Spotting Volume/Price Patterns And Market Trends: Confirming Trend Weakness

Confirming Trend Weakness: Lagging Trends

Since volume most often precedes price, weakening volume during a trend shows that traders lack the conviction necessary to keep the trend moving. This lack of conviction eventually shows up in reduced buying or selling pressure, which can spell doom for the continuation of a trend. This type of divergence is especially noticeable in uptrends. In an uptrend, as price climbs higher, more buying pressure is needed to sustain the move. Consistent or increasing volume is the signature of a robust trend. But if a security reaches a point at which those who planned to buy have already purchased their shares, the volume begins to weaken (or lag), and simple profit taking can cause the beginning of a serious correction.

Johnson & Johnson (JNJ) in Chart 4.11 is an example of a lagging uptrend, as volume is weakening throughout the trend. Notice how the 50-day moving average of volume is drifting lower as price rises. The declining volume during the uptrend indicates that fewer buyers are participating as prices appreciate. That situation leaves the door open for a nasty decline, as the chart illustrates.

As evidenced in Chart 4.12, a MACD overlay of volume can be a great short-term momentum tool to show the strength of volume pushes at various stages of a trend. Volume MACD can also be used to show lagging

Chart 4.11 Lagging Uptrend, VMA Overlay, Johnson & Johnson

Chart 4.12 Lagging Uptrend, Volume MACD Overlay, Johnson & Johnson

trends. Remember: When the MACD is below the zero line, it is in a weak position, and, when it is above the zero line, it is in a position of strength. In Chart 4.12 for Johnson & Johnson, note how the MACD of volume showed weakness (below the zero line) as price pushed higher. Then, note how the volume MACD spiked once sellers took over.

Trendless Markets: Volume Patterns at Support and Resistance Levels

As we discussed previously, a trendless or sideways market usually moves between upper and lower price boundaries. These boundaries are known as support (the lower boundary) and resistance (the upper boundary). Volume characteristics around areas of support and resistance help to predict the future direction of the trend.

Volume Accumulation at Support

Support can be thought of as the lower boundary of what is perceived as good value for the security between buyers and sellers. As price approaches the lower boundary support level, either buyers accumulate shares or selling pressure diminishes. In either case, prices are prevented from falling any further because of value that is perceived for the time being at that price level. Support levels can be easily identified on a chart by simply connecting the daily price lows during a particular time period. The level at which buyers enter is usually more of a tight price range near the support level than a specific price target.

Even though the dynamics of support zones are such that good value is seen at that price, there is no guarantee that the support level will hold. If it is broken, that is a sign that the sellers have won the battle by bringing more supply than the market can bear, causing price to adjust, sometimes sharply, to lower levels. As price approaches the support area, volume behavior can give clues as to the actions of the larger players, such as institutions and hedge funds. If volume increases and the price support area holds, this demonstrates buying interest at that level, which is usually a clue that the larger players are accumulating shares or contracts.

Chart 4.13 for Barrick Gold (ABX) shows how volume increased repeatedly as price approached the support area. The fact that volume increased and price reversed higher off support showed that the buying pressure at support was enough to create an imbalance on the side of demand over

 

Chart 4.13 Trendless Market, Support Level Accumulation, Barrick Gold

supply, which then pushed prices higher. Instead of continuing to purchase shares, however, buyers were content to let the price drift back down to accumulate shares again at a price level seen as a good value. After repeating this relatively bullish accumulation, the trendless pattern was broken as volume increased sharply with a strong price move to $48 after the period of accumulation in the $27—$28 range.

When Accumulation at Support Fails

While Chart 4.13 for Barrick Gold shows how shares are being accumulated as price bounces higher off of support on increased volume, there are other times where there is no evidence of buying at the support level. These situations can lead to breaks below support, or sharper price breakdowns.

Citigroup (C) in Chart 4.14 is an example of a price support around the $45 area. Notice how, as price moves lower and approaches the support line, the action (volume) is much more subdued than in the previous example. There are some minor pops higher in Citigroup’s volume, but nothing that shows that a real battle between buyers and sellers is taking place.

 

Chart 4.14 Trendless Market, Lack of Accumulation at Support, Citigroup

Finally, notice how volume picks up in mid-October as price falls, indicating a new supply of shares entering the market. Since there was not enough demand to absorb this new supply, price adjusted lower by breaking down through support.

Volume Distribution at Resistance

Resistance is a price boundary where supply levels prevent price from rising any further. The price at resistance is seen as the upper boundary of what is perceived as good value by traders. The most common method for determining the boundary range for resistance is to draw a line through an equity's respective highs during the time frame under analysis. A second method is to compare the amount of volume at a given price point with the amount of volume that was traded the last time it reached that same price point. If volume was greater on a previous attempt, then the resistance may be inferred as holding. Conversely, if volume was less on a previous attempt, then resistance may be failing, and a breakout could be imminent. As price reaches a resistance level or zone, either sellers take profits or buying pressure diminishes. Distribution at resistance is accompanied by an increase in volume over the previous day without price appreciation. If price is to get through a resistance area, a large enough increase in volume is needed to absorb the overhead supply. If volume does not increase to provide the fuel necessary to push through resistance, then either price will remain in a trading range or sellers will take over and drive the price lower.

IBM in Chart 4.15 gives a great example of a resistance area that needed an increase in volume to push through. Notice how volume was weak throughout the time that resistance held in the $77- $78 area. That signified that there was not much conviction or passion among buyers or sellers. Once buyers decided that the prospects for IBM made it worth more than $78 per share, they entered the market and provided enough buying power (volume) to absorb the overhead supply of shares, which in turn allowed IBM to move significantly higher.

The IBM example in Chart 4.15 was a happy ending for those buying IBM stock, but what about the other side, or when sellers overwhelm buyers? Remember, a resistance level is in place because there is more supply than demand at that price. If there is not enough conviction among buyers to push the price higher, then prices will ultimately move lower.

Chart 4.16 for KLA Tencor (KLAC) shows how the dynamics of price and volume around a resistance area can give clues to whether or not that resistance area is likely to hold. Notice how in October 2009 KLA

Chart 4.15 IBM Breakout over Resistance

Chart 4.16 Resistance in Trendless Market with Downside Breakout Volume Support, KLA Tencor

Tencor made a price high on solid volume in the 37.50 area. After a good sell-off, price once again approached the 37.50 level in December, but this time volume was much lighter. If nothing had materially changed for KLA Tencor over the previous couple of months, chances were that 37.50 would still be viewed as the upper end of fair value for the stock. If sellers were going to emerge at that level, the lighter volume in December was a clue that there may not have been enough demand at 37.50 to push price through that level.

Sure enough, after churning sideways for about three weeks in December at resistance, volume picked up as price fell. There was already some evidence that there was not much demand interest at this level, as demonstrated by the low volume. That opened the door for selling pressure or a new supply of shares coming onto the market to drive prices sharply lower. Notice how the increase in volume showed that change was on the way in the form of increased selling activity. This is a good example of how volume precedes price.

Volume in Action: Trend Consolidation/ Continuation Chart Patterns

In this section we will take a look at how volume behaves during a trend consolidation phase and breaks out in a continuation of the previous trend. We explore the corresponding volume patterns of some of the more widely recognized price chart patterns used in trading today.

Volume Behavior in Pennants

A pennant is short term in nature (usually lasting from 1 to 12 weeks) and normally reflects a brief consolidation before the continuation of the previous trend. Since this pattern represents short-term consolidation and trader indecision, it can on very rare occasions be a reversal pattern (as will be shown in Chapter 5), but the overwhelming majority of the time it represents a short pause before the prevailing trend resumes. This pattern typically forms at the midpoint of a move and occurs after a sharp price advance or decline, depending on the trend direction, on heavy volume. A breakout of the pattern on an increase in volume signals that the trend is resuming.

Chart 4.17 shows an example of a pennant pattern for Cisco Systems (CSCO). The pennant pattern is formed by price fluctuations within a range, and it needs at least two touches each on the resistance line and the support line to be valid. The pennant formation is recognized by its

Chart 4.17 Bullish Pennant Pattern Confirming Uptrend, Cisco Systems

Symmetrical triangle shape, with price action being compressed as the pattern matures.

Note that the “flagpole” is an important component of the pennant formation. It is the distance from the break of either support or resistance, depending on trend direction, to the high or low of the pennant. The flagpole must be formed on heavy volume to validate the pattern. Once the pattern is validated, the length of the flagpole is used to compute a price target for the move. Chart 4.17 shows a bullish pennant formation, its characteristics, and how to compute a price target:

• The price move starts at the $18 price level in July 2009.
• Price rallies sharply, breaking through resistance at $20.35 and hitting a high of $22.74 before the consolidation begins.
• Once a valid pennant forms, with at least two touches on each boundary line on contracting volume, a calculation of the length of the flagpole can be done as follows in order to set a trading price target:
• Measure from the point of the breakout over resistance ($20.35) to the top of the initial rally ($22.74) and subtract the breakout level from the high ($22.74 - 20.35 = $2.29). The computed value ($2.29) is used on the breakout of the pennant formation to project the price target.
• Once price breaks out of the pennant formation on heavy volume, add the length of the flagpole ($2.29) to the price at the point it broke out of the pennant, in this case $22.35, to get the trading price target of $24.64.

Volume Behavior in Flags

Flags are also short term in nature, lasting from 1 to 12 weeks. A flag is a small rectangular pattern that develops against the prevailing trend. For example, if the trend is up, the flag forms in a downward-sloping manner (a bull flag), and vice versa for downtrends (a bear flag). As with pennants, the pattern develops between a support and a resistance line. The flag differs from the pennant in that the flag is defined and contained by two parallel lines, while the pennant features two converging lines.

Volume is a key component in the development of the flag pattern. The flag formation also needs a flagpole, which must be formed on an increase in volume. Next, volume must contract as the flag pattern forms and matures. Finally, volume must confirm a breakout of the pattern by increasing noticeably at the point of the breakout. Chart 4.18 for iShares Barclays 20+ Year Treasury Bond Trust ETF (TLT) shows a bearish flag formation, its characteristics, and how to compute a price target:

• The price decline starts in the $106 area in early April 2009.
• Price breaks down through support at $100.38 on an increase in volume before finding support at $94.33, which is where the price consolidation begins.
• Price then rises between two parallel lines, forming a channel, or bearish flag, against the trend.
• Once the bearish flag formation is realized, you can compute the length of the flagpole by subtracting the low point of the flag ($94.33) from the support line that was broken ($100.38), which gives a flagpole length of $6.05.
• Price breaks down out of the flag formation at $96.70 on increasing volume, which validates the breakdown.
• The length of the flagpole ($6.05) is subtracted from the breakdown point ($96.70) to project a price target of $90.65.

Chart 4.18 Bearish Flag Pattern Confirming Downtrend, iShares 20+ Year Bond Trust ETF

Using Flags and Pennants in Practice

As with other patterns, suspected flag and pennant formations can be misleading if you don't carefully follow a few rules. Here are a few key points to remember about flag and pennant formations:

• The price action before the flag or pennant forms must be a strong move with healthy volume. This action forms the flagpole.
• The pennant forms a symmetrical triangle pattern, while the flag forms against the trend in a channel between two parallel lines. Volume contracts as the patterns are formed.
• The pattern becomes valid when there are at least two touches on the upper and the lower boundary lines.
• A breakout of the pattern is validated or confirmed by an increase in volume.
• The length of the flagpole is projected from a break of either support or resistance to either the high or low point of the formation, depending on the direction of the trend.
• The length of the flagpole is projected from the breakout point of the pattern to generate a price target.

Volume Behavior in Triangles

Triangles are patterns created during consolidation phases, representing a pause in the prevailing trend before continuing in the trend direction. They form in a horizontal consolidation that reflects diminishing interest in trading a particular security. In order for any triangle pattern to qualify as a continuation pattern, there must be a pre-existing trend in place. A triangle is formed with at least two touches on each of the converging support and resistance lines.

As with the previous consolidation/continuation patterns, volume is lackluster while the triangle forms. An increase in volume is used to confirm, or validate, the breakout of the pattern. Triangles come in three forms:

1. Ascending
2. Descending
3. Symmetrical

Ascending Triangles

An ascending triangle is a bullish pattern that has a flat top line (representing resistance) and an upward-sloping bottom line (representing support). The pattern consists of at least two highs at or near the same price level, with higher lows made on each rally attempt. The higher lows on each decline show diminishing supply or selling pressure on each push lower, which causes the upward-sloping support line. Volume should be lower than average and/or be decreasing as the pattern develops and the price action is compressed.

Chart 4.19 for Euro FX Composite illustrates the ascending triangle. Notice the flat resistance line and the upward-sloping support line. The resistance level was set at $1.2359 on the January 2006 high. Price declined after that, and the consolidation process started as price made a series of higher lows with each decline. Price then made another attempt to break through resistance at $1.2359, but was temporarily turned away, resulting in one final touch of the support line. The next attempt to break out was successful, as volume increased, showing an increase in demand, which caused price to reset to a new, higher level as the trend resumed.

Descending Triangles

A descending triangle is a bearish pattern because it appears primarily in downtrending markets. In contrast to the ascending triangle, it consists of a flat lower line (support) and a downward-sloping top line (resistance).

Chart 4.19 Bullish Ascending Triangle Pattern, Euro FX Composite

The pattern consists of at least two lows at or near the same price level, with lower highs made on each rally attempt. The lower highs on each rally attempt indicate diminishing demand on each push higher, thus causing the downward-sloping resistance line. Volume should he lower than average and/or be decreasing as the pattern develops and the price action is compressed.

Chart 4.20 for AMR Corp. shows a descending triangle. The initial low of the pattern was made at $10 in March 2004, with a test of that low coming later that year in May. That formed the flat support line in the $10 area, which was the level to watch for a break lower. Notice how, as the pattern formed, price made a lower high on each rally attempt, which allowed a downward-sloping resistance line to be drawn by connecting the highs. Volume was rather lackluster as the pattern developed before price finally broke lower with increased volume in July as the downtrend resumed.

Symmetrical Triangles

A symmetrical triangle is very similar to a pennant formation because it involves the same basic shape. Symmetrical triangles, however, are longer in duration, since they represent a longer-term period of trader

Chart 4.20 Bearish Descending Triangle, AMR Corp.

indecision. The consolidation period shows an absence of conviction from both buyers and sellers, thus allowing supply and demand to appear virtually equal as price consolidates sideways. Volume should be lower than average and/or be decreasing as the pattern develops and price action is compressed.

Chart 4.21 for Google (GOOG) shows a symmetrical triangle pattern that formed following a sharp rally. The pattern lasted for eight months, however, as lack of demand was matched by a lack of supply. Notice the pattern of lower highs and higher lows as the support and resistance lines converge. Volume moved higher as demand for Google shares finally forced the price higher to break out of the triangle. The breakout was upward in continuation of the previous trend, and the increased volume validated the breakout direction.

Volume Confirmation of Trend Continuation Patterns

These patterns can appear both in trending markets and following consolidation patterns. They reflect the resumption or continuation of a trend in its most recent direction.

Chart 4.21 Bullish Breakout from Symmetrical Triangle Pattern, Google Inc.

Continuation Gaps

Gaps are just what the name implies —a large step up or down in price, forming a “gap” from the previous position on tine chart. Most commonly, the term is used in the context of a “gap open,” where the price opens substantially above or below the previous closing price.

A continuation gap occurs in the middle of a move and in the same direction as the existing trend. Unlike exhaustion gaps, continuation gaps make good trade entry points in the existing trend, as these patterns are a signal that buying or selling interest has accelerated. These gaps are also known as measuring gaps or runaway gaps.

Chart 4.22 for Amazon.com (AMZN) shows a continuation gap in an uptrend. Notice how price moved higher off the November 2008 low before forming a bullish flag pattern as price consolidated. On January 30, 2009, price gapped higher on huge volume, signaling that the newly formed uptrend was ready to continue.

Candlestick Continuation Patterns

Candlestick charts have become one of the more popular tools of both the trader and the serious technician. The candlestick charting method was developed in Japan in the seventeenth century. Greg L. Morris introduced the software methodology to traders in the United States back in the

Chart 4.22 Bullish Continuation Gap, Amazon.com

early 1990s. As the story unfolds, a Japanese rice futures trader noticed that in addition to supply and demand, trader emotion played a large part in market behavior. This emotion could sometimes cause a disconnect between the price and the actual value of the rice market. The candlestick methodology was developed in an attempt to graphically represent intraday price relationships that were driven by trader sentiment. Candlestick charting is very popular among active traders because it reflects short-term outlooks (usually less than two weeks in duration). Chart 4.23 shows the components of a candlestick.

The difference between standard bar charting and candlestick charting is that the “real body” of the candlestick shows the relationship between the open and close for the period. If the close is higher than the open, the real body is hollow or white. If the close is below the open, the real body is darkened, whether it is black, red, or whatever color the chartist chooses. That is a very simplistic overview of how candlesticks are constructed. Candlestick charting is a very complex topic and beyond the scope of this book.

Chart 4.23 Components of a Candlestick

One example of a common candlestick continuation pattern that is especially common in the foreign exchange (FX) market is interestingly named the in-neck thrusting pattern. The example of the E-Mini Euro FX futures contract in Chart 4.24 shows the in-neck thrusting pattern as it unfolds during a downward move. Note that most candlestick patterns are short term in nature, so they develop quickly. Chart 4.24 illustrates the pattern in a downtrend, but this pattern is also valid in uptrends as well. In the downtrend example in Chart 4.24, the pattern unfolds as follows:   

Day 2. The candle has a white body (which means that the closing price is above the opening price) as buyers step in to try to stem the decline. This candle usually has a long tail, which signals that there was a strong battle to push price lower, but for this day the buyers prevailed.

Day 3. On the third day, buyers attempt to push price higher but fail, and the sellers resume control, which results in another large black candle resuming the downtrend.

Chart 4.24 Candlestick Continuation Pattern, E-Mini Euro Futures

Volume increases throughout the pattern, showing a definite battle for control of the market. In this case, it was ultimately won by sellers.

This chapter has presented volume overlays as a way to detect and assess trend strength. We have also learned to identify and confirm price chart formations using their corresponding volume patterns to predict continuation in trend direction.

Summary

• Volume allows traders the opportunity to see how much intensity or conviction is behind price movements of individual stocks or the market as a whole. In a sense, volume “validates” price movements and can also give insight as to whether a trend is likely to continue or change direction. Keep in mind the trader s mantra: Volume precedes price.
• As such, volume will show changes in its characteristics that will alert traders to the end of an uptrend or a downtrend before the price actually reverses. For example, in a downtrending market, the volume should expand during the down moves (confirmation of trend) and contract during countertrend bounces. When the volume patterns begin to change, they serve to alert a trader to shifts in trend.
• Trends, and the strength of those trends, can be assessed and confirmed through the use of overlays to determine volume strength and the conviction behind price movement. Such overlays can confirm robust or lagging trends.
• Popular overlays include volume moving averages, linear regression, and Moving Average Convergence/Divergence (MACD) of volume.
• Price formation patterns, when used in conjunction with their corresponding volume patterns, can also give strong confirmation as to the direction of a tradeworthy trend. Spotting the price patterns and corresponding volume patterns of pennants, flags, triangles, and gaps helps to predict a continuation in trend direction.