Volume Analysis (Part I of IV)

05/18/01 02:01:00 PM

by Dennis D. Peterson

Volume tells us how many shares are traded and thus gives us a measure of buying and selling enthusiasm.

Security: AOL
Position: N/A

Suppose someone offered you something you wanted for less money than it cost two weeks ago. Would you turn it down? What if everyone in your neighborhood had heard about this bargain and they all wanted the same thing? Would they turn it down too? Thinking about stocks and how many people are buying a bargain, or selling something that is too expensive, is one way to remember how to use volume. Obviously if a stock is perceived to be a bargain, then the whole neighborhood will jump in. If it's perceived to be too expensive, then not many will buy it.

You may have heard the phrase "volume leads price." Does this mean, for example, that if volume is increasing price will also? Obviously, this is not always the case. The phrase should be "volume and price together can tell you if the market is comfortable with a price." The statement "Volume leads price" leaves out so many details that it's more harmful than helpful.

If the majority of investors and traders think something is a bargain, then price and volume increase together. When price continues up and volume declines, it's a sign the market community as whole has lost its enthusiasm (more on this later). It's a bad sign for those who are buying, that is, those who have taken long positions. The other side of the coin is that as prices are declining, then volume should decrease. Obviously if something is becoming a bargain then there are fewer sellers and volume decreases. If volume increases as prices fall then a degree of panic has set in. The market is overreacting.

When prices go up on increasing volume and down on decreasing volume the market is said to be in gear with price and volume. It can also get out of gear on a regular basis. Out of gear normally means the market has gone too far - it has overreacted. When volume drops off below the norm established during the last two to four weeks, the market doesn't know what it wants to do and price will typically jump around unpredictably. To see this in action, I'll take a stock and first identify the volume trends -- I don't expect to see a whole bunch. Next I'll go to the prices and identify price trends. For the part of the price trend not covered by a volume trend, I will then have to see if the trend continued because of selling panic or overbuying exuberance (more on this later).

Figure 1: AOL price and volume. To perform volume analysis, first identify volume trends and then go to price and identify the price trends.

Graphic provided by: MetaStock.

Graphic provided by: Data vendor: eSignal<.

Figure 1 is a daily volume and price chart of AOL that typifies volume and price behavior. The chronology of the chart is as follows:

1. AOL begins a price downtrend with decreasing volume.
2. At $55 per share panic selling hits and drives the price below a rational price.
3. The price reacts back up, goes into a second downtrend with decreasing volume, and stops at $55.
4. An uptrend then starts initially on growing volume, but the volume goes up too much in too short of a time frame to be sustainable and then lessens as price carries on up to $75.
5. The third downtrend is again one that has decreasing price with decreasing volume, and it also stops at $55!
6. During May and June no one is sure what to do with AOL as indicated by the low volume.
7. Now look at where I have started each of the downtrends. They all start at $63 which happens to be the peak in July! To do this analysis I first looked for volume that was increasing or decreasing. I then went up to the price chart to draw the price trendlines, to see how price was behaving.

During this time frame the market thought that $55 was a reasonable price and $63 was too high a price. AOL only got higher than $63 by getting out of gear, and lower than $55 by either getting out of gear or bouncing around on low volume -- disinterest.

Dennis D. Peterson

Market index trading on a daily basis.

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VOLUME

Volume Analysis (Part I of IV)

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