Volume - The Other Confirmation Measure

Volume: The Other Confirmation Measure

Confirmation remains the key to SR analysis and to all other forms of price study, notably when trying to anticipate target levels. Confirmation is especially important when trading decisions are going to be made based on what appears to be going on with price.

However, price alone does not reveal every form of confirmation. Volume and the way that it changes is also critical in validating a breakout from SR levels. For example, if the neckline of a head and shoulders top is broken, the technician would expect to see an increase in volume as prices rise. This volume trend associated with price breakout serves as a confirming indicator in establishing the change in a trend.

Volume analysis can also serve as an indicator that disproves what appears to be happening in the price movement. For example, if the volume does not increase during a breakout from SR, then what otherwise appears as solid evidence may be considered suspect and due to some event unrelated to the stock or simply a false indicator. For example, a broad market index such as the Dow Jones Industrial Average may break through resistance and many stocks may breakout as well. However, some may bid up due to crowd mentality, while others may move higher due to improving fundamentals and institutional buying activity. While breakouts accompanied by a substantial increase in volume are solid confirming signals, an apparent breakout with low volume may be a false indicator, and a retreat back to the established trading range is likely.

Volume should change in a consistent and measurable form if it is to be considered as confirming information. For up trends, the volume will expand in the direction of the trend, and during pullbacks or consolidations, the volume numbers will recede. However, if the volume reaches an unusually high level in a short period of time, that could signal the culmination of the trend and serve as a contrary signal. This buying or selling climax would predict a reversal.

A bottom may take the shape of a two-step process forming a major support level and involving changes in volume. A bottom formation took place in Diamonds (DIA), in March of 2001 shown in Figure 7-1. The first leg was a climatic sell-off. Here, institutional investors liquidated their long positions at Point A. Next, the market rallied as short position holders took profits. The rally stalled, and the price retreated back down to the low, retesting the first bottom. During this decline, the volume did not expand, indicating that there were no more sellers in response to the lower prices (Point B). Technicians call this a sold out market. The major support level was established at the heavy volume day. At this

Figure 7-1

point, the market has discounted all of the negative figure 7-1 fundamental and formed a major support level. A market top started with a buying climax (Figure 7-2, Point A). Here, the news had been positive, and more and more buyers jumped onto the trend.

Profit-taking caused a decline in price, retracing 38% to 50% of the previous rally. After this, the price began to advance, retesting the first major resistance level, but this time volume did not rise as higher prices were paid (Point B). This anemic retest of the previous high indicated that everyone who could have bought was already long. Resistance was set one day after the big volume day, and a second, lower resistance level followed. Any negative news at that point would have caused profit-taking. If the news had been negative, the likelihood of a major

Figure 7-2

the top was high. Major resistance had been established on the charts.

Volume Indicators

Technicians have developed a host of volume-based indicators to confirm a breakout of SR levels. The most common is the on-balance volume indicator (OBV) developed by Joe Granville.¹  This is the running sum of the cumulative volume weighted by whether the market closes up or down for the day. If the market closes up, then the entire day's volume is added to the previous day's OBV value. If the market closes down, then the entire day's volume is subtracted from the previous day's OBV value. Traders look for the OBV line to confirm breakouts and the trend. Thus, if the market breaks out of a trading range, then the OBV line should break out as well. As an even stronger indicator, the OBV may lead and, thus, anticipate the price breakout. Once in an up trend, the OBV line should steadily rise as the price trends higher. If the OBV line begins to diverge, tracing out lower highs while the market is making new highs, a reversal of the trend is anticipated.

For market tops, when prices break, a key support line the OBV line should also break. It is an even stronger indicator if the OBV trend precedes the price. A down-trending OBV line indicates that more volume is occurring on down-closing days than on up-closing days. If the price continues to trade

Figure 7-3

within its trading range, the OBV line may predict the direction that the price can be expected to move in the coming breakout. Figure 7-3 is the Nasdaq 100 Trust (QQQ). The daily chart edged to a new high in September, but the OBV Line stopped at the previous high. Next, as the QQQ began to work lower, the OBV line broke through support before the same move in price, a good example of the OBV leading. One problem with the OBV indicator is the price may close down just a few cents for the day, causing all of that day's volume to be subtracted from the OBV line. The calculation is an all-or-nothing without weight being given for volume variations. The accumulation/distribution line² is another indicator that weights the volume by the percentage placement of the closing price relative

Figure 7.4

to the day's range, and then adds that adjusted volume number to the previous day's accumulation/ distribution line. This indicator takes into account where the market is closing each day and tracks volume accordingly. Most technicians view the accumulation/distribution line as superior to the OBV line based on the weighted volume. The accumulation/distribution line was improved further by taking the sum of the weighted volume over the applicable period and dividing it by the total volume. Figure 7-4 illustrates a positive reading that confirms a breakout above resistance.

Summary

The level of volume accompanying a breakout below support or above resistance provides confirmation of the breakout, or a lack of corresponding volume increases serves as an indicator that those breakouts are false and will retrace. The addition of volume-based indicators vastly improves the technician's ability to accurately predict price movement.

Remember, though, that the forward-looking analysis of price and volume serves only to improve your outcome, not to completely eliminate risk. We have to accept the reality that the whole purpose of this study is to improve our predicting and analytical skills. The next chapter summarizes modern trends in the science of SR.