Using Volume To Predict Price Movement

11/29/2007 12:00 pm EST

Focus: STRATEGIES

Tim Bourquin

Co-Founder, The Traders Expo and The Futures & Forex Expo

 

Day traders often find themselves overwhelmed with complex technical indicators, moving averages, and complex algorithms. However, sometimes it helps to step back and get back to the basics. One of those basic indicators is volume (the number of shares bought and sold in any given day). Not long ago, a hundred million share day on the New York Stock exchange would have left brokers breathless. Volume has increased dramatically over the past few years, the simple result of there being more money in play, driven by sharp increases in mutual fund and hedge fund assets. Now, in the wake of record-shattering days in the Dow, volume has spiked, and recently topped one billion.

As long as there has been trading, investors have used volume to get a read on where stocks are headed. And unlike most of the tools technical analysts use, this one is easily found on almost any financial Web site or in any daily newspaper with stock tables (usually expressed in thousands of shares).

A trader can't live or die by any one indicator. But understanding volume can provide insight into a stock's behavior to help you determine its overall health. The most important rule is this: volume precedes price. Typically, before a stock price moves, volume comes into play. The beauty of this indicator is its flexibility. Changes in volume can be used intra-day to determine short-term price movement or over several days to determine a stock's two to three day trend direction.

Before learning how to interpret volume, you have to know what is calculated. The first step is to identify a stock's typical trading range. Active traders were once relegated to writing down the volumes each day for their favorite stocks and then calculating the averages themselves. Now, of course, the Internet has made such information available to any investor online. Free data is available from hundreds of sites like Yahoo Finance. It will give you the average volume on any stock you choose.

In general, a price change on relatively low volume for a particular stock suggests an aberration, whereas a price change on high volume portends a genuine trend reversal. An active trader looks at volume to determine a price trend and the obvious goal is to trade in the direction of the major price trend. One of the best times to buy is when a stock is going down on low volume (with no news) as compared to recent increases on higher volume. This suggests that the selling is lighter and that the holders of the stock that are going to sell have finished selling and the rest are holding. The sellers of the stocks then may come back into the market when they see the price stabilize. It's also not a bad idea to sell on high volume on the way up (if the volume appears to be tapering off), as this usually creates abnormally high prices that cannot be maintained very long.

There are other ways to use volume to your advantage. Traders should also calculate on-balance volume (OBV), the relation between the number of shares traded and the price and trend of a stock, to portray whether price movement is coming from sellers or buyers. Unfortunately, I haven't been able to find a Web site that calculates this so you may have to do it by hand if you do not have charting software. Here's one way to do it. On one chart, keep track of the closing prices of a particular stock. On that same chart, begin a running total of trading volume - adding each day's volume to the total if the stock price goes up, subtracting it if the price goes down. That's the on-balance volume line, which you then can compare to the price line.

 

The basic theory is this: if price and volume are moving in the same direction, the trend of the stock price will continue. If they are running counter to each other, the trend will reverse.

The best-case scenario is one when volume surges without an accompanying surge in price. That typically means the buyers of a stock are more aggressive than the sellers. And once they take out the last shares the sellers have, the price just pops. It is difficult, if not impossible, to time the minute of the day when the stock will make its move. But when you see this combination of sideways price movement, an increase in volume trends, and an increase in on-balance volume, that typically means the stock are heading higher.

It's also a good sign when a share-price jump is joined by soaring volume or if declines occur on low volume. The idea is that light volume signifies little urgency, so a share-price decline probably wasn't the result of any major bad news. Low volume linked to a share-price increase is also a negative sign, because any lasting upward price movement should be confirmed with increasing volume. The worst-case scenario is high trading volume coupled with a falling share price. That means fellow stockholders are bailing out - a signal it may be time for you to do the same. One caveat: if volume is extremely high for a company with strong fundamentals, you might be witnessing a classic capitulation bottom, or panic bottom. That could be a good time to get back in, since the sell-off may have been irrational (perhaps based on a sudden drop in other stocks).

Volume should never be used independent of price action to determine buying or selling patterns, but it is an invaluable tool to gain insight into the markets and determine the current price trend.

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