Adding Volume To The Analysis

08/17/10 10:08:37 AM

by Alan R. Northam

The whole purpose of technical analysis is to use past price and volume data to determine the future direction of a security or market. An analysis that does not include volume, however, is not a complete technical analysis. When volume is considered along with price, a whole new analysis is often the result.

Security: SPY
Position: N/A

Any technical analysis without considering volume is not a complete analysis. Volume is the force behind the movement of price and must be considered. Volume is normally shown below the price chart in the form of daily bars showing the total volume for that security or market for that particular day. However, deciphering the daily volume bar chart is much like reading tea leaves. When you look at the volume bars, it's hard to understand what they are telling us. Just like when you are looking at tea leaves flouting in a pot of tea, only the trained eye can decipher the tea leaves, and it takes a trained eye to decipher the volume bars. There is much information to be learned about the price trend, if only we can understand what the volume bars are saying. This is an attempt to scratch the surface in understanding the volume bars and is in no way a complete study.

The following is some guidelines to use in understanding how to read the volume bars. I have arranged them in order of an uptrend followed by a downtrend, which is followed by a trading range. During an uptrend, volume normally increases during the upward rallies. During market corrections, volume normally decreases. Volume usually shrinks just before a market top, then spikes upward at the market top.

When volume does not follow these guidelines, the uptrend should be viewed as suspicious. Volume also increases just after a market top at the beginning of a new downtrend. When a market or security is moving in a downward direction, volume again should be increasing, and decreasing on corrective rallies. Volume normally drops off as a market approaches a bottom, however, just prior to the bottom volume increases in panic selling. Volume then falls off sharply at the market bottom. When volume does not follow these guidelines for a downtrend, the trend should be questioned. Volume also increases sharply at the beginning of a new uptrend.

During a trading range, volume normally decreases but will then increase on the breakout. I have outlined these volume guidelines below for easy reference:

VOLUME GUIDELINES
Volume increases:
1. At the beginning of a trend
2. During an uptrend
3. Sharply at the top of a trend
4. Just after the top of a trend
5. During an downtrend
6. Prior to a market bottom (panic selling)
7. On a breakout
Volume decreases:
1. During market corrections
2. Just before a market top
3. At the bottom of a downtrend
4. Sharply at the end of a downtrend
5. During a trading range

Figure 1 shows the daily price bar chart of SPY in the top pane and the daily volume bar chart in the bottom pane. The price bar chart in the upper pane shows that from April 2010 until July price moved down, as shown by the downsloping red trendline. However, in July SPY started moving upward, shown by a green upsloping trendline. Note also that price broke out above the downsloping red trendline on July 22 to signal a trend reversal from down to up. In early August, SPY moved back above its 200-day simple moving average to signal that a long-term uptrend was now in play. The question becomes, "Is SPY going to continue higher over the long term?"

To answer this question, an analysis of volume, the force behind the upward move, is in order.

Before we start to analyze volume with respect to the upward rally that started in July 2010, I would like to look at volume at the beginning and end of the downtrend from mid-April through early July. Note that just before the market top, volume started to decrease and actually shrank to its lowest level at the market top (see two red volume arrows during market top in Figure 1). According to our volume guidelines, volume normally decreases just before a market top, and thus the decreasing volume was a signal that the upward rally was reaching its top.

Note, however, that volume did not increase sharply at the market top. Volume does not always do so. When it does, it signals buying exhaustion. However, buying exhaustion does not always occur at every market top. This may occur when the upward rally is extremely weak and there simply is no more money available to buy stocks. This is why the volume guidelines are just that -- guidelines and not rules. Rules should not be broken, but guidelines can.

Guidelines tell us what the market should do, whereas rules tell us what the market always does. Note volume at the end of the downtrend in late June. At the end of the downtrend, SPY experienced two days of panic selling where volume spiked upward. According to the volume guidelines, volume spikes upward prior to a market bottom. Note the first volume spike occurred three days prior to the market bottom, whereas the second volume spike occurred at the exact market bottom. The volume guidelines also state that volume decreases at the market bottom. With respect to SPY, volume actually decreased the day before the market bottom. Again, the volume guidelines are just that -- guidelines. In either situation the volume spikes and the decrease in volume signaled the end of the downtrend.

FIGURE 1: SPY, DAILY. Chart shows daily price bars above and volume bars below.

Graphic provided by: MetaStock.

Now let's look at the rally from July onward (see Figure 2). In early July, the market made a bottom followed by an inside day. The next day, the market broke out of this one-day basing period (see red resistance line on the price chart) and started to rally upward (trend 1). Note that volume increases on the breakout just as the volume guidelines said it should (green arrow 1). As the rally continued upward, volume decreased. Rising prices on decreasing volume is recognized as a corrective rally. The volume guidelines show volume decreases during market corrections. On the last day of trend 1, volume spiked. Again, the volume guidelines state that volume normally increases sharply at the top of the trend. Thus, after such a lengthy rally, a volume spike is expected and when it occurs, it signals the end of the rally.

During the following downtrend (trend 2), note that volume increased. The volume guidelines state that volume normally increases during a downward trend. This points out an interesting situation. When we just look at the price chart, we think that trend 1 was the rally in the direction of the major trend and trend 2 was the correction to the trend. However, when we add volume, we see just the opposite. Trend 1 is the corrective rally to the preceding downtrend that lasted from mid- to late June and trend 2 is the continuation. This tells us that the direction of the major trend is downward and not upward. However, trend 2 was interrupted by trend 3, another upward corrective rally.

Before we jump forward to examine trend 5, note that trend 3 was also a corrective rally as identified by decreasing volume, and trend 4 downward was in the direction of the major trend, as noted by increasing volume. Again, this is the exact opposite as to what we would expect. We would naturally think that trend 3 was part of the ongoing upward rally and trend 4 was corrective. However, what we need to keep in mind is that volume increases in the direction of the major trend and decreases during corrections.

Now let's jump forward to uptrend 5. First of all, note that trend 4 ended with a one-bar basing period. The following day price broke out above this one-day basing period but did so on low volume (see red downward point arrow 4). The volume guidelines state that on breakouts, volume normally increases. Thus, we should have recognized this as a weak breakout and a sign that the upward push is tiring. Next, note that during the rally phase of trend 5, volume again failed to increase. Recall from the volume guidelines that volume normally decreases during market corrections. Thus, trend 5 is part of the continuing corrective rally that began in early July.

After price tried to rally higher for five days, note the volume spike (green arrow 5). Recalling again the volume guidelines, volume spikes occur at the top of the trend. Thus, we should have been aware that the upward corrective rally had come to an end. The actual market top occurred one day later on very low volume. What does the volume guidelines say about decreasing volume at the end of a trend? If you are confused, remember the word "guidelines."

FIGURE 2: SPY, DAILY. Chart shows daily price bars above and volume bars below.

Graphic provided by: MetaStock.

In conclusion, volume adds a new dimension to technical analysis. By looking at the rally upward from early July and the breakout above the 200-day moving average, the analyst may conclude that the main direction of SPY is upward and that SPY has entered into a long-term uptrend. However, by adding volume to the analysis, just the opposite is observed. Volume decreased during each and every upward rally and increased during the downward rallies. From the volume guidelines, we note that volume decreases during market corrections and increases in the direction of the main trend. By considering volume in the analysis, it is observed that the upward rally from early July is corrective and that the main direction of the trend is downward.

Alan R. Northam

Alan Northam lives in the Dallas, Texas area and as an electronic engineer gave him an analytical mind from which he has developed a thorough knowledge of stock market technical analysis. His abilities to analyze the future direction of the stock market has allowed him to successfully trade of his own portfolio over the last 30 years. Mr. Northam is now retired and trading the stock market full time. You can reach him at inquiry@tradersclassroom.com or by visiting his website at http://www.tradersclassroom.com. You can also follow him on Twitter @TradersClassrm.

	Garland, Tx
Website:	www.tradersclassroom.com
E-mail address:	inquiry@tradersclassroom.com

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Adding Volume To The Analysis

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