Five Powerful Volume Patterns

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Alan Farley

25 Feb, 2005

in Technical Analysis and 1 more

Volume patterns are much harder to interpret than price patterns. The difficulty stems from the clandestine strategies of big market players. These folks tend to move slowly and cover their tracks within the broad noise of daily movement.

While price bars tell many tales in a vacuum, volume has little or no meaning without underlying price movement. But don't abandon your volume study just yet. It still adds power to prediction when you apply it judiciously.

The importance of volume depends on its location within the overall pattern. For example, heavy volume through a broken trend line suggests the start of a new trend, while the same activity after a long rally or decline predicts a reversal. This counterintuitive logic confuses traders and inhibits their ability to decipher volume at key turning points.

Here are five volume patterns that show considerable predictive power when interpreted correctly. Watch for these setups whenever you're flipping through your charts. Then realize how volume can yield vital information long before price action tells the tale.

Awakenings

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Stocks often go dead for long periods after vertical rallies. The trick is to be prepared when they start to wake up. Petroleum Development (PETD) rallied over 500% in a bull market run that gave way to a long sideways market last March. Then volume begins to spike at two- to four-week intervals after the stock prints a May double bottom.

Volume-building into a congestion pattern after a discernible low often signals renewed buying interest that precedes a breakout. Notice how Petroleum Development's buying cycle finally lifts price into a test of the 52-week high in the low $30s. The stock pauses above resistance for two weeks after the breakout and explodes into a fresh uptrend.

Shock Spirals -- Down

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Tony Plummer examines the shock spiral in his classic book The Psychology of Technical Analysis. In this text he shows how unexpected events can trigger rapid price movement that takes on a spiral quality. Multimedia Games (MGAM) downward spike last summer certainly qualifies as a shock spiral event.

The trick with this phenomenon is to look for an A-B-C pattern in which A and C move in the same direction as the shock, while B moves against it. Additionally, the A and C waves often stretch to the same length, creating a "measured move" scenario. This translates into a substantial decline toward single digits for the casino provider.

Shock Spirals -- Up

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Shock spirals can occur in either direction. MedImmune (MEDI) triggered a huge volume spike when Chiron (CHIR) had to pull its competing flu drug off the market. Notice how the spike pushes the stock above strong resistance. This could set up an A-B-C rally, with the C wave breaking above the May high and sending price toward $30.

Is there any real difference between this pattern and a typical breakout pattern? Absolutely. The huge increase in participation across the former resistance level suggests price won't trade under the spike bar low for months or years to come. Routine breakouts carry a much higher failure rate.

Climax Events

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Climax events are counterintuitive because they signal the end of a trend just when the crowd piles into a stock. Notice how Cree (CREE) moves higher in two slow but steady rallies. The pace then quickens while volume starts to increase. Finally, price goes vertical for a few sessions, with volume peaking at a new high.

But both rallies run out of steam immediately because the stock has run out of buyers. This lets gravity kick in and trigger substantial declines. Watch out for the classic signs of a trend blowoff when you're trading vertical rallies or selloffs. Climax markets can turn you from a shareholder into a bagholder very quickly.

On Balance Volume

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XM Satellite Radio (XMSR) shows all the signs of a breakout above $32, except for one thing: The on balance volume, or OBV, pattern is very weak. This bearish divergence sends a strong signal to stand aside and let others take the risk of a false breakout. It also suggests that a good short sale could present itself, if and when the pattern rolls over and starts to break down.

OBV is a great analytical tool, but use it sparingly. It's most effective when price is approaching important tests of old highs or lows. But it's best to ignore the indicator while markets are grinding through the debris of old congestion patterns. Accumulation-distribution data are much harder to decipher when markets are going nowhere.

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On Balance Volume

I'll highlight one point. The last 'example' uses OBV and recommends "It also suggests that a good short sale could present itself" lets take a look at that stock now to see if this may have been worth looking into.(check chart now for added impact) Whoops! the stock screamed to new highs! This guy doesn't seem to familar with how to read an OBV. The two peaks he was looking at that show negative divergencee too far away to be labeled or recognised as OBV divergence. I dont believe you can use OBV in such a long term manor. Now looking at closer peaks, like the ones with the read dots on the charts, they can be used for divergence. Higher highs in the these two examples. And the second high (under 2nd red dot) is also a higher OBV high, confirming higher prices. The short term is much better for using OBV. Normally a few weeks to a few months but certainly not over nearly a year. This was a terrible example for Alan to pick. OBV is good when used properly. IF 2 short term higher highs print on a chart and the OBV prints a lower high on a second peak then take it into account. OBV's not great for a long term picture like the example Alan gave.

Mar 06, 2005

Member (234 posts)

"Here are five volume patterns that show considerable predictive power when interpreted correctly. "

This is the type of finalising statement that I have read so often in teaching articles. In the end, the onus is on the reader to do the interpreting correctly.

My personal opinion is that volume read in that way is not much use.The charts can be scanned as often as Farley likes and there will always be examples to back his arguments, except the ones I pick, but perhaps that is because I am a bit thick.

I believe that the number of trades is more important. Perhaps, because that data is less easily come across is the reason why it is so little publicised.

Split

Mar 06, 2005

Member (9070 posts)

Smells like Jack Schwager's "well chosen examples" to me. Look more closely at the chart provided:

PETD: OK there is a "double bottom" but go left to the action just after the first hit of the blue line. Why isn't that a double bottom?

MEDI: the volume spike circled is hardly that different to the one in late April or an even earlier one in late Feb. The stock subsequently did stay above 25 for a month or two but not by much and subsequently dropped back under it now.

CREE: great so what's so different about shock spiral up/downs v climax apart from what we can see AFTER the event

XMSR: for every one of these there are examples showing the exact opposite.

Overall this is poor stuff. If Alan Farley wants to demonstrate the effectiveness of these techniques he must back them up with statistical evidence - otherwise they are not worth a jot - and sadly he knows that too but still posted the article. Ask yourself why.

Ste1

Mar 06, 2005

Member (20 posts)

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