Within technical analysis, the examination of volume should always be hand in hand with examination of the trend and other technical patterns. Many traders ignore volume at their peril, and strangely enough there are very few volume based indicators compared to the many hundreds of price based signals available on current trading software. Although volume has great relevance to trading signals, price action is though always the ultimate determinant of buying or selling decisions.
The most popular indicator until very recently, and the one featured on most software, is called ‘On Balance Volume’, which is simply a running total of volume. This simple indicator aims to highlight if volume is flowing into or out of a share. It is constructed as follows: If the share closes higher than the previous close, all of the day’s volume is considered up-volume, and it is added to a cumulative total, and vice versa. This cumulative line is then plotted against the share price.
The indicator was developed by Joe Granville and was highly popular in the 1970s and early 1980s. The basic observation is that changes in OBV precede price changes, so a rising OBV line represents ‘smart’ money flowing into a share. Ideally both price and OBV should rise together, and both can be measured in terms of straightforward trend observations, such as higher highs and lows.
Sometimes the share price movement precedes OBV movement, which is known as a "non-confirmation". Non-confirmations can occur at bull market tops (when the share rises either before or with no associated OBV or at bear market bottoms where the reverse happens.
A more precise indicator – weighted volume
For many traders OBV is something of a blunt tool as it takes no account of the price movement on the day, and in a trading range market it can be very volatile and hard to interpret.
There are several indicators available that attempt to refine OBV, but it is possible to take this to another level by a two stage process. First we measure the daily volume and compare it to the average recent volume. We then measure the actual price movement which is incorporated into a composite indicator, to become a weighted volume index.
This has two effects: first, this indicator is far more precise, in as much as it reflects more accurately how much the volume relates to comparative price movements in the share. Second, we can pick out excessive price and/or volume moves each day. Once this is loaded into the software, it is easy to scan the market each day for volume and price anomalies.
Another filter – using candlestick analysis
There is one other filter that traders need to use to refine their entry points, and the reason is that there are times when price has moved sharply away from the previous close and volume has been high, but the intra-day action has been negative. In this case, the actual signal may be the opposite of the above, as this might show that the sharp money is actually fading the move.
Often at market tops, there is a violent price rise through the day, but the price ends up closing towards the low point for the session, even though it is still ahead of the previous close.
Volume indicators would show that action as bullish, but viewing the day’s candlestick would give a warning sign, and this might be viewed as a precursor to a possible top in the stock.
Volume spread analysis
This excellent body of work is a variation on the above and is another useful addition to the trader’s ammunition.
Volume Spread Analysis looks at the interrelationship between three variables on the chart in order to determine the balance of supply and demand as well as the probable near term direction of the market. These variables are the amount of volume on a price bar, the price spread or high/low range of that bar, and the closing price within the day’s range.
It is very difficult to construct an indicator containing all these bits of information, so the idea is to become visually accustomed to the signals as they occur.
VSA looks to pigeon-hole the market into four market phases: accumulation (where the smart money has bought), mark-up, distribution (‘smarts have sold’) and mark-down. The volume indicates the amount of activity going on, and the corresponding price spread shows the price movement on that volume. If there is an imbalance of supply, the market has to fall, and vice versa.
The idea is to pick out where the professional money is heading, because these operators trade with very large size, and they have to sell into up bars when the herd is buying, so that is how they unload their large size onto the public.
Many times, these types of bars are created from news reports that appear very bullish to the general trading public and invite their participation on the long side of the market. When this occurs, it creates the opportunity for professional operators to systematically sell their holdings and short the market, without driving the price down against their own selling.
When this type of pattern occurs, it signifies a transfer of ownership from the professionals to what VSA refers to as "weak holders," traders that will soon be on the wrong side of the trade. The analogy is the professional operators selling at retail or distributing when earlier they established their positions by buying at wholesale or accumulated.
The best volume signal in the market
There is a final and highly important signal where there is a clear reversal matched by climatic volume on both candlesticks – you need a black candle followed by a white one or vice versa, and both must have a wide range with the close towards the end of the range.
These patterns occur right at the end of a big down move, and whilst there may be some backing and filling, the upward thrust that sometimes follows may be exceptionally strong. This is a counter-trend, but potentially excellent signal for short term traders.