price bars are red, they tell me that volume is contracting.

In addition, I have also added a volume spike chart to the middle pane of Figure 1. The vertical lines are the daily volume bars. The volume bars above the horizontal line represent days when volume spiked to more than twice the volume compared to the previous day. The volume bars below the horizontal line represent those days when volume decreased by more than half the volume of the previous day. From the volume guidelines, note that volume sometimes spikes upward at the top of an uptrend. This is known as frantic buying and results from greed. Volume also sometimes spikes near the end of a downtrend. This is called panic selling and is a result of fear. These are represented by volume bars above the horizontal line. Volume also sometimes contracts sharply at the end of a downtrend. These volume bars are shown below the horizontal line. Please note, however, that frantic buying and panic selling do not always occur.

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This chart shows the price bars in the top panel, volume spikes in the middle panel, and a volume line chart in the bottom panel.

Now let's analyze the exchange traded fund SPDR Gold Trust (GLD) using just volume. The top panel of Figure 1 shows the daily price bars of GLD. A 200-day simple moving average (SMA) is shown to represent the long-term trend of GLD. Note that the 200-day SMA continues to move upward, signaling that price is in a long-term uptrend. We also see GLD made a higher high in mid June, as noted by the red resistance line drawn off this high point. During July, GLD moved lower to test support from the 200-day moving average. Since that time, GLD bounced upward and continues to move higher on its way to test overhead resistance. The question now is, "Will GLD break out above this line of resistance and make a new higher high, thus keeping the long-term uptrend intact?" To answer this question, we turn to our volume indicators and volume guidelines.

When we look at the price bars during the rally from late July onward, we note that all the daily trading bars are red. This informs us that during the complete upward rally, volume was below average. This is confirmed by the volume line chart in the lower panel of Figure 1, as noted by the volume line being below the 200-day moving average of volume. From the volume guidelines, we note that volume decreases during market corrections. This then tells us that the complete rally from the end of July is corrective. From our knowledge of technical analysis, we know that market corrections normally do not move above the origin of the preceding selloff. From this information, we conclude that the corrective rally from late July will most likely turn back downward before reaching and breaking out above the overhead resistance line. The volume guidelines also point out that volume normally increases at the beginning of a new trend. We can use this information to determine when the corrective rally has come to an end and a new downtrend has begun. Therefore, we should be looking at the volume chart in the bottom panel of Figure 1 to start moving higher and break out above its moving average.

If volume increases more than twice the preceding day's volume bar, a volume spike will appear on the volume spike chart in the middle panel of Figure 1. Volume sometimes spikes at the end of a trend. When we see a volume spike after a long rally, we know that the end is near. Further, we also know that if the current upward rally from late July is about to end, a new downward rally is about to emerge. Note that at the end of the long downward selloff from the late-June high, volume spiked a warning that the downtrend was coming to an end. This also signaled the emergence of the late-July rally.

In conclusion, volume adds valuable insight into the trend of a security. Above-average volume helps to identify a rally as a trend, while below-average volume helps to identify a rally as a correction. Sharp increases in volume help to identify the end of a trend. Sharp decreases in volume also help to identify the end of a downtrend. In our analysis of GLD, below-average volume helped to identify the late-July rally as being corrective. Therefore, we should expect GLD to turn back down before reaching overhead resistance drawn off the June high. We should also be looking for an above-average increase in volume to signal the end of the corrective rally. In addition to volume, the analysis should also contain a trend indicator to also help in identifying the end of the trend.

By Alan Northam of TradersClassroom.com

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