Technical Analysis

The Hidden Strengths of Volume Analysis – Part 2

In part 1, 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 now 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.

Let’s firstly take a look at AWB Limited.

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Since early 2006, the price of AWB had 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 part 1, 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.

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Bar 1 is the capitulation; a very wide ranging bar and ultra high volume. Remember that ultra high volume is signaled 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, i.e. 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. This means 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 background 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.

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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 identifies sellers because we had a weak close 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 buyer demand comes back again. And that is 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.

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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 we will see those buyers back again at this level. 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 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 for current trades.

Nick Radge can be contacted at The Chartist

Nick Radge is a professional trader, educator and author – who has been trading and investing since 1985. During this time Nick has worked for numerous international investment banks – from the trading floor of the Sydney Futures Exchange to International Desks in London and Singapore. In 1998 Nick returned to Australia and started a hedge fund. Nick now devotes all his time to The Chartist – a stock market advisory service – and trading.

He is also the author of Unholy Grails – A New Road to Wealth, published in March 2012.

Nick Radge is a professional trader, educator and author – who has been trading and investing since 1985. During this time Nick has worked for n...

wallstreetwarrior87

Experienced member
1,875 347
Hi Nick, once again some nice points for discussion.

I would like to ask a few questions if thats ok?

It is nice of you to do an analysis like this, but can you actually mark down on the charts where you would take your trades based on your reading of volume analysis. That way others can have a better grasp of what you are seeing. If not then this becomes nothing more than pointing out the obvious.

Capitulation is where traders are chasing what others have. It is the final sequence of a cycle. Yet you state that capitulation comes in the form of a down move? (Bar 1 on the 2nd chart).

So if it is not capitulation, what is it then? Again for the benefit of other readers, the price on the left hand side is the top of the market, so price has been driven up prior.

In bars 4 and 7 you suggest smart money is buying here ( I presume you mean accumulating), but is really the case. Look at what happens after, a move that tops out at about 4.80. Is smart money really going to be in a position for 4 months only to get price to this level? Does your volume analysis over the following months confirm this to be correct?

There is a lot of talk about "smart money", what actually is this, and what therefore is "un-smart money"

Those are just a couple of points to start with. Would be good to get some feedback.


Thanks
 

Nick Radge

Newbie
6 1
Let's take a look at a current example. This stock, QBE Insurance (QBE.AX), has been a market darling for many many years yet has slowly been trending lower from about $28. Note back in August last year the stock moved to new lows and points 'a' and 'b' we see large volume days, both of which are wide ranging and both of which have high closes. The high closes mean buyers are in control - no other way to look at it. However, the signficant volume also means there was a lot of seller pressure. This does not portend a significant low because there has been no real ' capitulation' as yet. However, it does suggest there is 'background strength' or buyer demand of value.

Now, to just go off topic for one second it's important to appreciate how these insto buyers operate. Their analysts will velaue stocks and offer an appropriate area to start purchasing, something along the lines of, "...if you can buy QBE below $14 you'll doing good". Obviously we don't know what that exact value level is but that's how it works. Considering that strong demand can be seen an 'a' and 'b' we can have a decent understanding of where perhaps that buyer level is.

Now, this is not to say the stock can't travel lower which bring me to my next point being that a turn around in a sustained trend is a 3-stage event. Stage-1 is a point of capitulation, which on this chart is at 'c'. We had a significant earnings event, a large gap lower, wide ranging bar, massive volume and a high close. Now the important point here it has happened with the background strength of 'a' and 'b'. Its added confirmation to our theory that buyer demand is at these lower levels. Stage-2, after capitulation, is where the 'hangers-on' slowly get bored of the underperfoming stock and slowly bail. They held through the capitulation in the hope of a quick rebound, but with no rebound they get bored and slowly exit. Stage-2 is the start of a base building exercise where the buyers are unwilling to pay up but are willing to sit back and absorb supply from bored holders. Volume drops in stage-2, as can be seen at 'd'. This stage can take 6 - 12 months to unfold but it does highlight, in conjunction with the capitulation and backgrouns strength, that a significant low is in place. Stage-3 occurs when all supply has been exhausted and absorbed by the buyers then the stock is ready to start moving higher. We'll know this when we start getting high closes on low volumes - meaning no selling pressure.

So to answer the question, there are two ways to trade this. Take an immediate long position after 'c' and expect prices to rotate back and forth in a range. I have been suggesting that this stock could rotate as high as $13 in the short term. For longer term buyers I suggest partial positions be taken anytime. I say partial because this stage-2 base building can extend for a number of more months. Once volume is consistently low and closes are consistenly high in the sessions range then perhaps stage-3 is upon us.

 

Nick Radge

Newbie
6 1
Another good example is the following chart of the broader Australian market. In July last year we saw a significant and swift decline of some 17% which culminated in a massive wide ranging bar with the close at the sessions high and a 50% increase in volume. This is the buyers meeting the capitulation and is now a strong foundation for prices to start moving higher. Its stage-1. Stage-2 is no under way. We're building a base and the probabilities are that the lows of last July/August will NOT be penetrated.

How to trade it? This being the broader market barometer and it suggesting no new lows will be in place, what we're looking for are higher beta stocks that are trending higher and showing strong relative strength. There are many of these available. Essentially we're taking the background strength of the market as a supportive indicator then drilling down to the constiuents that show the early signs of upward momentum to trade.

 
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wallstreetwarrior87

Experienced member
1,875 347
Let's take a look at a current example. This stock, QBE Insurance (QBE.AX), has been a market darling for many many years yet has slowly been trending lower from about $28. Note back in August last year the stock moved to new lows and points 'a' and 'b' we see large volume days, both of which are wide ranging and both of which have high closes. The high closes mean buyers are in control - no other way to look at it. However, the signficant volume also means there was a lot of seller pressure. This does not portend a significant low because there has been no real ' capitulation' as yet. However, it does suggest there is 'background strength' or buyer demand of value.



Now, this is not to say the stock can't travel lower which bring me to my next point being that a turn around in a sustained trend is a 3-stage event. Stage-1 is a point of capitulation, which on this chart is at 'c'. We had a significant earnings event, a large gap lower, wide ranging bar, massive volume and a high close. Now the important point here it has happened with the background strength of 'a' and 'b'. Its added confirmation to our theory that buyer demand is at these lower levels. Stage-2, after capitulation, is where the 'hangers-on' slowly get bored of the underperfoming stock and slowly bail. They held through the capitulation in the hope of a quick rebound, but with no rebound they get bored and slowly exit. Stage-2 is the start of a base building exercise where the buyers are unwilling to pay up but are willing to sit back and absorb supply from bored holders. Volume drops in stage-2, as can be seen at 'd'. This stage can take 6 - 12 months to unfold but it does highlight, in conjunction with the capitulation and backgrouns strength, that a significant low is in place. Stage-3 occurs when all supply has been exhausted and absorbed by the buyers then the stock is ready to start moving higher. We'll know this when we start getting high closes on low volumes - meaning no selling pressure.
Hi Nick, thanks for the reply.

I understand some of your points here and agree with some of them, but there are a lot of inconsistencies in the way you are marking/analysing the charts.

I have highlighted 2 comments (one in blue and the other in red). If we look at the red comment. I suggested to you that maybe your definition of capitulation was incorrect in your last article. In this you state that the big down bar after a sustained move up was capitulation, but on the chart above (QBE) you say capitulation is at the low of this market. So does this mean that your call on capitulation on AWB was wrong?

Precision is very important when using terms in the market. If you do indeed see both of these as capitulation then you can not be reading the market in a consistent manner, as these scenarios are totally different.

The second comment in blue; It is very dangerous to make a statement like this. You state this "The high close mean buyers are in control - no other way to look at it" as a fact. So I will offer you an alternative; A heavy squeeze day!(y) A squeeze day does not mean buyers are in control. In fact the players that are in control of that current cycle may not even be participating here (apart from at the open), and this will not be to accumulate any positions at this point. I can think of a few others but will not go deeper into it at the moment.

Have you considered that a lot of this analysis maybe upside down? You only appear to look at the market from the "smart money" POV (please correct me if im wrong). Yet we still do not have a summary of what "smart money" and "dumb money" (if thats the opposite) is yet.

I am not trying to be argumentative here , just trying to understand your theory/reasoning. Its just that, for this to benefit anyone (especially those new to volume analysis) the analysis must be consistent. You can not call capitulation in the middle of the range (as you have done on AWB), yet it is called at the end of the move on QBE.

I will suggest that the area on AWB that you refer to as capitulation is in fact actually an aggressive mark down phase. Even easier to tell as we have the next years price movement infront of us:)

Thank you again for the posts, it is a very interesting area of discussion.
 

Nick Radge

Newbie
6 1
I'm not sure I agree with the term 'dangerous' when it comes to decison making in the markets. It implies a degree of certainty, of which there is none. Decision making is about probabilities which are either taken from a systematic or quatitative simulation or from experience. In this example it comes from my 26 years experience. Regardless, its still about probabilities and with that comes the possibility (if not probability) of being wrong.

Any type of analysis is open to interpretation, unless of course if its systamatically quantifiable. What is presented here is not, therefore open to interpretation. Exactly what constitutes a trend? What constitues a range? How I define and how someone else defines these factors is why the world goes around. We all swim in our own pools of logic and if it were any other way then the market would not exist as it does.

I appreciate the open feedback and discussion.
 
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wallstreetwarrior87

Experienced member
1,875 347
I'm not sure I agree with the term 'dangerous' when it comes to decison making in the markets. It implies a degree of certainty, of which there is none. Decision making is about probabilities which are either taken from a systematic or quatitative simulation or from experience. In this example it comes from my 26 years experience. Regardless, its still about probabilities and with that comes the possibility (if not probability) of being wrong.

Any type of analysis is open to interpretation, unless of course if its systamatically quantifiable. What is presented here is not, therefore open to interpretation. Exactly what constitutes a trend? What constitues a range? How I define and how someone else defines these factors is why the world goes around. We all swim in our own pools of logic and if it were any other way then the market would not exist as it does.

I appreciate the open feedback and discussion.
Hi Nick, thanks for the reply.

The thing is, it was your comment that implied certainty, as you said "there was no other way to look at it" with regards to buyers being in control. I offered an alternative, but it seems to have been ignored? In fact I could offer another couple of alternatives, that would still conclude that buyers were not in control at the point you said they were. Indeed, if you look at the following 2 days it proves buyers were not in control!

So we have to use the evidence in front of us to confirm or deny our analysis. So it is not really open to interpretation here as you can see the outcome, there for you have "fact". So we need to now ask why the market fell again after this apparent "smart money buying event". So they must have been buying for another reason no? (notice i say someone was buying, but i am not saying they are in control). This is why price does not rise from this point.

So what could the volume at point A on QBE really reflect? The problem here is that only large volume is been noticed or been allocated importance on these charts. "Smart money" is heavily involved in at least 3 other areas on the QBE chart, which goes un-noticed by the majority, this is because it does not stand out in relation to high volume levels.

Of course if we keep stating that smart money is involved when we see heavy volume we will eventually get some part of the analysis correct.

What traders really should be striving for is an opportunity where there is no debate of being open to interpretation. This means the need for clarity, and staying away from times in the market that may temporarily deflect us away from clarity (ie new events, reports etc). And in the event of a catastrophe a stop is in place because nothing is 100%.

Bottom line; we should ask ourselves the real reasons we would want to trade if events in the market are open to interpretation. This ultimately would help traders progress far quicker than trying to learn something they dont understand.

There are all sorts of edges available to the individual, some small and some large, so its really upto the trader to decide what they want and how they will get it.

I guess this is what makes the market the apparent jungle it is.

Thanks
 

Nick Radge

Newbie
6 1
An update of that QBE example above. Prices have continued to push higher. I wouldn't be surprised to see a range develop now.

 

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