Spotting Volume/Price Patterns And Market Trends

SPOTTING VOLUME/PRICE PATTERNS AND MARKET TRENDS

Volume shows how many shares or contracts changed hands between buyers and sellers over a set period of time (e.g., an hour, a day, or a week) and provides insight as to the strength and sustainability of the trend.

While the actions of market traders can be summed up in daily price movements, volume reflects the conviction behind the move. Volume can be thought of as the collective sentiment of the market. In Volume Analysis we see a graphical representation of the supply and demand relationship displayed in our volume measurements. If price is trending with less conviction (i.e., declining volume), a change in sentiment may be under way that favors the odds for a change in direction. In contrast, if price is trending with stable or higher conviction (i.e., steady or increasing volume), the trend can be viewed as healthy and sustainable. Leaving volume out of the picture does not provide the depth of analysis necessary to make informed trading decisions.

All that said, just as with price, the signals provided by volume aren't always easily observable. Many textbook examples of volume confirming price trends shown in the last several chapters occur in real life and are easy to find for traders doing their homework. But that would be too easy. If all volume signals were obvious, all traders would recognize them and trade with them, and in the end they would no longer work. So it becomes important to deploy more sophisticated ways to detect trends in volume and translate volume/price behavior. This chapter begins to describe some of the more complex volume behaviors, those of consolidation/continuation patterns, and how to spot them over time.

We also focus on using volume overlays (supplemental volume indicators) to more clearly display the volume trend in conjunction with price. Chapter 5 gives the other side of the coin: identifying trend changes, or reversals, using similar tools.

Using Overlays to Spot and Assess Volume Trends

While a normal daily bar plot of volume can seem erratic and without pattern or trend, there are methods that can be used to detect trends in volume that are not readily apparent to the naked eye. This type of volume trend analysis is best accomplished through the use of overlays.

Overlays are indicators plotted over the top of price or volume bars with the same value scale. Such overlays are more commonly used with price plots, but using them with volume can display the corresponding volume activity for a given market trend. As volume precedes price, confirmation of a price trend (expanding volume in the direction of the trend) means that the trend is likely to continue, while non-confirmation of a price trend means that the trend is suspect and likely to reverse.

In this section, we take a look at three types of volume overlays: volume moving averages (VMAs), linear regression lines, and volume Moving Average Convergence/Divergence (MACD of volume).

Volume Moving Averages

A volume moving average shows the average volume (number of shares or contracts that have been traded) over a set period of time. The purpose of a moving average is to smooth out volatility or “noise,” which can be confusing and can compromise proper market analysis. This allows traders working within a preferred time frame to see if volume for a price move has been heavier or lighter than normal —which, in turn, can result in different interpretations of that price movement. Since higher volume totals show more conviction behind a price movement, days that have above-average volume are more meaningful than days that have below- average volume.

Moving averages come in many different types, such as simple, exponential, weighted, time series, and triangular. For the purpose of this first example, we will use a simple volume moving average (SMA). A moving average is constructed by summing the past n periods of volume and dividing by n. For example, if an intermediate time frame setting using a 20-day-period moving average of volume is desired, add up the last n = 20 days of volume and divide by 20 [(V1+V2 + • • • +V20)/20]. This gives an average volume total of the last 20 days that provides a much smoother graphical representation of volume than the sometimes erratic readings that can occur from day-to-day bar plots.

Such a moving average allows a trader to see whether volume is increasing (the sign of a healthy trend) or decreasing (the sign of a suspect trend). Any competent charting package will let you overlay volume with a moving average in a couple of mouse clicks.

One of the most commonly used moving averages for Volume Analysis is the 50-day volume moving average (VMA), which is good for a higher-degree trend analysis. There is one disadvantage to using this longer-term moving average: It tends to be slower to respond to changes in volume trends. For this reason, it's important that the time frame settings for the VMA match your time horizon as a trader. Chart 4.1 for JPMorgan Chase (JPM) shows how a 50-day VMA is used to confirm a downtrend, showing that sellers are clearly in control.

Chart 4.1 Long-Term Volume Moving Average Overlay, JPMorgan Chase

Chart 4.1 shows a rising pattern of volume bars, but the 50-day VMA overlay displays the volume trend more clearly. Note that as the 50-day VMA drops older and adds newer periods, it is still less responsive to current changes in volume. This was demonstrated by the 50-day VMA rising while volume tailed off in April. The longer the averaging period of the VMA, the slower the moving average is to respond to change and the greater the lag effect. This means that shorter time periods for the VMA (5 to 10 days) are much more sensitive to volume fluctuations than the longer-term VMA (50 days). The trade-off, thus, when setting n is between its sensitivity to most recent volume data and the timeliness of its signal. Longer n periods mean a smoother trendline but also more lag.

The VMA is an excellent tool for capturing the patterns of greater than “normal” or escalating periods of volume. These patterns of increased volume activity typically precede a reversal in price, depending upon where they occur in the price trend movement and on what side of the trend they occur. Ultimately, the time frame setting you choose for your VMA will determine its sensitivity to the volume trend. Depending on the length of the settings, the VMA can detect escalated activity in volume above the norm over the short term (up to 10 days), intermediate term (up to 50 days), and long term (50 days and more). This allows a trader to determine the volume norm and detect these surges in volume within a preferred trading time frame. The exponential moving average of volume gives more weight to recent volume values, thus increasing its sensitivity as compared to the simple moving average. (This is discussed in more depth in Chapters 5 and 7.)

The 60-minute view of Apple Inc. trading (AAPL) in Chart 4.2 shows how intraday surges in volume can be detected using a 7-period VMA. Notice how the volume surges and coincides with short-term turning points that can last for a number of days.

Escalating periods of volume that occur over a slightly longer time frame have more of an impact on price direction. The daily record of Apple Inc. in Chart 4.3 uses a 5-day VMA to detect short-term volume surges that can lead to reversals in the intermediate term that last anywhere from 1 week to 3 months.

Higher-degree trend changes can be detected by using an even longer VMA to detect volume surges. In Chart 4.4, a daily record of Apple Inc., a 20-day VMA is used to detect intermediate-term volume surges. These surges can affect price for periods up to 3 months or longer. Note how the October 2008 surge tipped off traders that a bottom was near. It took the 

Chart 4.2 Detecting Intraday Volume Surges Using a 7-period VMA, Apple Inc., 60 Minutes

Chart 4.3 Detecting Short-Term Volume Surges Using a 5-day VMA, Apple Inc., Daily

bottom 5 months to form because of the extraordinary market events unfolding at that time. The October 2008 volume surge alerted traders that buyers were stepping up to defend the $80 level, which provided support until the broader market turned in March 2009, allowing Apple to begin its strong uptrend.

Chart 4.4 Detecting Intermediate-Term Volume Surges Using a 20-Day VMA, Apple Inc., Daily

Linear Regression Overlay

A linear regression line can also be used as a volume overlay to show volume trends more clearly. Linear regression analyzes the relationship between two separate variables in order to define a single relationship that is plotted as a straight line —in this instance, volume and time. As volume totals can be very erratic from day to day, a linear regression line provides a straight trend line that can easily be interpreted, if a trend is indeed present. Linear regression is a tool that is available with more advanced harting packages. If you have the ability to add a linear regression line, it can provide an easy at-a-glance interpretation of the trend and the strength of the trend.

The linear regression overlay (LRO) is interpreted similarly to a moving average, but it has two distinct advantages over moving averages. First, unlike a moving average, a linear regression indicator (LRI) does not exhibit much lag. Second, since the indicator is not averaging volume, but rather “fitting” a line to the data points, the linear regression line is more responsive to volume changes.

Chart 4.5 for JPMorgan Chase shows a daily time frame from April 2007 through April 2008. In this instance, a linear regression line instead of a moving average has been plotted. Notice how straight and clear the linear regression line is compared to the previous moving average example. 

Chart 4.5 Linear Regression Overlay, Downtrend, JPMorgan Chase

Moving Average Convergence/Divergence Using Volume

The MACD price momentum indicator was developed by noted technical analyst Gerald Appel. Unlike the previous two overlay examples, the MACD of volume uses its own volume scale rather than sharing the volume scale used for individual volume bars. It is included in this overlay section, however, because its plot not only closely mirrors that of the volume bars, but also can give insights into volume momentum that are useful to traders employing a shorter time frame for their analysis.

The MACD is a trend-following momentum indicator using the difference between a 12-day exponential moving average and a 26-day exponential moving average to compute a singular daily value. An exponential moving average (EMA) is a technique for weighting more recent data more heavily in the averaging calculation; a 12-day EMA gets more weight from the most recent values and thus is more sensitive than a 26-day EMA. The difference between the two numbers indicates direction and strength.

The raw MACD figure, in turn, is normally plotted with its own 9-day exponential moving average, which is known as the signal line. Crosses above the signal line on the MACD show that volume momentum is building, while crosses below show that volume momentum is slowing.

Also, MACD values above zero are viewed as having positive momentum, while values below the zero line are viewed as having negative momentum.

The volume MACD can be used to pinpoint where volume momentum is peaking in relation to price. For JPMorgan Chase (JPM) in Chart 4.6, note how the MACD peaks at price lows (the solid black lines) and troughs at price highs (the dotted lines). This showed that volume momentum was building on sell-offs and diminishing on rallies or consolidations. This is another method of showing that sellers were in control during this time frame and that the downtrend was likely to continue.

Confirming Trend Strength: Robust Trends

In Chapter 3, we presented a brief overview of the market trends and volume/price patterns you will encounter as a trader. In this chapter, by using Volume Analysis we will take a more in-depth look at the trading terrain with a focus on consolidation/continuation patterns in trending and sideways markets. In Chapter 5, we will focus on reversal patterns. Once we’ve determined the price-trend direction, we will take a “read” on that trend. Price-trend direction can be determined using the price plot,

Chart 4.6 Volume MACD Confirms Downtrend, JPMorgan Chase

price bar, price indicators, or a moving average. Our Volume Analysis here will focus on the volume that precedes and confirms that trend. A robust trend is one that is showing a discernible trend in price (whether up or down), along with a simultaneous expansion in volume. Volume levels show how strongly market participants feel (intensity, sentiment, and conviction) about the future value of a security, whether the perceived value is higher or lower.

Confirming Robust Trends with VMA, Linear Regression, and MACD

Chart 4.7 for Newmont Mining (NEM) shows how the rising 50-day VMA confirmed the strong uptrend in price, signaling that this was a robust, healthy trend. This is a classic example of demand overwhelming supply, which is shown by the rising price and rising volume trend.

Chart 4.8 shows a linear regression plot line of volume for Newmont Mining. The rising slope of the line is an indication that more buyers are entering over the entire period, reinforcing the upward price movement. Note again how straight the regression line is and how easy it is to interpret.

 

Chart 4.7 Robust Uptrend Confirmed by 50-Day VMA, Newmont Mining

Chart 4.8 Robust Uptrend Confirmed by Linear Regression, Newmont Mining

Finally, we show how a volume MACD can be used to confirm robust trends, in this case an uptrend. NEM in Chart 4.9 is an example of the MACD of volume during the same uptrend. Note how the MACD peaks at short-term market tops (the dashed lines) and crosses below the MACD zero line during corrections (the solid lines). This shows strong buying pressure on rallies and weak selling pressure on pullbacks.

Carrying the example further, everything seems fine with the uptrend until NEM breaks out to even higher highs in early 2006. Notice how the MACD of volume is much weaker on its pushes higher as price moves sharply higher. This was an indication that the uptrend was in its latter stages and that there were fewer buyers to support the trend. It would have been a prudent time to lock in profits.

If we view the end of Chart 4.9 and move forward (see Chart 4.10), we can see what followed the MACD of volume warning just described. Price pushed to new highs, but the MACD of volume failed to confirm the price action, indicating that buying pressure was slowing. NEM then corrected over 22 percent, demonstrating the value of the MACD warning given.

 Chart 4.9 Robust Trend Confirmed Followed by Nonconfirmation, Volume MACD, Newmont Mining

Chart 4.10 Robust Uptrend and Reversal Following MACD Nonconfirmation, Newmont Mining