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Praise for Investing with Volume Analysis “Investing with Volume Analysis is a compelling read on the critical role tha 17MB Size Report. DOWNLOAD PDF . turned off and the lights in the studio go down, and I think about what women them the way Act Like a Lady, Think Like Complex Analysis (Princeton. “Investing with Volume Analysis is a compelling read on the critical role that “In Investing with Volume Analysis, the reader should be prepared to discover a.
It is our human nature. It started the next month in October. In security analysis, this perspective is technical analysis. Vlme gvs prc mng smlrl t hw vwls gv cnsnnts mng. As a result, all fundamental data, economic data, and any combination of financial or economic ratios lag price.
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WordPress Shortcode. Published in: Full Name Comment goes here. Are you sure you want to Yes No. You can continue searching for the Holy Grail of market success or you can develop the understanding required to start believing in your own ability to discern, and thereby, gauge the market. The two most common methods of analysis are the fundamental analysis and the technical analysis. Although the two schools of research may be used together effectively, they stem from vastly different perspectives.
Your perspective of the market, what it is and how it works, plays a major role in your investment success. Early in my career, while studying for my CMT designation, I taught technical analysis to many of the top brokers at the major brokerage firm where I was employed. A colleague who was part of the CFA program taught fundamental analysis. I once spent a day monitoring his crash course on fundamental analysis. His explanation of using financial ratios to assess the value of companies made sense.
Like many fundamental analysts, the presenter had his favorite stock. He provided seemingly convincing reasons for why this stock was overlooked and undervalued in relation to earnings, the industry, and other comparative valuations. Several days and weeks that turned into several months went by, and the stock did nothing but trade in a tight sideways channel despite the broader market being strongly bullish.
I pulled it up. It had developed a huge base and was breaking out on strong volume. I bought it. I watched the stock closely and prepared to change the limit order to market if it showed further weakness. It was at this time that I first realized that the fundamentals were indeed most likely wagging the dog, suggesting that the fundamentals were driving the technical aspects.
Believing I was bearing an olive branch, I sought out my new fundamental ally to point out that he was right and thank him for helping me make a buck. I even made a point to mention that he had bought the stock at a lower price than I had while I intentionally neglected that he had been sitting on dead money for over a year. Meanwhile, I had enjoyed participating in numerous stock issues throughout the bull market.
However, I was floored when he told me he had not sold the stock. I tried to inform him that the stock appeared to be weakening technically and perhaps he should sell part of it while he had a double in hand. No, he was far too excited. He proceeded to list many more reasons why the stock was still undervalued.
As a staunch technician, those details were just not important to me. I felt really bad for the guy. He had finally gotten it right, and yet he had missed it! How could I face him again? But, nah, I would just be wasting my good capital on bad assets. What kind of example would that be for my stockbroker students? This anecdote shows that my colleague and I each had our own perspectives of the market. The fundamentalist viewed stocks as companies in which he could become part owner. He believed his favored company was worth significantly more than the market price, so he bought it.
This perspective of the market springs from what is called fundamental analysis. My view of the market is that stocks are shares of companies. These shares go up because eager buyers push them up, and they go down because fervent sellers sell, forcing them down.
When I saw a stock that had previously gone nowhere suddenly pop up, I concluded the force of buying pressure could propel the stock further, and I bought it. Our different investment approaches did not reflect a difference in intelligence, but they did reflect a difference in our perspectives.
With that clearly stated, Investing with Volume Analysis introduces you to a perspective of market analysis based on the principles of supply and demand. In security analysis, this perspective is technical analysis. The Fundamental Approach Fundamental analysis presumes security prices are based on the intrinsic value of the underlying company. Price is formed based on these values and facts surrounding the company.
Seemingly, this is a highly logical approach, one that many assume is correct in most markets most of the time. Thus, fundamental analysis presumes the future prospects of a security are best analyzed through a proper assessment of the intrinsic value of the underlying company. Fundamental analysis is not concerned with the behavior of investors as measured through the stock price or trading volume.
In pursuit of value, the fundamentalist collects, analyzes, and models company information, including earnings, assets, liabilities, sales, revenue, and other information required to evaluate the company. Assumptions of the fundamentalist include a belief that markets are not completely efficient and that all necessary information is available to the public, but the company may not always be efficiently priced. Overall, fundamentalists are concerned with what the price should be according to their valuation models.
Therefore, the focus of technical analysis is the behavior and motivations of investors observed primarily through their own actions. It is imperfect people who determine market prices, not highly perfected valuation models. However, the technician does not deny that the pursuit of value is a primary source of market movement.
Yet, the technical perspective deems that market price is formed by the collective opinions of market participants pursuing value. In the exchange markets, prices are determined by what one party is willing to pay and another is willing to accept. It is through the diagnostics of price, volume, and other technical metrics formed by the actions and sentiments of market participants that the technician gauges stock performance.
Technical analysis assumes that market participants are efficient in price formation, thus avoiding any judgments about the intrinsic value of the underlying company. Therefore, the technician is not concerned with what the ideal price should be; rather, he is concerned just with what it is. The core aspects of the technician include believing that the markets are efficient at discounting even future developments, price moves through trends, investors are both logical and emotional creatures, and past behaviors tend to repeat themselves more so when enough time has elapsed that the behaviors have been forgotten.
Driving a Comparison Between Fundamental and Technical Analysis The movie Vantage Point begins by playing out the same scene over and over again, each time from a different vantage point as experienced by each major character. Likewise, the fundamentalist and the technician have similar objectives in analyzing securities.
Their views are, however, developed from different vantage points. An analogy can be drawn between a fundamentalist and a technician who both examine a high-performance automobile. The fundamentalist looks under the hood, kicks the tires, and inspects the frame—the physical aspects of the car. The technician does not look under the hood. Rather, he evaluates how the car performs under a set of conditions, such as turning, accelerating, and shifting. Similarly, when the gauges exceed the threshold of the expected parameters, the technician is led to the same conclusion as the fundamentalist, but without a physical inspection of the engine.
A fundamentalist might identify a good valuation point of a stock based on his analysis of the company. What is support? Support is demand buyers. So where does this demand come from? In this way, the two perspectives often yield the same conclusion using different methodologies. One opinion is based on the search for intrinsic value, whereas the other is shaped by extrinsic behavior. Demand has surpassed available supply. When the available supply outweighs demand, the price must go back down.
Volume is the scale weighing these forces of supply and demand that produce price. In this way, volume ultimately reflects the ebb and flow of money into and out of the market or the security. This book explores the market from this underemployed perspective of volume analysis, providing an investor with the tools and concepts to advance his or her own abilities in evaluating the market. Which developed first—technical or fundamental analysis? Most investors assume fundamental analysis preceded technical analysis.
This conclusion appears logical. It takes two opposite opinions to come together to produce a price, and a series of prices creates the chart. How much an item is worth is determined by how much one party is willing to pay to obtain it and how little another party is willing to accept to let it go. Although technical analysis utilizes charts, its essence is human behavior. And behavior might be as much a part of the price equation as value.
Upon moving into a new territory, Abraham allowed people to believe that Sarah, his beautiful wife, was his sister. A king then mistakenly sends for Sarah to marry him. Then Abimelech took sheep and oxen and servants—both men and women—and gave them to Abraham, and he returned his wife Sarah to him. Then he turned to Sarah. This will settle any claim against me in this matter. Was this exchange based on fundamental value? Obviously not! One cannot put a price on the love and fidelity of a spouse.
Otherwise, he would put his life in jeopardy by trying to negotiate. Abimelech probably had just one shot to strike an acceptable offer. If Abraham took offense at the first offer, Abimelech assumed he might die. Therefore, the first financial transaction recorded was based primarily on technical speculations of perceived acceptance—not fundamental considerations of intrinsic value.
The notion of unraveling the forces of supply and demand through price trends was at work even in the earliest of days. At the time, about different companies were incorporated into tradable stock shares. News and rumors of news undoubtedly were strong motivators to exchange stocks at specific prices. These records were then taken back to the ships and spread internationally. Using his unique charting methods, Homma became a literal samurai of trading, making a killing trading rice.
In this book, Homma claims that the most important aspect of investment is gauging the psychology of the market. As such, he described the developments of bull yang and bear yin markets and their tendencies to run to extremes and then reverse. Homma was also believed to be a practitioner of volume and weather patterns. Early American Market Analysis Today, in the United States, securities analysis is dominated by fundamental, not technical, analysis.
One might reasonably conclude that the modern markets and exchanges have always operated under these lines of thought. Yet the use of technical analysis in the modern markets has a rich history—one predating traditional fundamental analysis. Technical analysis? Perhaps it should. All of these publications and indexes, in fact, have their roots in technical analysis.
Dow The modern father of technical analysis is considered to be none other than Charles H. Dow, the founder of The Wall Street Journal. Financial information about common stocks was scarce, and the information available often was unreliable. Historical ledgers of prices were not readily kept. This revolutionary letter contained stock-price ledgers and company financial information, plus the first ever stock index, comprised of 11 stocks.
The concept of an index was revolutionary. It freed investors from tracking individual stocks, enabling them to follow the market instead. If investors knew the collective movement of just a few prominent stocks, they would have a good idea of how most stocks behaved as a whole. If investors knew how stocks were performing, they might be able to predict the actions of the overall economy. These ideas gave rise to Dow Theory, commonly regarded as the bedrock of modern technical analysis.
Such early innovations led Dow to introduce The Wall Street Journal on July 8, , a financial newspaper that he cofounded with statistician Edward Jones. In , Dow created what is now called the Dow Jones Transportation Average from nine railroad companies. On May 26, , he created its more popular companion, the Dow Jones Industrial Average, composed of 12 industrial stocks.
As editor of The Wall Street Journal, Charles Dow employed his remarkable theories to interpret market averages and forecast the economy in its pages. These writings are now considered to be among the most superb financial editorials ever composed.
Nevertheless, Dow never penned a summary explanation of his theories, to the frustration of his followers. Yet a friend of his, Samual A. Hamilton died in , clearing the way for the next person in the lineage of Dow thinking, Robert Rhea.
Rhea developed the first set of public charts for the Dow Jones industrial and transport indexes. He was a leading advocate of volume and relative strength analysis. Above all, Rhea was a master investor. Some argue Rhea was the best of a loaded field of early investing stars including the famous Jesse L.
Livermore and Richard D.
Budding Practitioners Other early contributors to technical analysis include Leonard P. Ayers, Richard D. Wyckoff, and Richard W.
Schabacker, each of whom put his stamp upon technical analysis by moving it in new directions from that of the late Charles Dow.
It was Ayers who first developed and promoted market-breadth analysis. He published his work through his company, Standard Statistics. It later merged with H. Poor and H. Wyckoff deviated from Dow theorists because he was more interested in the underlying reasons markets moved. Wyckoff saw the economic principles of supply and demand at work in the stock exchange.
He believed that the behavior observed through price and volume movements held the key to forecasting future market movements. These observations led Wyckoff to believe that the market operated under a set of three principles: Wyckoff believed volume was the key to identifying these operations. By applying these technically oriented ideas and principles, Wyckoff soon amassed a large fortune.
His newsletter was also quite popular, reaching more than , subscribers. Toward the end of his life, Wyckoff gave back to technical analysis by teaching his theories to others in his own investment course and publishing several books expressing his beliefs about technical analysis.
He strayed from Wyckoff in that he saw his study of the markets as a scientific inquiry into the depths of the market structure.
Schabacker wrote extensively about his ideas regarding technical analysis as a weekend editor of The New York Times and the youngest editor ever of Forbes magazine. It started the next month in October. Although his life was short, ending in at the tender age of 36, Schabacker made significant contributions to the field of technical analysis.
In this timeless work, Schabacker defines and defends the technical approach while contrasting it to fundamental analysis. The book also introduced various concepts behind price trends, characterized the concepts of support and resistance, and introduced many of the classic price and volume patterns.
Given this rich heritage, one might wonder why technical analysis is not more prominent today. It was commonly used in the early days of the exchange, when manipulation of the markets was widespread, both through the dissemination of company information and in the handling of floor operations. Because of manipulation, determining a fundamental equity valuation was difficult. Many investors believed the best course of action, instead, was to observe the action and behaviors of those who might have inside knowledge.
Early technicians recognized these issues as well. In fact, the existence of market manipulation was a good reason to differentiate between the movements of the long, intermediate, and short-term trends. Although there was potential for manipulation in the shortterm, the intermediate and long-term trends were too broad to be exploited.
Because of this, many early technicians confined their investment operations and advice to the big picture conveyed through the long-term trend. Although prices could be temporarily manipulated, volume data could not.
By analyzing trading volume, a technician could more easily detect whether a price movement represented true commitment. In the issue of the Magazine of Wall Street, Wyckoff wrote of the importance of following volume called sales back then as the fundamentals alone were not enough to make competent investment decisions. A turning point in the popularity of technical analysis occurred in the mids. Any attempts to manipulate the market now met with swift and harsh penalties.
These reforms provided much needed regulation of the markets and regulation of publicly traded companies. In , about the time of these reforms, Graham and Dodd at Columbia University released Security Analysis, now considered the Bible of fundamental analysis. The approach promised that adequate returns and safety could be achieved via a thorough analysis of the underlying company. Graham and Dodd discounted the importance of the short and intermediate movements of the markets.
Instead, they advocated owning stocks as long-term investments, not in timing the market.
Their book came at a good time because the recent reforms provided an excellent setting in which to evaluate companies. No doubt, this early stage in the history of market reforms created many market inefficiencies to exploit. Also at this time, Alfred Cowles at Yale came out against market forecasters.
Gazing down from his ivory tower, Cowles thought stock market forecasting methods used at the time were crude. He believed that highly educated economists were better suited for such tasks.
That is to say, at the time Cowles did not respect the market. His views later changed, however, leading others to develop Efficient Market Theory, the notion that stock prices are always correct and no one can predict them. Then, in the aftermath of the Great Crash, many investors abandoned stocks entirely. As a result, equity investing became a business left to a small number of professionals. At the same time, the SEC changed the rules of how the stock game was played.
The investment community felt the need to be perceived as more responsible. Meanwhile, academics elevated the fundamental approach while assaulting technical thought. Now, listen to this.
December , I went to Springfield, Massachusetts on behalf of the Market Technicians Association and I gave a gentleman by the name of John Magee our annual award, I think he was the third or fourth recipient. We all know who John Magee is. He wrote the famous book. The Bible on Technical Analysis comes out in When I met Mr. Magee, he was visibly upset. And he said— they never understood the laws of supply and demand. And I said— Who?
He said—the Securities and Exchange Commission. So from that date forward the whole establishment says—research is all fundamental. And as a consequence the universities started to teach their students all these fundamental things, it was the law of the land—you had to do the fundamentals. Consequently, they advocate investing solely in market indexes.
I am no longer an advocate of elaborate techniques of security analysis in order to find superior value opportunities. This was a rewarding activity, say, 40 years ago, when our textbook Graham and Dodd was first published. But the situation has changed a great deal since then. In the old days, any welltrained security analyst could do a good professional job of selecting undervalued issues through detailed studies.
But in the light of the enormous amount of research now being carried on, I doubt whether in most cases such extensive efforts will generate sufficient superior selections to justify their cost. In October , the SEC passed fair-disclosure rules. These regulations were intended to keep valuable insider information from reaching the general investing public unfairly or irregularly.
But the regulations instead have caused companies to withhold too much information from the public, in fear of violating the rules. As a result, less information is disseminated. Walters, CFA, said Clearly, many of our members feel that too many companies are taking an excessively conservative stance and misinterpreting the new regulation to mean that they should have no one-to-one or small-group communication with anyone at all.
Regulation FD only prohibits selective disclosure or private communication of material, non-public information. In an effort to increase competitive pricing, the exchanges have dropped the bid-ask spreads on securities from oneeighth to a penny. When spreads were large, specialists had plenty of room to operate and to profit from the spread.
However, there is little room when the gap is one cent. Consequently, the specialists attempt to profit by facilitating large block trades and by taking advantage of their prime view of the order flow.
The uniquely advantaged floor brokers are no longer compensated to absorb the risk of potential losses of stepping in order to stabilize the market. As the crash unfolded, orders left the exchange and were routed to digital exchanges. These exchanges pride themselves on fast execution. This resulted in information being held closely, resulting in an uninformed public.
Today, the markets are over-regulated, resulting in information being closely held for fear of punishment. Before, the exchanges were under regulated, resulting in bizarre runs and disorderly markets. Modern markets, according to Graham, are efficient, resulting in fewer opportunities to invest in misvalued stocks. It took several decades, but Yale finally got it right. In , Stephen J. If Cowles had given Hamilton the benefit of investing in the same instruments as he had chosen for his own portfolio, then the annual rates of return would have been essentially identical, According to Cowles, Hamilton would be long only 55 percent of the time, out of the market 29 percent of the time, and short the market 16 percent of the time.
Therefore, the risk incurred between the two portfolios would not be the same. In addition to these points made by the researchers, note that the study was done and ended in the midst of a strong bull market. The Dow Theory: Figure 2. This decision takes the form of price on an electronic quote machine, or at the post of a global exchange. Price influences other participants and then they make decisions according to the prevailing market trends. Price, therefore, plays a profound role in shaping the future outcome for many events in the global stock markets.
There were, of course, many opinions among the contestants of what the price ought to be. But the winner was the person who guessed closest to the actual price without going over. If I am buyer of a stock, it takes a second party willing to sell the same stock to commence the exchange. Why would he desire to sell it?
Obviously, he believes it is going down. Otherwise, he would not agree sell it. Thus, the seller and I disagree on the future outlook of the security, and that disagreement leads us to agree to exchange. This agreed-upon amount is called price in the exchange markets. Thus, price is a single point of agreement in a situation fraught with disagreement.
Price is truth. When intrinsic value does not equal market price, then that opinion is currently wrong. Price is the de facto belief of people. The collective knowledge anticipated by investors is manifested within price. As a result, all fundamental data, economic data, and any combination of financial or economic ratios lag price. No matter how well a fundamental model is constructed, the fundamentals cannot help one determine when to buy or sell.
Only volume and technically manipulated data such as derivatives of price have been demonstrated to lead price. Unlike fundamental or economic data, price datum is not subject to constant revisions.
As DNA contains all genetic information of the cell, price contains the collective information known by investors about the company. As shown in Figure 3. It represents the position clients want to be in at the beginning of the day.
After the investors have time to review the markets overnight, the open represents the desired position of investors to begin the day. The opening trade is the change desired by investors repositioning their portfolios for a new day. The change from the previous close to the open is a reflection of these new sentiments. The high is the furthest point the bulls were able to advance the stock higher before sellers regained control to push the stock back down.
The high represents a stronghold for sellers and a resistance area to buyers. There is one exception. When the stock closes on the high, it did not encounter any real resistance from the sellers. The buyers just ran out of time. The low is the furthest point the bears were able to force down the stock before buyers regained control to push the stock up. The low represents an area where enough supportive demand existed to prevent the price from moving lower.
The exception is when the security closes on the low. When the stock closes on the low, it did not encounter buying support. Rather, the bulls were saved by the closing bell of the session. It is perhaps the most important piece of information of all financial data.
A lot can happen between one close to the next close. Indeed, much of the intraday activities might be considered noise. It is the position investors desire to hold after hours when investors are unable to trade with liquidity until the next session opens. The closing price is the first and oftentimes, the only price the majority of investors desire to know. This is the difference of the closing value one day versus the closing value the next day. When this difference is positive, it tells us that demand is outweighing supply.
When this difference is negative, it tells us that supply is increasing beyond demand. The change is perhaps the most sought after piece of financial data on the planet.
It is measured from the top of the bar, where resistance set in, to the low, where support came in. The size of the range gives us important information about how easily demand can move the stock up or supply force the price down.
The wider the range, typically, the easier it is for the forces of supply and demand to move the stock price. Volume Analysis: Digging Deeper Someone once asked me why he should believe in technical analysis. To answer this question, I first needed to establish what type of evidence he would accept. I then explained that technical analysis is the law of supply and demand working within the exchange markets. For example, when securities change hands on the auction markets, the volume of shares bought always matches the volume sold on executed orders.
When the price rises, the upward movement reflects that demand has exceeded supply or that buyers are in control. Over time, these trends of supply and demand form accumulation and distribution trends and patterns. But what if there were a way to look deep inside these price trends to determine whether current prices were supported by the volume? Well, this is the objective of volume analysis: In the next chapter, we examine the second variable of most important relationship: You are taught early on to buy low and sell high.
The evening news tracks the major indexes as if they were horse races, so most people naturally believe that a higher close is good news and a lower close is bad; yet you are left none the wiser about navigating your own finances by knowing this daily result. Price surely matters.
But this is a market. Waiting for the final number on a given day or week tells you what happened but not why or, more importantly, how. Picture a mall parking lot. Is it full or halfempty? Is it Saturday or a workday?
How many people are walking the shops and sitting in the restaurants? Regardless of what they buy or how much they pay, what matters to the investors of that mall is that customers are showing up and participating. This book breaks down the fundamental ideas that constitute volume analysis and gives you the tools you need to interpret volume to help you make better, smarter trades.
Volume as a general term describes the amount of a given tradable entity for example, shares of stock, commodities contracts, options contracts, and so on exchanged between buyers and sellers.
If volume is high, more units of a security have changed ownership. If it is low, then fewer units have changed hands. There are several categories of volume to examine: Average volume enables the technician to discern whether volume is increasing or decreasing relative to the past.
In short, is the mall fuller this Saturday compared to every Saturday in the past year—or relatively empty? Volume Data in Market Analysis A trade produces only two pieces of information: Proficiency in volume analysis is a rare skill. Properly understood, though, volume analysis can provide its practitioner with the power to peer deeply into market mechanics. Volume is a literal illustration of the power behind the forces of supply and demand. Volume is understood as the validation of price, the source of liquidity, the substantiation of information, the fulfillment of convictions, the revelation of divergent opinions, the fuel of the market, the proponent of truth, and the energy behind the velocity of money.
If you believe any of this information might be important in making an investment decision, volume analysis is important to you. Volume Validates Price Volume plays a critical role in securities analysis. But the key is that the more shares exchanged at a given price, the more that volume confirms price.
In the same way, low volume tells a different story. If fewer investors participate at a given price point, more doubt is cast on the validity of that price. How much confidence would you have that the listed price is fair and reasonable?
Probably not much. The same principle applies to trading volume. The more people participating in a price movement, the more the price movement is validated. For the technical trader, volume dictates the quality of the price. Assume that there was only one seller and no buyers. In that case, what is the probability of being able to exchange quickly the item back into cash at about the same price? A market that is not facilitating trade will not survive long.
In the high-volume scenario, though, where many transactions occur in a narrow range of prices, the opposite is true: You can sell it for cash immediately and likely at about the same price at which you bought it. High volume normally infers high liquidity, the ability to exchange an instrument or item for currency at a fair price.
Volume Substantiates Information Volume validates price, but it also contributes to forming price. As new information is disseminated to the public, volume reveals the flow of this information.
By observing the change in volume as information is released, a trader can tell how quickly new facts are absorbed by market participants. In this way, volume substantiates the importance of the new information.
As volume rises, it equates to more emphasis being placed on new information by investors. Similarly, news or information that does not greatly impact volume indicates that the information has little significance to the market. Upon learning this, you buy 1, shares of the same stock. Later on, though, you learn that the famous investor bought just shares. This should change your view of the security considerably.
You expect a wealthy investor to buy 1 million shares—if he or she acted on conviction. Volume Expresses Interest and Enthusiasm Market volume is money searching for a place to reside. There are only two reasons investors choose to invest. One is to seize on an opportunity.
The other is to reduce the risk of being positioned incorrectly. Rising volume reveals that investors believe there is a greater interest and enthusiasm, whether on the buying or selling side of a given market or share. Falling volume shows that fewer investors see opportunities, so they stay on the sidelines. Volume Denotes the Disparity of Opinions Volume can enlighten the savvy investor when there is a disparity of opinions.
Often, information and commentary in the media lead the investing public to choose sides, regardless of the underlying facts or when no facts are evident. Trading activity expressed as volume is the empirical evidence that these diverging opinions are at work, with each side betting on its own beliefs.
The greater the disparity of opinion, the greater return each side expects to realize from an investment. Thus, a wide divergence in these beliefs shows up as higher volume as the bulls and bears take positions to attempt to profit. Volume Is the Fuel of the Market For an engine to run, it needs fuel. The fuel of the market is provided by new supply selling and demand buying. Volume, thus, is the fuel that enables markets to move. Like the space shuttle when it is launched into space, the majority of fuel is spent just to get to orbit.
This explosive force of energy to propel the space shuttle into space or new heights requires an above average reserve of the fuel, but then the space shuttle can then use only a small portion of the remaining fuel reserve to carry out the rest of its mission. Volume is to stocks what rocket fuel is to the space shuttle. It is the desire of large institutions to buy or sell without drawing attention.
The reality, though, is that they cannot. Large institutions must carefully choose securities to avoid those that adversely affect price from their own trading operations. After a security is chosen for purchase or liquidation , a big institution must be cautious: But volume analysis sees through that trick. If a trade goes through, it must be reported.
A significant increase in volume is a clear sign that a big institution is at the table—even if price movement is subdued. Volume Is the Cause Early twentieth-century stock guru Richard Wyckoff once defined his own laws of investing.
For volume analysts, that means that the gap between the number of shares offered by sellers versus those bidded on by buyers is the cause of price change. Charles Dow, founder of The Wall Street Journal and the namesake of the Dow Jones averages, believed that a high volume indicated a more accurate price and that, in turn, volume actually led price.
In short, Dow felt that a substantial increase in volume often preceded significant price movements. Since that simple proclamation more than a century ago, the concept has been validated by a multitude of research studies. Financial analysts do not consider volume, whereas technical analysts underutilize it. This chapter discusses how volume provides essential information in two critical ways: Volume Leads Price Although practitioners of technical analysis and academia have often been at odds, volume information is one area where they tend to largely agree.
Volume can provide essential information by indicating a price change before it happens. The message is extremely telling, particularly when the volume reaches extreme levels. During such times, volume offers far superior information than price alone could ever provide.
We find evidence that the premium is a significant presence in almost all developed markets and in a number of emerging markets as well. Figure 5. Volume Interprets Price The second critical way in which volume provides information is by helping the technician interpret price. These researchers demonstrate how volume, information precision, and price movements relate, as well as how sequences of volume and prices can be informative.
Moreover, they also show that traders who use information contained in market statistics do better than those trades who do not. Thus, technical analysis arises as a natural component of the agents learning process. As such, this book gives volume the significance it is due as an essential element of investment analysis. Yet doing so without also discussing price is also insufficient. Volume cannot be properly understood without price any more than price can be adequately assessed without volume.
Independently, both price and volume convey only vague market information. However, when examined together, they provide indications of supply and demand that neither could provide independently. According to common perception, the market should be fairly easy to understand. Why does the market go up?
The market goes up because there are more buyers than sellers, and the market goes down because there are more sellers than buyers.
Yet, we have heard these phrases uttered countless times by common investors and by supposed market experts. In an auction market, price and volume are jointly determined through the agreement to trade. Trading volume, then, is the number of shares exchanged between buyers and sellers.
As a disciplined portfolio manager, I follow such indications rigorously. To ensure that I do not miss out on any possible price appreciation, I enter a market order to buy 1, shares.
On the exchange, our orders cross, thereby enabling me to buy 1, shares from the fund manager. So here is the question: Which force is in control, demand or supply? Is it me, the buyer, who has put in a market order suggesting urgency, or is it the seller, whose limit order suggests her complacency but with ten times the number of shares to distribute?
If you are not certain about the answer, do not feel alone. The theoretical and practical answers have been debated.
The essential point is that price is determined by the net of demand less supply. Thus, when the trade fills on an uptick, it indicates that there is more demand than supply, whereas when the trade goes through on a downtick, supply outweighs demand.
If you add up all these ticks and the price is heading down over time, they form a supply line; you have then what is called a falling support line.
In technical analysis, this is called a downtrend, indicating that supply has been greater than demand over time. In technical analysis, this line is referred to as an uptrend. Volume Analysis—Use the Force What if you had a way to look deep inside the interactions of these two opposing forces, supply and demand, to determine whether the volume supported the price action. This is the objective of volume analysis. Volume analysis analyzes volume data to determine the strength of supply and demand by examining the intrinsic relationship between price and volume.
Volume analysis attempts to expose the relationship between price trends and the corresponding volume information. Bernardo and Judd described this relationship: Support and Resistance In this price-volume analysis, think of volume as the force that drives the market. Force has been defined as a power exerted against support or resistance. To a technician, this definition of force is quite revealing. In technical analysis, support is a price in which buyers reside.
When a stock falls to a support zone, buyers enter the market believing the stock price to be undervalued at this low level. You can identify support zones by finding key low points where these buying operations have occurred in the past. In the same fashion, resistance is an area in which sellers reside. Likewise, when a security rises to a resistance zone, sellers come in believing the stock price is overvalued at this high price level.
Created with TradeStation. Trends The concept of a price trend was mentioned previously in this chapter. But what is a price trend? An uptrend is simply a support line that rises during the course of time. An uptrend is representative of demand for shares that are greater than the supply of shares.
An uptrend can be identified by connecting significant lows. Selling pressure pushes the stock price down, but this pressure is unable to push it back down beyond the previous low levels. A string of higher lows constitutes an uptrend. These rising lows that arose over time show that demand is overwhelming the supply.
With each dip, buyers are eager to scoop up more shares than are shares available for sale at the given price, indicating that the security is being accumulated. In economics, you might call this trend a demand line. In this book, we use these terms interchangeably and refer to an uptrend as a rising support line or demand line see Figure 5. Correspondingly, a downtrend is simply a falling resistance line. A downtrend is a line of resistance that with time falls even lower. A downtrend indicates that demand is overrun by supply.
With each advance in price, sellers are more anxious to exit a position than there are buyers at that price level, forcing the price back down because they must sell their shares at a lower price to find a willing buyer. A downtrend is identified by connecting significant highs so that each high is lower than the previous high. The downtrend reveals that, with time, sellers are willing to accept lower prices, thus indicating that the security is in a state of distribution.
In economics, this falling line of resistance might be referred to as a supply line. In technical analysis, it is referred to as a downtrend. As in the case of the uptrend, we use downtrend, falling support line, and supply line interchangeably see Figure 5. According to Newton, a change in the motion of a body indicates a force is in operation.
In security analysis, volume is the operational force behind price change. In other words, a body left to itself will maintain its condition unchanged. A security might have volume without change. In such cases, volume information might contain little predictive value. Specifically, force equals mass times acceleration. Physically, this relates to how much force it requires to move an object a given distance at a given speed.
You can apply this law as a premise to understanding the markets. Richard Wyckoff referred to this principal as the law of effort versus result, which asserts that the effort must be in proportion to the results. In my first year on the colligate track team, I was designated to run in the 4-by-1 mile relay, where each of the four runners runs a 1-mile leg. I was not a miler. I primarily ran the long-distance events, such as the 5K and 10K.
Interestingly, of the four relay members, none of us were milers. I led off with the first leg of the relay, and the race started out fast. I had good speed for a distance runner but was coming off of an injury and had not been training for the shorter distance events. My first lap time was 60 seconds—too fast for my taste because my heart rate was , but I was toward the back of the pack and did not want to let my team members down. My next lap time was 61 seconds, and again I was toward the back of the pack.
Now I was dead tired, and my heart soared close to I completed my next lap in a pedestrian 79 seconds and was now dead last in the race. Ashamed of myself and determined to put my team members in better position, I let loose passing a few runners on the last lap, clocking in a final lap time of 59 seconds for an unconventional 4: I was quite embarrassed handing off the baton near the tail end of the pack.
Despite my poor lead-off leg, we ended up placing second in the race and, surprisingly, I had the best split time on the team!
This is odd because, normally, the fastest runner on a relay team runs last.
However, in this relay, the fastest leg was by far the first. What happened? During this meet, the open mile was run a mere two races after the four-mile relay. Meanwhile, the other teams chose to run their milers in the first leg of the 4 by 1 with the thought of maximizing their rest before their upcoming mile races.
As a result, the first leg was much faster than the remaining legs. We just need to get that third lap closer to par with the others. Do that, and you could be the best miler in the conference.
Here, my results were the lap times my speed while my effort was my heart rate. The key to determining that my pace was unsustainable was the relationship between my speed and my heart rate.
Between laps one and two, my speed slowed by one second, yet my heart rate jumped by nearly 20 percent. More effort yielded me an inferior result, leading to my third lap crash and burn.
Stocks operate on much of the same principles. In security analysis, the effort force is volume that achieves the result of price change acceleration. The movement in price should not exceed the movement in volume. To discern this relationship, you must study price change acceleration relative to the volume change force.
Consider this example: A stock breaks out 10 percent from its previous close on a volume percent higher than normal. The next day, the stock advances another 5 percent on percent higher volume. On the third day, the stock moves up 2 percent on percent higher volume. The high volume on the price breakout is a bullish indication.
However, with time, volume force expands while the price change acceleration wanes. This situation can be an early warning signal that although the stock runs strong, it might be susceptible to its own crash and burn see Figure 5. Many academics1 re discovered the positive correlation between trading volume and price change in their research. We review more evidence of volume leading price when discussing volume indicators.
Adam Smith developed a similar theory but in the field of economics. Adam Smith believed that when demand exceeded supply, price increased, and when supply was greater than demand, price decreased. The exchange markets operate under the same laws of supply and demand as traditional economics.
Economic theory assumes that supply increases as demand rises; namely, as producers are motivated to produce more goods or services. However, the auction market mechanism changes the dynamics of this operation. In the exchange market, supply is mostly finite. Yes, with help of investment bankers, companies can increase the supply of shares. However, the directive of every publicly traded company is to increase shareholder wealth through dividends or stock price appreciation.
The board of directors do not offer shares unless deemed necessary to increase or in a crisis to stabilize the price of the stock. Thus, both supply and demand operate on an opportunity cost model, where wealth is looking for the best opportunity for growth, or at worst the best place to preserve capital.
Supply in the form of sellers comes from existing shareholders or short sellers who believe cash or another opportunity represents a greater value than the stock at its present price. Demand or buyers comes from investors who believe the stock represents the best opportunity for at least a portion of their wealth. Other factors, such as trading cost, taxes, and spreads might enter into the equation, but these are not pertinent to the context of this text.
The securities exchange markets function as an auction. The volume of shares bought always matches the volume sold on all executed orders. When the price rises, the upward movement reflects a situation in which demand exceeds supply that is, the buyers are in control.
Likewise, when the price falls, it implies that supply exceeds demand that is, the sellers are in control. You also know that with time, these trends of supply and demand form patterns and trends of accumulation and distribution. Whether these trends are up, down, or sideways, volume is the force exerted to uphold these trends. You also learned that the imbalance between supply and demand is manifested through the trading volume as the external force causing price movements.
Wyckoff had a similar law called the law of cause and effect. For there to be an effect, a cause must first exist.