The Hidden Strengths of Volume Analysis Nick Radge
The power of correct volume analysis cannot be overlooked. Unfortunately the ability to read volume correctly is not readily discussed or freely available. Off-the-cuff remarks such as, “increased volume on advances is bullish and increased volume on declines is bearish” are bantered around but that’s as far as it goes. The correct use and application of volume can make for some quite startling insights into price action, especially when one is swing trading or leaning against support and resistance points or zones of confluence. I set up my charts with a couple of extra volume measures. I use a normal volume histogram that can be found with almost all software packages. However, if there is a larger volume spike skewing the ability to read the volume properly I will edit the data accordingly. Next I add a 10-day moving average of the volume. This gives me a guide as to what is below average or above average volume on any given day. Lastly I add in a 2standard deviation of the 20-day volume average. Essentially this is like the upper Bollinger band of the volume average. This shows me when ultra-high volume occurs.
Figure 1: Chart Setup for Volume Analysis
With these added extra’s we can quickly gauge the personality of the day’s volume as well as benchmark it against the surrounding volume. The exact volume reading is not important. The concept of relative volume is the key. I’m going to make reference to The Smart Money throughout this article. The definition I use for the Smart Money is: A group of professional users that act in unison at very specific levels and points of time to change the order of supply and demand. The Smart Money are the one’s who constantly buy the lows and sell the highs. Let me say that this is not a bunch of traders ringing around attempting to manipulate the price. We don’t need to know who or why but these are the people we wish to follow. We do so by watching their footprints and their footprints are show within the daily volume. The Smart Money will show their hands by selling into strength and buying into weakness. Now because the Smart Money can change the order of
supply and demand we can therefore ascertain that strong price action may in fact contain weakness and weak price action may in fact contain strength. I appreciate that goes against most things you’ve ever learnt about volume but it’s important to keep that thought in the back of your mind. Increased supply and therefore weakness may occur during price strength. Increased demand and therefore strength may occur in price weakness. The first thing to understand about volume is that it’s not just the volume by itself we’re interested in. A major misconception is to think that for every buyer there is a seller and in turn volume is null and void. If that were really the case then prices would simply not move. What drives prices is the fear and greed of the buyers and sellers. It’s therefore the relationship and interaction between volume and price that shows us what is really occurring in the market. Think of volume as the effort of one side and the price activity as the result of those efforts. If sellers are desperate to exit then they will be more inclined to sell at the bid rather than sit back on the offer. If there is not much buying demand below the market then prices are going to be driven lower until those sellers are fulfilled or are unwilling to pursue prices any lower. Conversely, if buyers are desperate they will buy the offer and not sit on the bid. If buyers are desperate and there is not much supply above the market then you’re going to see prices move up until those buyers are fulfilled or unwilling to pursue prices any higher. The mantra of volume analysis is: “What is the result of the effort?” The most basic example of a volume/price relationship pattern is a straightforward blow-off top or bottom. As technicians we all know what these are and we also know what they tend to mean. Figure 2 shows a perfect recent example of a blow-off bottom in Lihir Gold (LHG).
Figure 2: Typical blow-off low in LHG
The gap opening on that low day means sellers were indeed desperate. There is no other way to account for that gap except simple selling pressure. They over-ran all buyer demand until they were fulfilled. They even managed to keep pushing prices lower. But remember above I suggested that demand strength occurs in price weakness? LHG had certainly been declining up until that point. So if there were no demand strength, how could prices rise from thereon? The demand strength is shown by the effort and the result. Effort was certainly very high because volume was very high, in fact ultra high. This means a substantial number of transactions took place between buyers and sellers. But what is the result of that effort? The result of all that effort is that the market closed on its highs for that day which means that buyers have clearly over-powered the desperate sellers. When a lot of effort or a lot of volume takes place we know the Smart Money is involved because they are the big players and they are the one’s that can change the course of supply and demand. This is a prime example where the Smart Money has decided that LHG is a value buying proposition and
they move into the market to absorb the selling volume. They are the stronger party. It’s the weaker hands capitulating. This is why I said that demand strength will appear on weakness. If the Smart Money have absorbed all the selling volume and the sellers are fulfilled, how can prices go any lower? They can’t is the basic answer. And if prices can’t go lower then they will tend to go back up because now there is no overhanging supply capping the market. Let’s look at the exact same concept but without the blow-off. Remember the core thinking; increased supply and therefore weakness may occur during price strength and what is the result of the effort? Again we’ll use LHG but note this time the absolute high bar is a very small tight range and not the standard blow-off that we’re normally used to seeing.
Figure 3: The Smart Money appears at the absolute high
Firstly the volume shows itself as extremely high, almost ultra high. We therefore know there are a lot of transactions taking place and in turn a lot
effort being put into the day. So what is the result of that effort? A very tight range with the close on the lows and below the open. What does it suggest? Clearly that the sellers have overpowered the buyers. The buyers must have been desperate because prices have been gapping higher and they were most likely desperate from probable good news. Ever heard the truism, “buy the rumour, sell the fact”? Do you ever wonder why prices go down after a positive announcement? Do you think the Smart Money new the facts or the good news beforehand and is why they’re already long? I think so. So when the good news is announced to the market all the weaker hands jump in and start buying and the Smart Money take the opportunity to offload their positions into the demand strength. Look at that LHG chart again in Figure 3. Prices were already trending higher. The Smart Money has already bought because they knew what was coming. When the announcement came they took their profits and sold their positions to all the latecomers. The force of buying from all the latecomers was large. We know this because the volume was high. But the force of the Smart Money selling and standing firm in the face of large buying was even larger and is why the days range was so small. If the Smart Money thought prices were going to travel higher, then they would not be selling and we would’ve had a wide ranging up day on light volume. But because the Smart Money knew that prices would most likely not go any higher, they stood their ground and simply offered their supply into the buying from the weaker hands. Let’s think about what all those weaker hands are thinking at the close of that session. Good news has been announced. I bought the stock accordingly but it’s now closed below where I purchased it so I’m wearing a loss immediately. You can see them almost scratching their heads! Because the Smart Money had absorbed all the buying demand there is now no follow through buying demand. All the weaker hands are all of a sudden slightly nervous. Any slight weakness will see them exit their positions. They wait a day or so in wonderment but look at what occurred on the 3rd day after the high. A down day on increasing volume. Those weaker hands that bought the highs have had enough and are getting out whilst they can. They walk away with yet another loss but none the wiser for why prices couldn’t go higher on the good news. So whenever you see a very tight range at new highs or lows that is accompanied with ultra high volume, you know the Smart Money is
trading the other way. They are large enough to change the trend so you’d better listen. These are two simple examples of reading volume correctly. There are many more to be aware of, but remember the mantra, “what is the result of the effort?” The best book on volume/price analysis is Master the Markets by Tom Williams who is the Richard Wyckoff of the modern era. Its 190-pages packed with volume and price characteristics and I rank it as one of my top-5 trading books ever. I am such a believer in this book and the information that it holds that a complimentary e-version is given to all my subscribers. Nick Radge has been trading and investing for 20-years. He now publishes Australia’s premier Technical Analysis market letter for stock and CFD traders wanting to learn to trade using price and volume without the hindsight. He holds an Australian Financial Services License and can be contacted via www.thechartist.com.au
The Hidden Strength of Volume Analysis – Part 2 In the last journal I discussed two examples of how and why volume can show the changing face of supply and demand. When the order of supply and demand is change we will get a change in market direction, sometimes a significant change in trend or otherwise some degree of retracement of the prior move. We will continue on from that discussion and show larger periods of transition which can lead to quite substantial turning points in the major trends. These can be easy to identify, but do require some patience. If you did not read the prior article it would now be worth reviewing that before going on. Please refer to the July/August Journal, specifically pages 24 through 27. Let’s firstly take a look at the bigger picture for a stock that is currently in the headlines for all the wrong reasons; AWB Limited.
Since early 2006, the price of AWB has been in a downward spiral. The story that eventually came out suggested AWB was doing some bad business against the UN sanction in Iraq. The initial shock sent the shares plunging by 18% in a single week. This is a sure sign of a change in sentiment and it’s not exactly rocket science to know there must have been some kind of bad news that changes the outlook. But what is important here is that this significant sell off is actually the first sign that strength may start to appear in the near future. As I discussed in the first article, demand strength actually starts in price weakness and here is a sign of capitulation. A wide ranging bar on increased volume is a sign of panic and when we see panic we can usually expect that a bargain could be in the offering, but this is where the patience is required. What we usually start to see after capitulation is a transition from sellers to buyers. This transition has two important characteristics; firstly it takes some time and secondly prices do tend to drift lower. Let’s zoom into the AWB chart at Area 1 and also add our volume indicators.
Bar 1 is the capitulation; a very wide ranging bar and ultra high volume. Remember that ultra high volume is signalled when the volume histogram penetrates the volume Bollinger band. Bar 2 gaps lower but closes on the weeks high and does so on high volume. This is a sign that the Smart Money is interested in buying. There is no other way that prices can close higher on increased volume if buyers were not involved. Bar 3 however shows sellers returning; a push lower, a low close and another increase in volume. Bar 4 is the turning point and is a sure sign that buying interest is occurring. This is the time to start thinking that this market will turn higher soon. This bar shows a move to new lows but a complete rejection, that is, a high close and very high volume. We’re seeing the Smart Money taking positions, even though the stock is drifting lower. Now take a close look at bars 5 and 6. What happens? Essentially they are inside days with a slight downward bias but look at the volume? There is none. Volume has dried right up. What this means is that sellers are done; they’re exhausted. Those that wanted to sell have either been fulfilled or do not wish to chase prices any lower. Bar 7 sees another probe lower, another high close and yet again a rapid increase in volume. Combined with bars 2 and 4, both of which show back ground strength, this is continued evidence that the stock is being accumulated. It’s only a matter of time before enough of the supply has been accumulated that prices will start to rise again. For the next 2 months AWB rallied 34% off that exact low. The first signs of upward price momentum would be the signal to initiate longs. We have the Smart Money footprints in the volume so we just need to time the entry for our own comfort. Take a look at the bars from that low. All down bars had low volume; all up bars had high volume. There was a specific transition from sellers to buyers which led to a reasonable, albeit unsustainable, price rise. The following chart shows that advance in more detail. Bar 8 was a very promising bar indeed; a wide range higher, a high close and a good increase in volume. With the high close we can deduce that buyers had the control. Bar 9 is an important bar for current longs. It shows an attempted push higher, a reasonably tight range but more importantly a weak close and solid increase in volume. This is the first time that sellers had come back to the market. Now these sellers can originate from two sources; either profit takers that bought at lower levels, after all, it was a rapid rise in quick time which will always create profit taking; or it is very old longs who were waiting for the evitable bounce to get out of their positions. We’re not to know which, but what we do know is that selling has emerged and that caution is required.
Bar 10 shows a rise into new recent highs but a close on the absolute lows. This is of paramount importance – what does it mean? Bar 9 showed sellers because we had a weak close yet on high volume. Immediately following, Bar 10 shows a low close on low volume, which suggests buyers have disappeared. If buyers have gone who is going to support the market if those sellers from Bar 9 decide to chase prices lower? Nobody. If there is no buyer demand or buyer support then prices have the risk of falling until that buyer demand comes back again. And that exactly what has occurred. Let’s move forward to Area 2 where prices fall through the early lows set in Area 1. Please refer to the following chart.
Bar 11 makes a low at $3.57, has a close off the lows and shows a mild increase in volume. The $3.57 level is important because the lows made on Bar 7 were at $3.55 which is where the prior buying entered the market. It could be easily argued that those buyers back then should be seen again at those levels. So the minor increase in volume and a close off the week’s lows is an important sign when they correspond with an old low to the left. Prices continue to drift lower as weaker hands stop out below the lows made earlier in the year. However, although Bar 12 closes off the lows it’s quite a low volume bar not quite conducive to a significant change in supply and demand. Prices move sideways on low volume until we see Bar 13 take out the major lows and close on those new lows. The difference here is that volume is poked up through the volume Bollinger band suggesting ultra high volume. Again, this is probably a sign of capitulation as it’s a clear break to new lows suggesting sellers in control. But look at bar 14. Is that not the very same thing we started to see on Bar 2 of the first chart? A wide ranging bar down, a high close and massive volume. In fact this could almost be construed as a blow-off low, although the range is not quite wide enough
for a text book example of such. Nonetheless it does show that buyers are in again. The following bar is a down close but volume has dried up – sellers exhausted? Bar 15 takes out the lows of bar 14 by 2c before rallying hard and closing high. Again, volume was very high suggesting that buyers are stepping up to the plate. Interestingly enough this current price/volume activity is occurring immediately before the findings of the Cole Inquiry. Does the Smart Money know the outcome already? Remember in article 1 I suggested that good news tends to precede a fall and that bad news a rally? Would the release of the report be considered potentially damaging news? Yes it could. We know the old adage that things look the worst at the low and best at the top but it is possible that volume is suggesting that the worst is over and that quite possibly we’re going to start to see prices trade higher. The very last bar on this chart was the release of the report to Parliament. We have a probe above the small ledge but a lower close than the open and a rapid increase in volume. This is not an immediately good sign because it does suggest strong selling. Therefore we’d need to assess the volume/price relationship of the coming few weeks to better measure the willingness of the buyers seen at bars 14 and 15. All in all, the relationship and volume/price is a very strong measure of subtle changes in supply and demand and can lead to both minor and major changes of trend. Therefore it’s beneficial for both traders and investors alike to really understand these nuances so they can better position themselves for new trades or offer warning signs of current trades.
Nick Radge has been trading and investing for 20-years. He now publishes Australia’s premier Technical Analysis market letter fro stock and CFD traders wanting to learn to trade using price and volume without the hindsight. He holds an Australian Financial Services License and can be contacted via www.thechartist.com.au
