Understanding the way volume affects the market is key to successful trading, as price signals won’t always tell the whole story. Professional traders have one advantage over the private trader: they can read volume. Not only that but they can – and will – hide volume from you to give themselves an advantage. Large banks and brokerage houses claim that to make a market, they need an edge over the rest of the crowd. Large orders that are processed do not appear on the tape, as they would show up on the radar of other professional traders who would then change their bid/offers or pull orders.
The professional trader uses price and volume, and usually no other indicator, to read the true balance of supply and demand, as Richard Wyckoff preached at the turn of the century. The study of price and volume and their relationship is vital to detect turning points in the market, as professional operators have large amounts of capital and need to work this capital to make money. This cannot be done by buying at the market or limit orders as it would destabilise prices, causing an unreadable situation.
‘Whip-sawing’ – prices marked rapidly up and down – is used to shake out the crowd and catch stop losses, but the real reason is to process large orders while covering any strategy and not giving the game away at the same time. When the market starts to trend, we say the large operators have control. They know that there are thousands of stop losses out there waiting to be triggered. This gives them the opportunity to process large orders and conceal their true intentions as they attract other traders, who can see their actions and act immediately to better their own accounts by reading volume. For example, ultra high volume on a down bar should stop the decline, with demand swamping supply.
The other advantage professional traders will have is the news: they will already have positioned themselves in advance of news and will try to wrong-foot as many traders as possible, gunning for stop losses and misleading the crowd into thinking the opposite of their true intentions. Why is it that bad news always appears in the last two weeks of a bear market and good news always at the top of a bull market? It is done to put you under pressure at the bottom and to make you hunger for more at the top of a bull market. This allows the operators to unload large blocks of stock or futures contracts at the best possible prices and to reaccumulate at the bottom to increase profits – usually at a large loss to the crowd. The cycle is then repeated over and over, giving us bull markets and bear markets – which is why you are bombarded day and night with news on earnings, unemployment and payrolls.
These operators know that you are ruled by three things in the market: fear, hope and greed. Fear of missing out, hope that when you are losing prices will recover and you can close out at break-even and greed that when you have a profitable position you hang on for greater profits and often fail to see the tide coming in.
By studying volume and its relationship to price, you can begin to detect subtle changes in supply and demand. You will see when the large operators are active and, by observing the results of their actions, you should begin to see a picture of the ongoing market unfolding before you in a trading session. Let’s say you are sitting in front of your computer one day, watching a bar chart, and you see a large amount of volume on an up bar. You will – because you have been told this is so – assume that strength always appears on up bars and weakness always appears on down bars. But in fact, up bars with excessive volume are a sign of weakness, as down bars with high volume show strength.
But how can this be true? Imagine you are an institution with a large block to dispose of: how can you do this without moving the price against you? Answer: by marking up the price to bring in buyers. Rising prices create demand, demand does not create rising prices. If you see prices rising, you are more likely to buy than sell as you will expect to make a profit as prices continue to rise. But if you cannot read volume, your image of these rising prices will distort the true picture: you will not see the excessive volume indicating weakness.
Reading one bar in the chart does not give you the complete picture, so further careful observation is necessary. Does the market top out and do prices start to fall back? If so, this could indicate that supply has swamped demand, capping the top of the market. But it might also only be the start of distribution. One high volume up bar on its own does not create a bear market but usually marks the start of supply. By reading the volume, it is possible to detect when the large operators have been active and whether their opinions have changed, probably turning bearish. If you cannot read volume, you are likely to think the market will keep rising and may buy on the reactions. The institutions, however, will be aware that the crowd is soaking up all it can and will artificially hold prices up until all has been unloaded. That point will be characterised by a low-volume up bar (signifying no demand), indicating to the large operators that the buying has dried up and the mark-down can begin. The opposite would be true if the operators have marked prices down far enough and can cover at a large profit – usually at a loss to the crowd, who are now panicked into selling in fear of even lower prices, usually on bad news. And so the cycle is repeated, over and over.
Professional operators move in and out of the markets at various times. The following two charts show trading on the S&P E-mini futures contract and each bar represents 30 minutes. The first chart shows high volume with professional activity, which is highlighted. The second chart shows no activity. This is as important as professional activity because markets work both on supply and demand and on no supply and no demand.
caption: Professional Activity
caption: Non-Professional Activity
By reading the volume with price, you can learn to trade successfully in any time frame as you will begin to know enough to distinguish the real movements from the false ones. There are a lot of false drives in the market which are deliberately done to trick you into losing money. This is how the professional operators stay in business. But by understanding the different intensities that appear in the market, you can make money too. All you have to do is follow the big operators: when they move, you move too. So, you may ask, all I have to do is sit back and wait for the operator to tell me when?
Unfortunately it’s not that simple. Because volume is the powerhouse of the market, we have to observe the corresponding price action: is there an old trading area to the left on the chart, say an old high or an old low? If you see low-volume down bars with a narrow spread, then this would indicate that the professional operators were bullish and that they would be willing to absorb the supply as they reached the old top. However, if you see low-volume on up bars as the market approaches the old top, then this would indicate that the market was weak and it would be fairly safe to short near this level.
This would also be true for trend lines. Trend lines are the railroad for prices when the market is trending strongly and we would be looking for support or resistance as these trend lines are approached. For example: if you see a wide spread on increased volume as it approaches an old trend line (or old top or bottom), you can expect this to be broken. But if you see no demand (weakness) or a test (strength), it will not be broken: you can place your orders and make a profit as you can read the path of least resistance.
Imagine the path of least resistance to be water running down a hill. It would not just run down in a straight line, it would twist and turn if obstacles were in its way – so the path of least resistance would be the easiest path, not necessary the quickest one. This is how the operators mark prices round to find volume. If there are large orders at a certain price, the operator might avoid that price level as it would mean he would have to absorb this supply at higher levels – a quick way to go broke. This is why we have shakeouts and whip-sawing in the early stages of a rally, because it is not cost-effective to absorb ever-increasing supply at higher levels. Volume holds the key to the truth.
(This article is reproduced with the kind permission of Shares Magazine).