Pump Up The Volume! - Part Two

In part one of this series we demonstrated how you can set up up volume studies and alerts in Ensign Software to monitor volume levels within any given market or time frame. In part two of this series we will be looking at how to use these alerts in your trading.

Volume can tell us a great deal about bullish and bearish sentiment or stated another way, accumulation versus distribution. These terms are very useful ways of qualifying or categorizing buying and selling or price action in a market.

Accumulation takes place when volume increases as prices rise and decreases as prices fall. Distribution takes place when volume increases as prices fall and decreases as prices rise. This pattern can be observed in all liquid markets. A cycle of accumulation will be followed by a cycle of distribution and vice versa. Additionally, you will typically have several degrees of volume cycles at work at any given time depending on what time frame you look at.

Simply stated, when a cycle of Distribution ends, you want to cover if you've been short and get long. The same is true in reverse. When a cycle of Accumulation comes to an end, its time to sell and get short. In this issue of Trade Tips we are going to look at some examples of how volume works in Indices.

Volume in Indices

It is not possible to get volume in a capitalization weighted index like the S&P 500 though you can look at futures volume. The caveat there is that daily futures volume is reported the following day. In this example, we are using the weekly chart of the Dow Jones Industrials:



This chart does a good job of illustrating how useful of a tool volume can be in confirming major turning points in a market. It also points out how breakouts within a larger cycle of distribution are likely to fail. This is a weekly chart so each bar represents five trading days. If you track price and volume on a daily chart, you will generally find that it takes three to five days of accumulation or distribution to turn an entire market around. This is something that I learned from the work of William O'neil which I both respect and recommend to anyone who is interested in learning more about how to use volume as an indicator in their trading. (Note: The chart is missing volume data for two weeks where gaps are visible).

Some times it is not the high level of volume that should get our attention but rather the lack of it. If you have raised children, you know that there are times when they are just too quiet and more often than not it means that they are in to something they shouldn't be.

The same sort of thing happens in financial markets. When an index is breaking out, you want to see strong volume to confirm that the breakout is for real and not a bull trap. If you don't get that volume to confirm the breakout, the rally is likely to stall. There are two good examples of this on the weekly chart of the Dow Jones Industrials shown above. A breakout should be noisy and demand your attention,  just like a teenager blasting his stereo at levels that demand a response.

When an index is making six year highs, as was the case recently in the Dow, its another one of those times you want to see strong volume. Take a look at the daily chart of the Dow shown below.
Note how the trading range began to contract two days before the absolute high. Now glance below at the volume graph. Note how even though price was continuing to rise (rather dramatically on May 5th) volume was tapering off!

The absolute high was marked by a narrow range day on May 10th in light volume. Yes, the FOMC announcement on the 11th was the catalyst that sent the market tumbling lower. However, this market had been "stalling" for a week prior.



As Larry Pesavento has said, "there is no greater indicator than price". He is right on the money. The major indices are leading indicators of the economy. Price patterns within the major indices are unquestionably the best leading indicator available to the market technician. Volume can be an effective tool for evaluating price patterns as we have tried to demonstrate. In the next issue of Trade Tips we will delve in to the use of volume in trading stocks as well as intraday futures.


Copyright©2006 - La Canada Capital Management, LLC - All Rights Reserved