Volume Basics: A Trader’s View

VOLUME BASICS: A TRADER’S VIEW

Is it volume which causes price changes, or do price changes cause volume —the hen or the egg, which came first?

— H. M. Gartley, Profits in the Stock Market

Having recognized the value of volume, he spent only three paragraphs discussing this highly important and valuable take Why was so little consideration given to volume? One explanation is that the data required for Volume Analysis were largely unavailable at the time and reserved only for the eyes of an elite group of market participants, an “insiders' club" comprising floor traders, market makers, and institutions.

Today, with the development of sophisticated desktop trading interfaces along with more readily available market data, traders can access information that was previously in the exclusive realm of insiders. This more accessible data flow has opened the door into the realm of Volume Analysis and the strategic deployment of volume-based indicators, oscillators, and overlays to enhance trading performance.

In this chapter, we challenge you to rethink any preconceived notions of price and volume as they relate to your trading strategy and offer you a short primer on the basics of volume.

The Case for Volume

Volume Analysis provides a trader with a clear and focused view of the collective behavior of financial market participants. Overwhelmingly, we traders have been indoctrinated with price-based indicators, but what if what is lying under the hood staring us in the face has eluded us? What if, at the end of the day, the behavior revealed by volume is the high- octane fuel that creates, accelerates, or decelerates market conditions?

We’ve been told that market trends are created by market participants agreeing in aggregate that a fair price for a stock or commodity can be found and that price moves accordingly to higher or lower levels. In Volume Analysis, we view the development of market trends as a dynamic process that cannot simply be explained based upon price movement alone. Our standard for identifying and predicting trend changes incorporates the volume action accompanying these price movements. Throughout our exploration of volume, our guiding principle will remain arguably simple.

Volume Action Is Linked to Price Movement

Most traders have a minimal understanding that a price move accompanied by strong or heavy volume is likely to continue in its current direction, and, conversely, if volume is lighter than "normal,” the trend may be suspect. These concepts are about as in-depth an understanding as most traders will ever develop about volume. So what of the behavior of volume in technical chart patterns, in trend continuation and reversals, and in volume overlays?

It is our belief that volume is an essential component of every price move and pattern. If a trader is unable to read or translate volume information, if his understanding of it remains limited, then he is forced into the trading strategies and routine guidance more commonly serving the interests of the institutional crowd. By taking our trading off-road and examining the complexities of volume, we are taking a detour from trading based on price-driven data alone. It is our hope that as you explore the pages of this book on volume, you will gain predictive insight into trend direction and reversals and ultimately develop your own set of defensive tactical strategies.

A Dynamic Volume Analogy

There are many analogies to describe the dynamic effects of volume on price trends. Most commonly, it is compared to fuel in a car engine. If the tank is low on gas (i.e., weak volume), the car engine eventually will falter and stall. Had the tank been full (i.e., strong volume), the car would have just cruised on down the road. Just as too much fuel can flood an engine, too much volume, in the form of spikes and surges (indicates an emotionally charged trading environment), can signal that the “engine” might stop heading in its current direction (i.e., a change in trend is near).

Remember: Volume action is inextricably linked to price trend movement.

In The Traders Book of Volume, our focus will be to translate the meaning of volume information into trading strategies and ultimately into tactical volume overlays. How to begin to do this is to understand some volume basics; the coordinates we are measuring will act as our guide. We begin by understanding what information is embedded within and represented by volume.

Volume as a Measure of Supply and Demand

On any given day, both volume and price in the markets are constantly readjusting to accurately reflect the current market environment. If there is an imbalance of buyers in the market, price may adjust to higher levels to entice existing holders to sell their positions to offset demand or buying pressure. If there is an imbalance of sellers, price may adjust to lower levels to entice new buying to offset supply or selling pressure.

As more traders line up and execute their intentions on either the buy side or the sell side, the increased activity shows up in the form of volume. How volume interacts with price on any trading day reveals the level of supply and demand in the market for that security or commodity. The behavior of volume during the trading day represents hard evidence that the imbalance between buyers and sellers is being resolved. Ultimately, it is the volume action, not the price action, as most of us have been taught, that signals the first indication of the direction of that resolution.

Volume as a Gauge of Trader Sentiment and Interest

When we look at a fuel gauge, we get a sense of our ability to go the distance. Similarly, we can take a volume measurement to represent how much bullish or bearish sentiment there is in trading a particular market, index, or issue. Elevated interest in the form of higher-than-normal volume gives clarity as to when and at what level the next potential price move may occur. “Normal” volume will depend on our trading time frame and the unique volume characteristics of the index or issue being traded, but once normal is determined, any departure from that is significant.

A case in point: Using a volume moving average, a trader can identify higher-than-normal volume with small price swings, which may indicate that shares are being either accumulated or distributed in a sideways market. Below-normal volume on larger price swings, especially in trending markets, may signal to a trader that a shift in trend is imminent. Volume Analysis thus serves to improve a trader's predictive ability as to the timing and direction of trends and reversals.

Using Volume to Track the Major Market Players

A major strength of Volume Analysis is its ability to track the trading activity of the largest market participants: that is, mutual funds, large hedge funds, and institutional players. These elite players often intentionally camouflage their positions. By using Volume Analysis, a trader has the ability to recognize their volume patterns and uncover their tracks. Traders with volume expertise are in the enviable position of being able to take the lead or tailgate their positions.

Measuring and Charting Volume Data

Much as drivers assess coordinates before taking their vehicles off-road, we will be taking a preliminary look at how volume data are measured and charted.

Volume is very versatile in that it can be used in its “raw” form (which is expressed and read simply as volume bars plotted at the bottom of a chart) or in “smoothed” form (which uses a calculated overlay such as a moving average). These pure volume measurements can in turn be used alone, as components of other volume indicators, and in combinations, ultimately allowing us to gauge our trading terrain.

Volume has been defined for charting purposes as the number of units traded during a given period of time. These units are typically represented by either shares or contracts. Volume is plotted with price to determine the strength or conviction behind price movement. There are several variations in the way this volume information can be displayed on stock and commodities charts. These different methods of display have their own strengths and weaknesses. Our trading time frame generally dictates our display preferences. This section explores some of the more common ways to exhibit and interpret volume information on common stock or other security charts.

Bar Plots

The most common method for plotting volume is the standard bar plot. The bar plot allows for quick analysis between price points to measure the strength or conviction behind a move. Chart 1.1 shows a simple bar plot of volume.

 Chart 1.1 Bar Plot, Nasdaq 100 Trust ETF Daily

Chart 1.2 Futures Contract Volume, Nasdaq 100 Index Futures

Bar plots of volume can be either zero-based or based on the lowest volume total in a data or time series. In either case, a good bar plot gives the bars a consistent, uniform starting point, which makes comparisons between values easier. For instance, in Chart 1.1, notice how volume spikes higher at price lows on the chart. Later in the book, we will examine the meaning of these spikes and their implications for future price movements.

Although the example in Chart 1.1 shows the trading of an exchange- traded fund (ETF) in the form of shares, we should note that such volume depictions also work for futures, which are sold as contracts, not shares. Chart 1.2 shows an example of volume expressed in contracts traded.

Colored Bar Plots

One preferred way to enhance the display of volume is to color the volume bars. Many charting packages allow for the coloring of volume bars, making it easier to distinguish between days in which price closed higher and days in which price closed lower. Chart 1.3 has volume bars colored in black on days when price closed higher than the previous day,

 

Chart 1.3 Colored Volume Bar Plot (Grayscale), QQQQ Daily, Nasdaq 100 Trust ETF Daily

while days that closed lower than the previous day are colored in gray. Although our color choices in this book are limited to shades of black and white, other colors, most commonly red and green, can be used in most charting software. These color differentiations allow for quicker identification of positive versus negative volume.

Simple Line Plot

The simple line plot is another method that is less commonly used for displaying volume. Rather than displaying volume bars, volume is shown as a line. Chart 1.4 shows a simple line plot for volume. Showing volume in this way can allow for a quick analysis of volume spikes and surge patterns. It will not work on more thinly traded (lower-volume) securities, as the line plot can be very erratic. Unlike the bar plot, smaller-scale shorter-term volume comparisons are more difficult to measure.

Volume Moving Averages

The selection of a volume plotting methodology increases in importance when adding overlays to volume. One of the most widely used methods

Chart 1.4 Simple Line Plot, Nasdaq 100Trust ETF Daily

of analyzing volume data is with a calculated volume moving average, more commonly known as a “VMA”

A volume moving average shows the average number of shares or contracts that have been traded over a set period of time. In the Nasdaq 100 Trust ETF (QQQQ), Chart 1.5, a bar plot of volume also contains a 9-period moving average of volume, a common volume moving average setting for shorter-term traders. (We'll discuss time frames in more detail in Chapter 7.) Note how the volume moving average plots make it easy to spot the days where the daily volume jumped above the average.

We've examined some of the different ways that volume data, the basic building blocks of Volume Analysis, can be displayed to accommodate a trader's charting preferences. Placing pure volume (bars) below price on a trading chart establishes that first reference point for Volume Analysis. In the remainder of this book, we will be taking a new perspective on the volume window and focusing on translating these volume bars, indicators, oscillators, and overlays into profitable trading signals and strategies.

Chart 1.5 A 9-Period Volume Moving Average with Bar Plot, Nasdaq 100 Trust ETF Daily

Summary

• Volume has the ability to uncover the movements of larger market participants and track their “footprints in the sand”
• Volume serves as a gauge of supply and demand and overall trading conviction, and is inextricably linked with price movement. Volume can be used to predict the direction, strength, and timing of those trends.
• Volume data, in conjunction with price information, may be charted in a variety of ways. The basic volume bar plot with a volume moving average (VMA) overlay is one of the most effective ways to chart the volume/price relationship.