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How To Use Price And Volume To Trade Profitably

08/31/10 09:03:09 AM
by Billy Williams

To gauge a stock's strength or weakness, study price and volume.

Security:   FOSL
Position:   Hold

The trading community has long noticed the relationship between price and volume ever since the days when traders gathered under a buttonwood tree to trade stocks long ago before that area became present-day Wall Street. This relationship between price and volume has allowed traders to gain insight whether the health of a stock could lead it higher or having it fall out of favor and being sold off at lower and lower prices.

The relationship between price and volume will determine if a given stock will trend, change course, or consolidate within a given price range.

Volume reveals the total buying and selling transactions for a given stock. If there were more buyers than sellers on a trading day, then the price action would be bullish and the stock's price could rise as the stock was under accumulation. However, if there were more sellers than buyers on the same stock on a given day, then the price action would be bearish with the stock's price falling since it was under distribution.

Over time, if the stock is under accumulation or distribution, then it will trend in a given direction, giving traders the opportunity to ride the trend profitably. By taking notice of increased volume, you can gauge the strength or weakness of a stock and trade accordingly.

If volume goes back and forth daily between accumulation and distribution, then price will remain in a trading range, since neither the bulls or bears are committing enough trading volume to take control, leaving the price oscillating between price points. Trading volume is low when a stock is trading back and forth and results in these periods of price consolidation, with the exception being at these support and resistance price points where one side will force back the direction of price. Still, neither the bulls nor bears commit enough buying to force the stock in the resumption or reversal of the dominant trend. See Figure 1.

For countertrends, trading volume can take a dramatic and explosive reversal, causing price to force the stock out of its present direction. When stocks of companies have been increasing in value and steadily trending higher, but then reporting disappointing sales results, stampedes can result, forcing the price of the stock down, flipping its upward momentum.

FIGURE 1: FOSL. FOSL trends higher, while volume shows that it is under accumulation and spiking higher as price action makes new highs.
Graphic provided by:
For example, breakout traders look for periods of price consolidation where the volume reveals that no single side is taking control of a stock, resulting in the stock trading in a price range, typically in a flat base pattern. By observing for stocks that are trading near an all-time high while watching for buyers to take control of the stock's direction, traders can time their entries as the stock trades up through its upper price point.

Take time to study price charts and the relationship of the price action with the trading volume and you can time your entries with better precision but also pick stocks whose underlying buying/selling volume will help you be on the right side of the trade.

Billy Williams

Billy Williams has been trading the markets for 27 years, specializing in momentum trading with stocks and options.

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