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(A brief introduction to volume analytics)
The terms “volume analytics” and “volume analysis” are used interchangeably. As the name implies, it is the study of the volume behavior of stock market exchanges and indexes with the purpose of determining probable future price reversals. The extensive body of knowledge associated with this approach has given rise to a view of the markets that is proven, time-tested, highly consistent, and profitable. We apply volume analytics principally to the major US indexes.
Volume analytics is not an exclusive discipline. It can stand fully on its own, yet may also be used in conjunction with other technical analysis methods. In fact, this approach could well be the missing piece of the market analysis puzzle that so many traders have been seeking.
Volume analytics’ basic premise is that volume and index behaviors are closely interrelated and that the trading patterns of an index can be predicted, or at least anticipated, from a proper understanding of the unfolding volume patterns. Below, we will first outline and discuss a few of the basic principles and applications of volume analytics, then provide actual chart examples from the S&P 500. We will also give you a few simple rules and tips on getting started in volume analysis.
With the myriad of technical indicators and trading approaches available today, the question arises: why bother with volume analysis at all? The answer is that volume is the best and truest sentiment indicator for what is really going on in the markets. Volume is the underlying cause of all price movements. Without a change of volume, the price of a security cannot move. To make this point, imagine that a (thinly traded) stock does not trade at all on a particular day. Consequently, that stock’s price might not even be listed in the newspaper the following day – because if there is no volume (i.e., no one is buying and no one selling), it logically follows that there can be no price change (price movement). On the other extreme, if there is unusually high interest in a stock, everyone will hear about it, because volume levels will spike far above normal, signaling “something big and significant” went on (or is expected).
Without a doubt, a detailed study of volume patterns has much to reveal, much more than is commonly believed. One of the reasons volume analytics has not always received the attention it deserves is that intraday real-time volume data and charts for entire indexes were not available until recently. Now that they are, you have the opportunity to closely monitor and analyze the volume behavior of a particular index, as it unfolds in real-time. This allows you to heed one of the golden rules of trading, “Do not play against the market”, which brings us to our next topic.
Why apply volume analytics to indexes and exchanges, rather than to individual stocks? Indexes best describe the mood of the market as a whole. Regardless of what you trade, a particular index or sub-index, stocks, options, futures, most of these trading vehicles tend to move in concert with the broad market. As a rule, the market dictates the direction of a particular security, never the other way around. It therefore makes sense to get a good grasp on what is happening at the index or stock exchange level, and we have found volume analytics to be an excellent vehicle to make that determination.
Before starting our discussion on how volume patterns drive index reversals, we need to define several terms.
Volume Moving Averages (VMA): Every trader is familiar with moving averages of securities prices, perhaps the most frequently used technical indicator. We simply apply the concept to volume, rather than to price, and plot Volume Moving Averages (VMA) that range in duration from as short as a few minutes to as long as several months. However, there is a slight twist to this: Volume activity typically follows certain predictable patterns throughout the trading day, with high levels prevalent immediately after the open, lower values around noon, and increased levels once more toward the close. We call this pattern the “time factor”. Unfortunately, the time factor provides a rather distorted picture of the daily volume activity. It makes it difficult to differentiate those volume events, which are truly significant, from those that are simply part of the normal daily fluctuations. We have solved the time factor issue by normalizing volume data before charting it. Charting normalized volume allows a much clearer determination of whether or not volume levels are spiking above normal levels, an aspect that is at the core of our methodology.
I am interested in the appearance of large peaks (“spikes”) in the VMA - known as VMA spikes – and how an index reacts when they are generated. Sudden VMA surges are indicative of bursts of significant buying or selling activity. As such spikes occur, we determine whether the index is moving up or down at that time. If the direction is up, we call the associated volume surge a resistive VMA spike; if the index direction is down, we label the spike a supportive VMA spike. In the absence of distinct volume spikes, we still call any volume generated as the index is moving up resistive volume, as it moves down, supportive volume.
The most basic premise of volume analytics is that we can always anticipate an index will react to (significant) volume spikes – as a rule, resistive volume spikes will force a downward move in the index; supportive volume spikes will generate upward index momentum. This basic assertion must be qualified by two key questions:
1. What determines the extent and characteristics of an anticipated move: Will it be short-lived or have “staying power” over the mid- to long-term? Will it be gradual, sudden, or volatile?
2. What determines when an anticipated move will most likely occur: Will it happen immediately, promptly, or will there be a certain time lag (a “delayed volume reaction”)?
Research shows that the answers to these questions vary considerably, depending on (a) the general market context, and (b) the technical characteristics of the actual volume spike(s) being analyzed. Therefore, in order to get the most value from volume analytics, it must always be placed in the proper context:
Market context: Where in the larger market picture do supportive / resistive VMA spikes appear: During short-term pullbacks within a larger uptrend? As part of short-term upside corrections within a larger downtrend? At the presumed end of a weakening long-term trend? At the beginning of a new trend or somewhere in its middle? During distinct trend runs or in markets with choppy sideways trading action (i.e., in support / resistance corridors)?
Technical considerations: When analyzing a VMA spike, consider its magnitude, both vertically (the height of a thrust) and horizontally (its width or breadth). Comparatively larger and / or wider spikes obviously carry more weight. Caution must be exercised when analyzing volume spikes on a short time frame, as their potential impacts on mid- or long-term trends can easily be misjudged. A noteworthy spike appearing on a 5-minute chart could well affect an index in the short-term, but it may not necessarily have much of an impact on the prevailing long-term trend. A spike may look imposing and appear to be critical on 1-day chart, yet it may not loom as large on a 30-day chart or even seem significant at all on a 60-day chart.
The following suggestions will assist you in making the most of volume analysis.
When you look at the big volume spikes shown in the following examples, ask yourself what could possibly have caused all this extraordinary volume activity and how might this affect the S&P 500 index. Quite simply, the market can react in one of two ways: either continue along its current path or reverse course and head the other way. Index values will always (sometimes immediately, sometimes with a delay) react to volume spikes, and the greater the magnitude of a spike (or series of spikes), the stronger the ensuing reaction. (The many complex reasons why sudden volume surge take place are beyond the scope of this article).
Example 1: Remember last year, when the long market downtrend finally reversed and switched to a steady up-trend?
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Fig. 1 |
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Again, a volume analysis chart provides us with fresh insight. Three volume spikes (two large ones in July and October 2002, as well as a smaller VMA peak in February 2003) correspond with a distinct long-term trend change for the S&P 500. You could argue it was prompted by the outbreak of the war in Iraq. However, our volume analysis indisputably demonstrates that that index “was ready” to move up, given the large buildup of supportive volume, as evidenced by the two very significant volume spikes. It could also be argued that the new uptrend actually began on October 10, 2002 and that the January 2003 move to retest the recent lows was just a mid-term correction of the new up-trend.
Example 2: Do you remember the market action in March 2004?
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Fig. 2 |
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On this 30-day chart, you can clearly establish that each major volume spike was followed by an index reversal.
Example 3: Fig. 3 shows that the discussed relationship between volume spikes and index reversals applies equally well to the short-term, not just to the mid- and long-term. Note how each volume spike coincides with an index reversal point.
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Fig. 3 |
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Trading remains an inexact science, or perhaps more fittingly, an art. Every trader knows that no system or analysis technology is 100% perfect, and neither is volume analytics. We have just touched on the topic briefly here, yet the examples provided should have given you at least an idea of the benefits this proven and refined methodology could bring to your trading. If you would like to add volume-based approaches to your trading arsenal, please visit www.MarketVolume.com for further information. There is much to discover.
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