Trading Basics – The Demand Index

08/18/2005 11:55 am EST

Focus: STRATEGIES

Thomas Aspray

, Professional Trader & Analyst

In addition to the On Balance Volume (OBV), another of my favorite indicators that uses volume in addition to price is the Demand Index (DI), developed by James Sibbet. He used it almost exclusively in the commodity markets, especially the precious metals, but I have found it to be a useful tool for stocks as well.

This indicator looks at the change in price along with the volume for that period to calculate the buying pressure (BP) and the selling pressure (SP). The actual formula is quite complex but the indicator is available in most good charting programs. Sibbet's original scaling method has been modified by most current computer software programs so it can be displayed on a normal scale.

The most simplistic interpretation is that when the DI is rising, the BP is greater than the SP. Conversely, when it is falling, the SP is greater than the BP.

Figure 1
Figure 1

As was the case with the OBV, signals from the weekly data should be used to determine the major trend. For example, if the weekly studies are positive and the daily studies are negative, a short position would be recommended only for scalpers with tight stops. Conversely, if the daily studies were positive, a larger position with wider stops could be taken. Divergence analysis is the key to gaining important signals from the DI, with trend line analysis also important. In the first example, Fig. 1, we look at almost four years of data for Intel (INTC). From the early 2002 highs at 36.78, it declined to an initial low of 16.28 in early July (line A). Further new lows were made in October at 12.95 (line B), however, the DI was higher. This bullish or positive divergence is further illustrated by the uptrend, line 1.

Intel rallied for the next year, reaching 34.51 in November of 2003 (point 2). During the ensuing six week correction, the DI dropped sharply, violating the uptrend (line 1) and the zero line. This was the first warning that if INTC were to make new highs, the DI would not confirm the new highs. In fact, when INTC made new weekly closing highs at point 3, the Demand Index was much lower.

Figure 2
Figure 2

As we discussed in the first article, it is critical to look at several different time frames when trading. Fig. 2 shows a daily chart of Intel during the formation of the highs in late 2003 and in early 2004. On a daily basis, the DI peaked in mid-October (point 1), and then formed a series of lower highs as prices moved higher (points 2 and 3). The sharp drop in December pushed the daily DI to relatively oversold levels. The following rally took INTC to marginal new price highs (point 4) but the Demand Index failed to make new highs (dashed line). For the trader, the combination of the strong negative divergences from the weekly DI, nearness to strong long-term resistance in the $35-37 area, and daily signs of deterioration were a good reason to sell. INTC declined for the rest of 2004 and eventually dropped below 20.00

For Shorter Term Traders: Those chart students may have noticed that the trend line breaks in the daily Demand Index can give the short-term trader advance warning of breaks in the price trend lines.

Figure 3
Figure 3

The daily chart of the SPY (Fig. 3) shows several good examples of how DI trend lines can be used to identify entry and exit points. Both prices and the DI formed a well defined uptrend during January and February of this year (line A). The uptrend in the DI was broken on March 11th with the SPY closing at 120.39. The SPY closed higher the next session, which was a Monday, then formed a key downside reversal on March 15th, closing below the price uptrend.

The following downtrend in prices and the DI was derived from the March 3rd and April 12th peaks, line B. The downtrend in the DI was overcome with the strong close on April 29th at 115.75. The downtrend in prices (line B) was broken two days later with the close at 116.60. The correction in mid-May with the low on May 13th allowed us to draw two new uptrends, both labeled C. This new uptrend in the DI stayed intact until June 21st when it was broken. The SPY closed higher the next day and then plunged on June 23rd though the price uptrend is still intact.

Figure 4
Figure 4

One of the more surprising developments for both the professional and individual investor in 2005 was the continued out-performance of the small- and mid-cap stocks. They have been extremely strong in the past four months as the daily chart of the S&P Mid-Cap 400 Index (IJH), an exchange traded fund, indicates (Fig. 4). The downtrend in price and the DI was drawn using the March 8th and the April 7th peaks (line A). The DI made its initial low at point 1, then formed positive divergences at points 2 and 3. The DI’s downtrend (line a) was broken on May 2nd with the close at 63.72. Two days later the price downtrend was broken with the close at 64.57. The correction that ended on May 13th formed the basis for the new uptrend in prices (line B) and the DI (line b).

The DI formed its initial peak in mid-June (point 4) and then started to diverge from prices as it formed a lower high at point 5. The rally continued, but the DI formed another lower peak at point 6 on August 3rd and the uptrend in the DI (line b) was broken as the IJH closed at 72.27. Although the fund’s price has held up well, the DI continues to act weak. The weekly DI (not shown) shows no signs yet of a significant top.

Once you look at the Demand Index in this manner I feel confident that you will start to see the same familiar patterns that I have discussed here. After careful examination you will first identify the uptrend or downtrends in prices and in the Demand Index that are developed from points that are 10-15 days apart. Once these lines are drawn they will generally stay intact for 30-40 days, before a new signal is generated.

I welcome your feedback on this series of articles, or suggestions for future articles. Also if you would like me to analyze one of your trades, please contact me at tomaspray@intershow.com

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