Just as more clues help detectives solve crimes, volume (or the lack thereof) can be a critical piece of information in the investment decision-making process. Analyzing volume can help you find efficiently priced investments, identify trends, and validate patterns.
Volume has subsided in recent months, after a volume spike that occurred in the early part of 2016 when volatility surged. This decline in volume, coinciding with the recent sideways broad market action, may suggest there remains a fair amount of uncertainty among investors.
Volume is vital
Volume is simply the number of shares traded in a particular stock, index, or security. For example, as of May 12, 2016, the most actively traded stock, based on a 90-day average, was Bank of America (BAC) with an average of 123 million shares traded per day.1
From a chart perspective, volume is critical. Indeed, technical analysts believe that volume precedes price; to confirm any trend, volume should increase in the direction of the trend.
For instance, if a stock were to increase from $23 to $25 on relatively high volume, technical analysts would consider this to be a more sustainable trend (i.e., the stock could keep going up over the short term) than if the same price increase were to occur on relatively low volume. Price moves made on low volume may be said to “lack conviction” and could be viewed as being less reliable.
What volume is saying now
You can tell when volume is high or low for an index, stock, or other security by comparing it to another time period, an average, or some other benchmark. For example, beginning in early January, volume for the broad market, as measured by the S&P 500, surged as stocks sunk—the market shed more than 10% year-to-date through mid February. During this time frame, volume for the S&P 500 exceeded 800 million shares on several days, a level that stocks breached only once over the same time period in 2015.
Consider the chart below, which shows the average daily volume for the S&P 500. The top half of the chart shows the daily price of the S&P 500 and the bottom half shows the corresponding daily volume.
Even though volume is still well above 2015 levels, it has continued to ease over the past few months. This declining volume trend, coupled with the recent sideways move in stock prices—the S&P 500 has vacillated between 2,033 and 2,111 since March 29, 2016—might suggest that the market is searching for direction, given that lower relative volume can be indicative of a weak trend.
Historical patterns suggest that volume could continue to decline over the summer, relative to the rest of the year, as has been the recent historical trend. With that said, last year was a notable exception as volume did not decline as much as usual (see chart).
Volume patterns and indicators
For a wide range of chart patterns, volume is essential. Here are a few examples of common technical trading patterns used by slightly more advanced chart users, and how volume plays a role in the analysis:
- In a continuation pattern (i.e., when a stock rises and then flattens out for a period, or when a stock decreases and then flattens out for a period), volume should decrease as the pattern develops. If it doesn’t, it is a signal of a potential breakout and reversal of that existing pattern. A breakout after the continuation pattern completes should occur on an increase in volume.
- In a head and shoulders pattern, volume usually decreases with each successive peak. If it does not, a trader might not expect the reversal pattern to complete. If volume does decrease with each peak and the pattern completes, the bearish breakout should then occur on increasing volume.
- In flag and pennant patterns (short-term patterns completed in one or two weeks that are initiated by sharp and nearly straight-line moves), volume usually decreases during the pattern. If it does not, a trader might not expect the continuation of that pattern to continue. After the pattern completes, the breakout should then occur on increasing volume.
There are even some technical indicators that use volume, rather than price, as the central input. The ARMS Index, for example, measures relative volume in advancing stocks versus declining stocks. A value below 1 for this index suggests bullish sentiment and a value above 1 indicates bearish sentiment.
On Balance Volume (OBV) is another indicator that incorporates volume. OBV tries to detect momentum by providing a running total of volume, showing when volume is flowing into or out of a stock or other security. OBV is used to confirm price trends and spot divergences. An upward-sloping OBV would be used to confirm an uptrend, while a downward-sloping OBV might confirm a downtrend. Both OBV and the ARMS Index are available in Active Trader Pro®.
Watch and listen
You may hear many a market prognosticator calling for the market to do this and that. However, it is possible to tune out much of the noise and look to volume, along with other technical and fundamental signals, for evidence of what stocks might be up to next.
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