The Basics of Volume Part 1
Most all the indicators used in technical analysis are based on pricing data. We either use prices themselves, a statistical manipulation with moving averages, or oscillators, etc. Volume, though, is an independent variable and can therefore be extremely useful in confirming price action. There are lots of ways of using volume, such as the construction of oscillators, on balance volume lines, and the design of indicators using both volume and price. Some of these more sophisticated variations will be discussed in future articles. In this one, though, I am going to concentrate on the basics.
First, it is important to understand there is always a perfect balance between buyers and sellers because the amount of a security sold is always identical to that which is purchased. What moves pieces is the relative enthusiasm of buyers or sellers. If sellers are more motivated than buyers the price will decline and vice versa.
Volume is usually displayed in charts as a series of histograms underneath the price. This is a useful form of presentation since it reflects expansions and contractions in activity. There are several key principles used in interpreting volume. However, before I cover this aspect, it is important to understand that when I talk about changes in the level of volume I am referring to volume changes relative to the recent past. For example, it's not possible to compare the volume on the NYSE today when it's in the hundreds of millions with the volume at the start of the century when it was less than one million. This is because there are now far more shares listed. Activity has also grown because of futures and options arbitrage, and reduced commission charges allow more frequent trading. But you can compare high volume this week with volume two weeks ago. The following represents a brief synopsis of some of the basic principles of volume interpretation:
1. Volume should go with the trend
When prices are rising it is normal for volume to expand, and when prices are declining volume typically contracts as in Figure 1.
Figure 1 Volume is Going With the Trend
Figure 2 reveals that when we talk of rising or contracting volume, we mean the overall trend of volume, not individual sessions. The green arrows mark the trend, which is an expanding one. Within that trend, though, there are individual sessions, such the two flagged by the red arrows, where volume is below the surrounding days. When prices are rising and volume is expanding market action is not telling us much, except to say that this is a normal state of affairs and that the up trend is soundly based.
Figure 2 Volume is Going With the Trend
However, when prices rise, as in Chart 1, featuring the Mexico Fund, and the trend of volume is down, it is abnormal and warns us that rising prices are being fueled more by a lack of selling than the enthusiasm of new and aggressive buyers.
Chart 1 Mexico Fund
Most of the time you will find bear market rallies being associated with a trend of declining volume, such as that shown in Figure 3, where volume contracts as the short-term bear market rally develops. Just as falling volume and rising prices are abnormal, so are declining prices and expanding volume. In a healthy market, prices and volume contract together, more because of a lack of buying than a preponderance of selling. However, when prices decline and volume expands, it tells us that downside pressure is present because sellers are very aggressive and this is not a good portent for future prices.
Figure 3 Contracting Volume on Rallies is Bearish
In this regard, Chart 2 featuring Nucor, shows how volume starts to pick up as the price starts to decline. This is a very subtle sign, but a very important one nonetheless because it tells us that sellers are getting anxious. Since prices are declining it also informs us that buyers are not enthusiastic enough to pick up the slack. Quite often you will see the situation where, following a rally, prices start to slip. However, on the first or second day that this starts to happen, volume picks up noticeably. This is abnormal and again flags a danger signal since it indicates that prices are falling due to the urgency of sellers rather than falling of their own weight due to a lack of buyers.
Chart 2 Nucor
2. Volume leads price during rallies
It is normal for a peak in prices to be preceded by a peak in volume. In Figure 4 you can see that the volume peaks at A but the price tops out at C. The level of volume at C is less than that at A and B. At point B, a negative divergence between price and volume developed as prices moved higher and the peak in volume moved lower. This type of action tells us that prices are no longer being supported by an influx of enthusiastic buyers and that the prevailing trend is suspect.
Figure 4 Rising Prices Need Expanding Volume
Chart 3 of IBM, displays two interpretive principles. First, we see the concept of volume leading price. Secondly, note how volume expands noticeably on the first two days of the decline. This, as discussed above, is abnormal because volume is not going with the trend, and is therefore a bearish sign.
Chart 3 IBM
Excerpted from "Volume Basics", S&C Magazine, July, 2000 issue
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