Interpretation of Volume for All Markets
posted under
Philosophy of Technical Analysis
by ceecabolos
The level of volume measures the intensity or urgency behind the price move. Heavier volume reflects a higher degree of intensity or pressure. By monitoring the level of volume along with price action, the technician is better able to gauge the buying or selling pressure behind market moves. This information can then be used to confirm price movement or warn that a price move is not to be trusted. (See Figures 7.3 and 7.4.)
To state the rule more concisely, volume should increase or expand in the direction of the existing price trend. In an uptrend, volume should be heavier as the price moves higher, and should decrease or contract on price dips. As long as this pattern continues, volume is said to be confirming the price trend.
The chartist is also watching for signs of divergence (there's that word again). Divergence occurs if the penetration of a previous high by the price trend takes place on declining volume. This action alerts the chartist to diminishing buying pressure. If the volume also shows a tendency to pick up on price dips, the analyst begins to worry that the uptrend is in trouble.
Volume as Confirmation in Price Patterns
During our treatment of price patterns in Chapters 5 and 6, volume was mentioned several times as an important confirming indicator. One of the first signs of a head and shoulders top occurred when prices moved into new highs during the formation of the head on light volume with heavier activity on the subsequent decline to the neckline. The double and triple tops saw lighter volume on each successive peak followed by heavier downside activity. Continuation
patterns, like the triangle, should be accompanied by a gradual drop off in volume. As a rule, the resolution of all price patterns (the breakout point) should be accompanied by heavier trading activity if the signal given by that breakout is real. (See Figure 7.5.)
In a downtrend, the volume should be heavier during down moves and lighter on bounces. As long as that pattern continues, the selling pressure is greater than buying pressure and the downtrend should continue. It's only when that pattern begins to change that the chartist starts looking for signs of a bottom.
Volume Precedes Price
By monitoring the price and volume together, we're actually using two different tools to measure the same thing—pressure. By.Volume Precedes Price
By monitoring the price and volume together, we're actually using two different tools to measure the same thing—pressure. By..the mere fact that prices are trending higher, we can see that there is more buying than selling pressure. It stands to reason then that the greater volume should take place in the same direction as the prevailing trend. Technicians believe that volume precedes price, meaning that the loss of upside pressure in an uptrend or downside pressure in a downtrend actually shows up in the volume figures before it is manifested in a reversal of the price trend.
On Balance Volume
Technicians have experimented with many volume indicators to help quantify buying or selling pressure. Trying to "eyeball" the vertical volume bars along the bottom of the chart is not always precise enough to detect significant shifts in the volume flow. The simplest and best known of these volume indicators is on balance volume or OBV. Developed and popularized by Joseph Granville in his 1963 book, Granville's New Key to Stock Market Profits, OBV actually produces a curving line on the price chart. This line can be used either to confirm the quality of the current price trend or warn of an impending reversal by diverging from the price action.
Figure 7.6 shows the price chart with the OBV line along the bottom of the chart instead of the volume bars. Notice how much easier it is to follow the volume trend with the OBV line.
The construction of the OBV line is simplicity itself. The total volume for each day is assigned a plus or minus value depending on whether prices close higher or lower for that day. A higher close causes the volume for that day to be given a plus value, while a lower close counts for negative volume. A running cumulative total is then maintained by adding or subtracting each day's volume based on the direction of the market close.
It is the direction of the OBV line (its trend) that is important and not the actual numbers themselves. The actual OBV values will differ depending on how far back you are charting. Let the computer handle the calculations. Concentrate on the direction of the OBV line.
The on balance volume line should follow in the same direction as the price trend. If prices show a series of higher peaks and market.
troughs (an uptrend), the OBV line should do the same. If prices are trending lower, so should the OBV line. It's when the volume line fails to move in the same direction as prices that a divergence exists and warns of a possible trend reversal.
Alternatives to OBV
The on balance volume line does its job reasonably well, but it has some shortcomings. For one thing, it assigns an entire day's volume a plus or minus value. Suppose a market closes up on the day by some minimal amount such as one or two tics. Is it reasonable to assign all of that day's activity a positive value? Or consider a situation where the market spends most of the day on the upside, but then closes slightly lower. Should all of that day's volume be
given a negative value? To resolve these questions, technicians have experimented with many variations of OBV in an attempt to discover the true upside and downside volume.
One variation is to give greater weight to those days where the trend is the strongest. On an up day, for example, the volume is multiplied by the amount of the price gain. This technique still assigns positive and negative values, but gives greater weight to those days with greater price movement and reduces the impact of those days where the actual price change is minimal.
There are more sophisticated formulas that blend volume (and open interest) with price action. James Sibbet's Demand Index, for example, combines price and volume into a leading market indicator. The Herrick Payoff Index uses open interest to measure money flow. (See Appendix A for an explanation of both indicators.)
It should be noted that volume reporting in the stock market is much more useful than in the futures markets. Stock trading volume is reported immediately, while it is reported a day late for futures. Levels of upside and downside volume are also available for stocks, but not in futures. The availability of volume data for stocks on each price change during the day has facilitated an even more advanced indicator called Money Flow, developed by Laszlo Birinyi, Jr. This real-time version of OBV tracks the level of volume on each price change in order to determine if money is flowing into or out of a stock. This sophisticated calculation, however, requires a lot of computer power and isn't readily available to most traders.
These more sophisticated variations of OBV have basically the same intent—to determine whether the heavier volume is taking place on the upside (bullish) or the downside (bearish). Even with its simplicity, the OBV line still does a pretty good job of tracking the volume flow in a market—either in futures or stocks. And OBV is readily available on most charting software. Most charting packages even allow you to plot the OBV line right over the price data for even easier comparison. Other Volume Limitations in Futures
We've already mentioned the problem of the one day lag in reporting futures volume. There is also the relatively awkward practice of using total volume numbers to analyze individual contracts instead of each contract's actual volume. There are good reasons for using total volume. But how does one deal with situations when some contracts close higher and others lower in the same futures market on the same day? Limit days produce other problems. Days when markets are locked limit up usually produce very light volume. This is a sign of strength as the numbers of buyers so overwhelm the sellers that prices reach the maximum trading limit and cease trading. According to the traditional rules of interpretation, light volume on a rally is bearish. The light volume on limit days is a violation of that principle and can distort OBV numbers.Even with these limitations, however, volume analysis can still be used in the futures markets, and the technical trader would be well advised to keep a watchful eye on volume indications
To state the rule more concisely, volume should increase or expand in the direction of the existing price trend. In an uptrend, volume should be heavier as the price moves higher, and should decrease or contract on price dips. As long as this pattern continues, volume is said to be confirming the price trend.
The chartist is also watching for signs of divergence (there's that word again). Divergence occurs if the penetration of a previous high by the price trend takes place on declining volume. This action alerts the chartist to diminishing buying pressure. If the volume also shows a tendency to pick up on price dips, the analyst begins to worry that the uptrend is in trouble.
Volume as Confirmation in Price Patterns
During our treatment of price patterns in Chapters 5 and 6, volume was mentioned several times as an important confirming indicator. One of the first signs of a head and shoulders top occurred when prices moved into new highs during the formation of the head on light volume with heavier activity on the subsequent decline to the neckline. The double and triple tops saw lighter volume on each successive peak followed by heavier downside activity. Continuation
patterns, like the triangle, should be accompanied by a gradual drop off in volume. As a rule, the resolution of all price patterns (the breakout point) should be accompanied by heavier trading activity if the signal given by that breakout is real. (See Figure 7.5.)
In a downtrend, the volume should be heavier during down moves and lighter on bounces. As long as that pattern continues, the selling pressure is greater than buying pressure and the downtrend should continue. It's only when that pattern begins to change that the chartist starts looking for signs of a bottom.
Volume Precedes Price
By monitoring the price and volume together, we're actually using two different tools to measure the same thing—pressure. By.Volume Precedes Price
By monitoring the price and volume together, we're actually using two different tools to measure the same thing—pressure. By..the mere fact that prices are trending higher, we can see that there is more buying than selling pressure. It stands to reason then that the greater volume should take place in the same direction as the prevailing trend. Technicians believe that volume precedes price, meaning that the loss of upside pressure in an uptrend or downside pressure in a downtrend actually shows up in the volume figures before it is manifested in a reversal of the price trend.
On Balance Volume
Technicians have experimented with many volume indicators to help quantify buying or selling pressure. Trying to "eyeball" the vertical volume bars along the bottom of the chart is not always precise enough to detect significant shifts in the volume flow. The simplest and best known of these volume indicators is on balance volume or OBV. Developed and popularized by Joseph Granville in his 1963 book, Granville's New Key to Stock Market Profits, OBV actually produces a curving line on the price chart. This line can be used either to confirm the quality of the current price trend or warn of an impending reversal by diverging from the price action.
Figure 7.6 shows the price chart with the OBV line along the bottom of the chart instead of the volume bars. Notice how much easier it is to follow the volume trend with the OBV line.
The construction of the OBV line is simplicity itself. The total volume for each day is assigned a plus or minus value depending on whether prices close higher or lower for that day. A higher close causes the volume for that day to be given a plus value, while a lower close counts for negative volume. A running cumulative total is then maintained by adding or subtracting each day's volume based on the direction of the market close.
It is the direction of the OBV line (its trend) that is important and not the actual numbers themselves. The actual OBV values will differ depending on how far back you are charting. Let the computer handle the calculations. Concentrate on the direction of the OBV line.
The on balance volume line should follow in the same direction as the price trend. If prices show a series of higher peaks and market.
troughs (an uptrend), the OBV line should do the same. If prices are trending lower, so should the OBV line. It's when the volume line fails to move in the same direction as prices that a divergence exists and warns of a possible trend reversal.
Alternatives to OBV
The on balance volume line does its job reasonably well, but it has some shortcomings. For one thing, it assigns an entire day's volume a plus or minus value. Suppose a market closes up on the day by some minimal amount such as one or two tics. Is it reasonable to assign all of that day's activity a positive value? Or consider a situation where the market spends most of the day on the upside, but then closes slightly lower. Should all of that day's volume be
given a negative value? To resolve these questions, technicians have experimented with many variations of OBV in an attempt to discover the true upside and downside volume.
One variation is to give greater weight to those days where the trend is the strongest. On an up day, for example, the volume is multiplied by the amount of the price gain. This technique still assigns positive and negative values, but gives greater weight to those days with greater price movement and reduces the impact of those days where the actual price change is minimal.
There are more sophisticated formulas that blend volume (and open interest) with price action. James Sibbet's Demand Index, for example, combines price and volume into a leading market indicator. The Herrick Payoff Index uses open interest to measure money flow. (See Appendix A for an explanation of both indicators.)
It should be noted that volume reporting in the stock market is much more useful than in the futures markets. Stock trading volume is reported immediately, while it is reported a day late for futures. Levels of upside and downside volume are also available for stocks, but not in futures. The availability of volume data for stocks on each price change during the day has facilitated an even more advanced indicator called Money Flow, developed by Laszlo Birinyi, Jr. This real-time version of OBV tracks the level of volume on each price change in order to determine if money is flowing into or out of a stock. This sophisticated calculation, however, requires a lot of computer power and isn't readily available to most traders.
These more sophisticated variations of OBV have basically the same intent—to determine whether the heavier volume is taking place on the upside (bullish) or the downside (bearish). Even with its simplicity, the OBV line still does a pretty good job of tracking the volume flow in a market—either in futures or stocks. And OBV is readily available on most charting software. Most charting packages even allow you to plot the OBV line right over the price data for even easier comparison. Other Volume Limitations in Futures
We've already mentioned the problem of the one day lag in reporting futures volume. There is also the relatively awkward practice of using total volume numbers to analyze individual contracts instead of each contract's actual volume. There are good reasons for using total volume. But how does one deal with situations when some contracts close higher and others lower in the same futures market on the same day? Limit days produce other problems. Days when markets are locked limit up usually produce very light volume. This is a sign of strength as the numbers of buyers so overwhelm the sellers that prices reach the maximum trading limit and cease trading. According to the traditional rules of interpretation, light volume on a rally is bearish. The light volume on limit days is a violation of that principle and can distort OBV numbers.Even with these limitations, however, volume analysis can still be used in the futures markets, and the technical trader would be well advised to keep a watchful eye on volume indications
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