Interpretation of Volume for All Markets

INTERPRETATION OF VOLUME FOR ALL MARKETS

The level of volume measures the intensity or urgency behind the price move. Heavier volume reflects a higher degree of intensity or pressure. By monitoring the level of volume along with price action, the technician is better able to gauge the buying or selling pressure behind market moves. This information can then be used to confirm price movement or warn that a price move is not to be trusted. (See Figures 7.3 and 7.4.)

To state the rule more concisely, volume should increase or expand in the direction of the existing price trend. In an uptrend, vol­ume should be heavier as the price moves higher, and should decrease or contract on price dips. As long as this pattern contin­ues, volume is said to be confirming the price trend.

Figure 7.3 The upside price breakout by McDonalds through the November 1997 peak was accompanied by a noticeable burst of trading activity. That’s bullish.

Figure 7.4 The volume bars are following Intel’s price uptrend. Volume is heavier as prices are rising, and drops off as prices weaken. Notice the burst of trading activity during the last three day’s price jump.

The chartist is also watching for signs of divergence (there's that word again). Divergence occurs if the penetration of a previ­ous high by the price trend takes place on declining volume. This action alerts the chartist to diminishing buying pressure. If the volume also shows a tendency to pick up on price dips, the ana­lyst begins to worry that the uptrend is in trouble.

Volume as Confirmation in Price Patterns

During our treatment of price patterns in Chapters 5 and 6, volume was mentioned several times as an important confirming indicator. One of the first signs of a head and shoulders top occurred when prices moved into new highs during the formation of the head on light volume with heavier activity on the subsequent decline to the neckline. The double and triple tops saw lighter volume on each suc­cessive peak followed by heavier downside activity. Continuation patterns, like the triangle, should be accompanied by a gradual drop off in volume. As a rule, the resolution of all price patterns (the breakout point) should be accompanied by heavier trading activity if the signal given by that breakout is real. (See Figure 7.5.)

In a downtrend, the volume should be heavier during down moves and lighter on bounces. As long as that pattern con­tinues, the selling pressure is greater than buying pressure and the downtrend should continue. It's only when that pattern begins to change that the chartist starts looking for signs of a bottom.

Volume Precedes Price

By monitoring the price and volume together, we're actually using two different tools to measure the same thing—pressure. By

Figure 7.5 The First half of this chart shows a positive trend with heavier volume on up days. The box at the top shows a sudden downturn on heavy volume a negative sign. Notice the increase in trading as the continuation triangle is broken on the downside.

the mere fact that prices are trending higher, we can see that there is more buying than selling pressure. It stands to reason then that the greater volume should take place in the same direction as the prevailing trend. Technicians believe that volume precedes price, meaning that the loss of upside pressure in an uptrend or down­side pressure in a downtrend actually shows up in the volume fig­ures before it is manifested in a reversal of the price trend.

On Balance Volume

Technicians have experimented with many volume indicators to help quantify buying or selling pressure. Trying to "eyeball" the vertical volume bars along the bottom of the chart is not always precise enough to detect significant shifts in the volume flow. The simplest and best known of these volume indicators is on balance volume or OBV. Developed and popularized by Joseph Granville in his 1963 book, Granville's New Key to Stock Market Profits, OBV actually produces a curving line on the price chart. This line can be used either to confirm the quality of the current price trend or warn of an impending reversal by diverging from the price action.

Figure 7.6 shows the price chart with the OBV line along the bottom of the chart instead of the volume bars. Notice how much easier it is to follow the volume trend with the OBV line.

The construction of the OBV line is simplicity itself. The total volume for each day is assigned a plus or minus value depending on whether prices close higher or lower for that day. A higher close causes the volume for that day to be given a plus value, while a lower close counts for negative volume. A running cumulative total is then maintained by adding or subtracting each day's volume based on the direction of the market close.

It is the direction of the OBV line (its trend) that is impor­tant and not the actual numbers themselves. The actual OBV val­ues will differ depending on how far back you are charting. Let the computer handle the calculations. Concentrate on the direc­tion of the OBV line.

The on balance volume line should follow in the same direc­tion as the price trend. If prices show a series of higher peaks and

Figure 7.6 The line along the bottom shows on balance volume (OBV) for the same Compaq chart. Notice how much easier it was to spot the downturn in October 1997.

troughs (an uptrend), the OBV line should do the same. If prices are trending lower, so should the OBV line. It's when the volume line fails to move in the same direction as prices that a divergence exists and warns of a possible trend reversal.

Alternatives to OBV

The on balance volume line does its job reasonably well, but it has some shortcomings. For one thing, it assigns an entire day's vol­ume a plus or minus value. Suppose a market closes up on the day by some minimal amount such as one or two tics. Is it reasonable to assign all of that day's activity a positive value? Or consider a situation where the market spends most of the day on the upside, but then closes slightly lower. Should all of that day's volume be given a negative value? To resolve these questions, technicians have experimented with many variations of OBV in an attempt to discover the true upside and downside volume.

One variation is to give greater weight to those days where the trend is the strongest. On an up day, for example, the volume is multiplied by the amount of the price gain. This technique still assigns positive and negative values, but gives greater weight to those days with greater price movement and reduces the impact of those days where the actual price change is minimal.

There are more sophisticated formulas that blend volume (and open interest) with price action. James Sibbet's Demand Index, for example, combines price and volume into a leading market indicator. The Herrick Payoff Index uses open interest to measure money flow. (See Appendix A for an explanation of both indicators.)

It should be noted that volume reporting in the stock mar­ket is much more useful than in the futures markets. Stock trad­ing volume is reported immediately, while it is reported a day late for futures. Levels of upside and downside volume are also avail­able for stocks, but not in futures. The availability of volume data for stocks on each price change during the day has facilitated an even more advanced indicator called Money Flow, developed by Laszlo Birinyi, Jr. This real-time version of OBV tracks the level of volume on each price change in order to determine if money is flowing into or out of a stock. This sophisticated calculation, how­ever, requires a lot of computer power and isn't readily available to most traders.

These more sophisticated variations of OBV have basical­ly the same intent—to determine whether the heavier volume is taking place on the upside (bullish) or the downside (bearish). Even with its simplicity, the OBV line still does a pretty good job of tracking the volume flow in a market—either in futures or stocks. And OBV is readily available on most charting software. Most charting packages even allow you to plot the OBV line right over the price data for even easier comparison. (See Figures 7.7 and 7.8.)

Figure 7.7 An excellent example of how a bearish divergence between the on balance volume line (bottom) and the price of Intel correctly warned of a major downturn.

Other Volume Limitations in Futures

We've already mentioned the problem of the one day lag in reporting futures volume. There is also the relatively awkward practice of using total volume numbers to analyze individual con­tracts instead of each contract's actual volume. There are good reasons for using total volume. But how does one deal with situa­tions when some contracts close higher and others lower in the same futures market on the same day? Limit days produce other problems. Days when markets are locked limit up usually produce very light volume. This is a sign of strength as the numbers of buyers so overwhelm the sellers that prices reach the maximum trading limit and cease trading. According to the traditional rules of interpretation, light volume on a rally is bearish. The light vol­ume on limit days is a violation of that principle and can distort OBV numbers.

Figure 7.8 Overlaying the OBV (solid line) right over the price bars makes for easier comparison between price and volume. This chart of McDonalds shows the OBV line leading the price higher and warning in advance of the bullish breakout.

Even with these limitations, however, volume analysis can still be used in the futures markets, and the technical trader would be well advised to keep a watchful eye on volume indications.

INTERPRETATION OF OPEN INTEREST IN FUTURES

The rules for interpreting open interest changes are similar to those for volume, but require additional explanation.

1.With prices advancing in an uptrend and total open inter­est increasing, new money is flowing into the market reflecting aggressive new buying, and is considered bullish. (See Figure 7.9.)

Figure 7.9 The uptrend in silver prices was confirmed by a similar rise in the open interest line. The boxes to the right show some normal liquidation of outstanding contracts as prices start to correct downward.

2. If, however, prices are rising and open interest declines, the rally is being caused primarily by short covering (holders of los­ing short positions being forced to cover those positions). Money is leaving rather than entering the market. This action is considered bearish because the uptrend will probably run out of steam once the necessary short covering has been completed. (See Figure 7.10.)

3. With prices in a downtrend and open interest rising, the technician knows that new money is flowing into the market, reflecting aggressive new short selling. This action increases the odds that the downtrend will continue and is consid­ered bearish. (See Figure 7.11.)

4. If, however, total open interest is declining along with declining prices, the price decline is being caused by discouraged

Figure 7.10 An example of a weak price rebound in gold futures. The price rise is accompanied by falling open interest, while the price decline shows rising open interest. A strong trend would see open interest trendline with price, not against it.

or losing longs being forced to liquidate their positions. This action is believed to indicate a strengthening technical situation because the downtrend will probably end once open interest has declined sufficiently to show that most losing longs have completed their selling.

Let's summarize these four points:

• Rising open interest in an uptrend is bullish.
• Declining open interest in an uptrend is bearish.
• Rising open interest in a downtrend is bearish.
• Declining open interest in a downtrend is bullish.

Figure 7.11 The downturn in copper during the summer of 1997 and the subsequent price decline was accompanied by rising open interest. Rising open interest during a price decline is bearish because it reflects aggressive short selling.

Other Situations Where Open Interest Is Important

In addition to the preceding tendencies, there are other market situations where a study of open interest can prove useful.

  1. Toward the end of major market moves, where open interest has been increasing throughout the price trend, a leveling off or decline in open interest is often an early warning of a change in trend.

  2.A high open interest figure at market tops can be considered bearish if the price drop is very sudden. This means that all of the new longs established near the end of the uptrend now have los­ing positions. Their forced liquidation will keep prices under pres­sure until the open interest has declined sufficiently. As an exam­ple, let's assume that an uptrend has been in effect for some time. Over the past month, open interest has increased noticeably. Remember that every new open interest contract has one new long and one new short. Suddenly, prices begin to drop sharply and fall below the lowest price set over the past month. Every sin­gle new long established during that month now has a loss.

The forced liquidation of those longs keeps prices under pressure until they have all been liquidated. Worse still, their forced selling often begins to feed on itself and, as prices are pushed even lower, causes additional margin selling by other longs and intensi­fies the new price decline. As a corollary to the preceding point, an unusually high open interest in a bull market is a danger signal.

  3.If open interest builds up noticeably during a sideways con­solidation or a horizontal trading range, the ensuing price move inten­sifies once the breakout occurs. This only stands to reason. The mar­ket is in a period of indecision. No one is sure which direction the trend breakout will take. The increase in open interest, however, tells us that a lot of traders are taking positions in anticipation of the breakout. Once that breakout does occur, a lot of traders are going to be caught on the wrong side of the market.

Let's assume we've had a three month trading range and that the open interest has jumped by 10,000 contracts. This means that 10,000 new long positions and 10,000 new short posi­tions have been taken. Prices then break out on the upside and new three month highs are established. Because prices are trading at the highest point in three months, every single short position (all 10,000 of them) initiated during the previous three months now shows a loss. The scramble to cover those losing shorts nat­urally causes additional upside pressure on prices, producing even more panic. Prices remain strong until all or most of those 10,000 short positions have been offset by buying into the market strength. If the breakout had been to the downside, then it would have been the longs doing the scrambling.

The early stage of any new trend immediately following a breakout is usually fueled by forced liquidation by those caught on the wrong side of the market. The more traders caught on the wrong side (manifested in the high open interest), the more severe the response to a sudden adverse market move. On a more positive note, the new trend is further aided by those on the right side of the market whose judgment has been vindicated, and who are now using accumulated paper profits to finance additional positions. It can be seen why the greater the increase in open interest during a trading range (or any price formation for that matter), the greater the potential for the subsequent price move.

  4.Increasing open interest at the completion of a price pattern is viewed as added confirmation of a reliable trend signal. The break­ing of the neckline, for example, of a head and shoulders bottom is more convincing if the breakout occurs on increasing open inter­est along with the heavier volume. The analyst has to be careful here. Because the impetus following the initial trend signal is often caused by those on the wrong side of the market, sometimes the open interest dips slightly at the beginning of a new trend. This ini­tial dip in the open interest can mislead the unwary chart reader, and argues against focusing too much attention on the open interest changes over the very short term.

SUMMARY OF VOLUME AND OPEN INTEREST RULES

Let's summarize some of the more important elements of price, volume, and open interest.

1. Volume is used in all markets; open interest mainly in futures.
2. Only the total volume and open interest are used for futures.
3. Increasing volume (and open interest) indicate that the current price trend will probably continue.
4. Declining volume (and open interest) suggest that the price trend may be changing.
5. Volume precedes price. Changes in buying or selling pres­sure are often detected in volume before price.
6. On balance volume (OBV), or some variation thereof, can be used to more accurately measure the direction of vol­ume pressure.
7. Within an uptrend, a sudden leveling off or decline in open interest often warns of a change in trend. (This applies only to futures.)
8. Very high open interest at market tops is dangerous and can intensify downside pressure. (This applies only to futures.)
9. A buildup in open interest during consolidation periods intensifies the ensuing breakout. (This applies only to futures.)
10. Increases in volume (and open interest) help confirm the resolution of price patterns or any other significant chart developments that signal the beginning of a new trend.