Trading Basics – Don’t Forget Volume
09/11/2008 12:00 am EST
Editor's Note: I am on the road once more, but the following article, though written over a year ago, is still valid in my opinion, as too many traders do not pay enough attention to volume.
How often have you found a very clear chart pattern, waited patiently and established a position only to be quickly stopped out as the breakout turned out to be false? Though it has happened to all of us, in many cases careful analysis of the volume patterns would have kept you out of the trade. If you analyze the trades you have made in the past year, I believe you will find that if you could have avoided just 10% of your trades, the performance would have been greatly improved. Trading strategies that can help you be more selective in the trades you take may be the key to dramatically improving your trading performance.
From the previous articles, it should be clear that I find careful analysis of chart patterns essential to any trading strategy. If you do not look at the volume in conjunction with the patterns you may miss some valuable clues. Any time a market, stock, or commodity makes a new high or a new low, I want to know whether the volume confirmed the new highs or new lows. In other words, to keep a market bullish you would want to see that new highs are accompanied by equal or higher volume than the previous high. This will tell you that new buyers are likely coming into the market. Conversely, if a market is declining, lower volume on new lows will give the trader an indication that the majority have already sold.
The chart above (Fig. 1) shows the weekly price activity of the QQQQ, an exchange-traded fund that mirrors the Nasdaq 100. You will note that as the QQQQ continued to make new lows in July 2002, point A, the volume continued to expand, hitting a high of 7.34 million shares the week of July 26, 2002. After rebounding for a few weeks, the decline resumed, making a series of new lows in September and early October (line 1). The volume was about 30% lower on this decline and it shows a pattern of lower highs (line 2) suggesting that selling pressure was not as heavy as it was in July.
When trying to determine whether the overall market is making an intermediate turn, it is beneficial to get confirmation from all sectors. The weekly chart, Figure 2, of the S&P Depository Receipts (SPY), based on the S&P 500, illustrates that when the July lows were violated in October (line 1), volume was less than on the previous low (line 2). This also indicated that the selling pressure was also less in the S&P 500, which supported the analysis of the Nasdaq and suggested that a meaningful rally could take place.Since the early 1980s, one of my favorite volume indicators has been the On Balance Volume (OBV) developed by Joseph Granville, one of the earliest, and most flamboyant market technicians. He developed it as a way to determine whether the smart money was buying or selling. It is calculated by keeping a running total of the volume figures, and then adding in the volume if the close was higher than the previous period, or subtracting the volume if the closing price was lower. If you are doing this in a spreadsheet, such as Excel, the starting volume can be arbitrary, as is the pattern of the OBV, not the absolute number, that is important. When viewed on a weekly basis it can be very useful in spotting major turning points. The OBV analysis in the spring of 1985 was instrumental in helping me identify the major top in the dollar, despite fundamental evidence to the contrary.
There are several ways that the OBV can be analyzed. The first is to determine whether the OBV is acting stronger or weaker than prices, and then to also look for divergences between the OBV and prices. I feel that the OBV analysis can be clarified by running a 21-period weighted moving average (WMA) on the OBV. When the OBV is above its WMA, it is positive and when below it, it is negative. The slope of the 21 WMA is also important, as is trend line analysis on the OBV. As with many technical tools, fewer signals are given when using weekly rather than daily data. Figure 3 shows the weekly chart of Nasdaq ETF with the OBV and its 21-period WMA. The OBV dropped below its WMA in January 2002 (point 1) and stayed below it until late October (point 2) when the OBV was able to move back above its flattening OBV. There were no clear-cut divergences between the OBV and prices at the lows, but in my experience this is not unusual.
Divergences are often noted at major highs and lows as was the case in Figure 4, showing Oracle (ORCL) at the 2000 peak. The weekly OBV moved above its WMA in late October 1999, and stayed above it until May 2000 when the WMA was broken at point 3. The OBV did confirm the March highs (line A), but when the stock made new highs in September, line B, the OBV was lower. This negative action was confirmed by the trend line analysis as the uptrend in the OBV (line 2) was broken in July. As ORCL was making new highs above 46 (line B), the OBV just rallied up to its former uptrend, confirming the negative divergence. The corresponding uptrend in prices (line 1), was not broken until November. I have found that at important highs or lows you often observe divergences, moving average signals and trend line breaks whether you are trading stocks or commodities.
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Tom Aspray, professional trader and analyst, serves as video content editor for InterShow's MoneyShow.com Video Network. Mr. Aspray joined InterShow full time in June of 2007 where he also does other editorial work for the site, including the bi-weekly trading lessons and the weekly charts to watch. Mr. Aspray has written widely on technical analysis and has given over 60 presentations around the world. Over the years, he has applied his methodologies not only to the stock and commodity markets but also the global markets, mutual funds, and foreign exchange. Many of the technical indicators that Mr. Aspray wrote about in the 1980s, such as the MACD, have since gained worldwide acceptance. He was originally trained as a biochemist but began using his computer expertise to analyze the financial markets in the early 80s. As a consultant, Mr. Aspray wrote daily institutional reports for firms such as Fleming Jardine and Barings Bank and was noted by the Wall Street Journal as one of the "top bond market technicians."