Importance of Volume

The importance of volume for confirming candlesticks and why candlesticks work whatever the market, whatever the time frame

Looking at these Doji patterns is a good time to introduce an important aspect of any reading of candlestick charts: volume.

What does "Volume" mean?

Volume is, quite simply, the amount of trade going through at each price or each period of time. If volume is light you can assume that the price action you’re seeing may not be the real deal.

If you see a move on strong volume you can be assured that the move is the result of strong buying or selling, and therefore there’s some sustainability to the move in question. Quite simply, accompanying volume is one of the best ways to confirm any candlestick pattern, but if you see a reversal pattern (or a major price move) on very weak volume you should treat it as suspect.

Volume is illustrated on a candlestick chart in a separate box below the main body of the chart, usually expressed as a histogram. There have been attempts to incorporate volume into the candlesticks themselves. One example is an Equivolume candle chart, where the width of the real body varies depending on whether it was accompanied by strong or weak volume. The fatter the body the more volume was seen. I’ve never been that much of a fan, but that’s possibly because I started off with bar charts, and I got used to having volume down at the bottom below the prices.

Coming from a trading floor background I always felt that volume was a great word to describe trading activity. If you were in the coffee lounge behind the LIFFE Floor, you could hear a change in noise level from the market, and even if you didn’t you soon heard the noise of feet running back to the floor because something had happened to cause a sudden leap in activity.

Even today in a dealing room at one of the large banks or brokers you can tell almost instantly whether a market is quiet or busy. I think this is where a lot of remote traders miss out when they sit and trade from home. They can try to re-create this by using the business news channels or a Squawk service for “ambient” noise, but the best tool the chartist has for tracking activity is the volume histogram.

A jump in volume means something’s happening. A candlestick pattern that’s got (relatively) large volume accompanying it generally makes for a stronger signal.

Example

Let’s go back to our old favourite chart from the end of the last section to illustrate this point:

Figure 3-23: Eurex Bobl futures; 10-minute candlestick chart; 22 & 23 April 2003

You can see that both the candlesticks I highlighted, the Gravestone Doji and the Dragonfly Doji, were particularly strong in the volume department. I have also highlighted a few other Doji candlesticks on this chart (with the blue down arrows), but as you can see if you look down to the volume histogram, there was no significant accompanying activity; this suggests that these Doji were probably the result of indifference rather than a big two way swing between buyers and sellers that could have trend changing significance.

Note regarding Doji on short-term charts

I purposely chose Doji to illustrate the point about volume, because when markets get quiet you get a lot of Doji. This is quite simply because volatility is very low, and therefore the chances of opening and closing at the same levels increases.

I spend a lot of time looking at short time frame charts, but find that candlesticks work well whatever the time frame, something that this chart once again illustrates very well.

The Doji candles that were formed on light volume were merely the result of the market going sideways; marking time because no one was actually around to trade. They appear over lunchtime when the morning rush is done and the market is waiting for the US session to get underway. They’re often the result of half the market going out to buy a sandwich, rather than any major reversal in thinking about the market.

A closer look at our Dragonfly Doji example

If you took a look at our Dragonfly Doji in Figure 3-23 without the assistance of the volume histogram you’d surely class it as a similar deal, based on it being such a tight range. In this 10-minute period only three different prices were traded, 111.00, 110.99 and 110.98. The market opened and closed at 111.00, hence there is no real body, just a line at the top of the candle. If we add the volume into the equation we suddenly realise that this 10-minute period with an extremely tight range was actually one of the busiest 10-minute periods over the whole day. Neither the bulls nor the bears appeared to have achieved much, but they certainly had a good old go at each other, and because the market was on the day’s lows, and had sold off 38 ticks from the high of the previous afternoon, the bulls can be rightfully happy with their work. In fact you could almost argue that there was someone out there who wasn’t prepared to see the market drop below the psychologically important 111.00 mark, and spent that entire 10-minute period hoovering up the sell orders and making sure the market was always bid over, so that the sellers eventually realised they’d hit a brick wall.

Psychology

Generally if you hit a brick wall there’s only one way to go, and it’s no exception in the markets. The sellers walked away after our high volume tiddler of a Dragonfly Doji, but it was only the volume that highlighted how significant this candlestick actually was. Without the volume we wouldn’t have realised the significance of this Doji.

More on the subject of short-term trading

A question I often get asked is whether candlesticks work well in time frames other than the daily chart, particularly for short-term traders. My answer is a categorical “Yes.” In my daily analysis I view 10-minute, 60-minute and daily candlestick charts all the time, and during the course of a day constantly spot reversal patterns on the 10-minute chart. The nice thing about this is the instant gratification that they can provide. While on a daily chart you have to wait 2 days to see a Hammer and a green candle to confirm it, on a 10- minute chart this would only take 20 minutes. The message is exactly the same: the Hammer is a period of time where the market sells off then rallies to retake the earlier losses. The green candle adds its weight to the argument for a reversal. It doesn’t matter whether this combination of movements takes two days or 20 minutes, the market still need to do exactly that to get those two candles. I will spend a bit more time on these ideas later on (see pages 125-126).

With these patterns you should always look for confirming volume, which proves that a battle has indeed taken place at this time.

In fact on short-term time frames candlesticks like Shooting Stars and Hammers make even more sense. If you’ve ever spent any amount of time looking at a day session unfolding you’ll see times when stops are triggered and the market heads quickly off in one direction, especially when an old support or resistance level is breached, only for the move to suddenly reverse. To use a Hammer as an example, the big traders look for places where small, weaker traders have their sell stops, and they trigger these stops, then flip their direction and start buying the market, taking it back through the old support level as quickly as the stops had seen us drop below there. This sort of price behaviour generally leaves a long lower shadow on the short-term charts, or a Hammer to you or me.

Chapter summary

Having read this chapter you should now be aware of those key candlestick patterns that are constructed of just one candlestick.

The Hammer and Shooting Star are strong reversal patterns whatever the time frame viewed.

The Hanging Man and the Inverted Hammer may be similar in shape to the Hammer and the Shooting Star, but they’re seen in different trends, and as such their impact is usually greatly reduced.

Doji are powerful reversal patterns in downtrends and uptrends, and are very easy to spot due to the lack of real body.

Volume is another important element to consider when viewing candlestick charts.

We will now move on to reversal patterns that are constructed using more than one candlestick.