Volume as applied to Dow Theory has a bit of a checkered past. Only Schaefer and Russell have been definitive in expressing its importance, though Russell will often use Point & Figure charts, which exclude volume entirely. Rhea commented that Hamilton was skeptical about the importance of volume, which in turn made Rhea skeptical. Hamilton's complete set of editorials written for Barron's and the WSJ are rife with mixed messages in regard to the use of volume as a tool in predicting market strength or weakness. Let me make it clear here today, volume matters. But how does it matter and how can it help us? That is the important question to answer. Let's cover several volume scenarios and how the force, or lack of, plays on price action and clues us into market strength or weakness. (Remember Volume does not exist in a vacuum, it is tool to be used along with other tools in determining trend)
• Volume That Deceives
• Volume Within A Channel
• Surging Volume As A Force To Move Price
• Surging Volume As A One-Day Occurrence
• Surging Volume That Follows Through
Volume That Deceives
Day to day market movements ultimately add up to something we can use in our market research. Along the way, volume will run at different rates based on season, trend, price points, etc... Truth is, volume in most circumstances is absolutely useless, and ultimately, absolutely crucial. That's right - useless, but crucial. Con'foo-sed? Think of it this way, on a 2,000-mile drive across country, how important is it that the car brakes work? The truth is, you could go without the brakes for 99% of the trip. But being able to use your brakes for just 1% of the trip will save your life. So again, useless, but crucial. The main reason people are deceived by volume is they don't know when to consider it. Take our current rally within the down trending channel. Volume is very light on the advance, which is leading many bears to believe that the rally is doomed. I am not so sure that is correct. To me, we are just cruising down the road for now, and we haven't needed to use our brakes yet. In order to determine the importance of this rally we will need to wait for a while until we get to the top of the channel. Along the way, within the meat of the channel, volume tells us very little. Volume can be huge or scarce in this abyss, it just doesn't matter yet. The current rally could accelerate Monday morning with a huge volume spike accompanied by a strong price advance towards the upper range of the channel, but I would still give more credence to what happens as the market looks to break out of the channel. Currently the chart shows me that we have three declining tops in the industrials combined with three lower lows - Downtrend intact, Period. If we can approach the top of the channel, I will then pay attention to volume to see if we can breakthrough on increasing volume, consolidate the gains on low volume, then breakout within a week on moderate to high volume. That is my recipe for a trend direction or true channel-breaking move. A final word about deceptive volume. Pay attention to the market condition before applying any thoughts on volume. Is it a bullish uptrend, bearish downtrend, or a consolidating line? Continuation rally, decline or countertrend rally or decline? When you detect the condition as best you can, then you can apply the proper approach to detecting which price points are truly important. When you have the proper price points, you may then make a proper study of volume to detect changes in the market direction. All the rest is filler.
Volume Within A Channel
Understanding volumes effect within channels is simple if you treat it like playing blackjack. Meaning that if you are trading within a channel you must follow the rules without question. If you do, in the end you will tilt the odds in your favor. Within a channel, volume tracks a certain way when the channel is likely to hold and an entirely different way when a channel break is imminent. As price approaches the top or the bottom of a channel, volume tends to become dull and price movement laborious. It is here that "Trading" positions can be established, because we have favorable and definable odds. Our stops can be placed far enough outside of the channel as to not be shaken out by a small run outside of the channel, while our potential gains are large if the channel holds. The clue to a real channel break is less obvious, but still can be sought out with a little knowledge of what the "Typical" break looks like. Whether it is the break of a "line" or a bullish or bearish channel, the push away from the channel into a new price band will need to exhibit "New Behavior". Previously, volume in the channel would sputter at the top and bottom, now when we get a break outside of the channel it will usually be on a rush of volume, and when that rush subsides the test of the strength of this new behavior will begin. If the volume now becomes dull as price approaches the old channel this is a strong indicator that the channel is broken and a new range is going to be established. The clincher is that volume will accelerate, with price, away from the channel after a low volume test back towards the channel. An exception to look for within all price channels and range bound markets is the commonly known "key reversal". Key reversals are price moves up or down that end the previous market trend by closing strongly away from the highs or lows from the morning or afternoon trading. In this instance, if the key reversal occurred at the top or bottom of a channel, one would have to assume that, whether volume was high or low, price would be of paramount importance and volume should be relegated to the background, as the price structure of the market becomes our lead clue.
Surging Volume As A Force To Move Price
We just finished with a thought on "key reversal" days. Key reversals are often on high comparative volume, and on these days index prices often move as much as two percent intra-day. These days are generally serious clues to trend changes occurring in the short and medium term price direction of the market. (Before we make this a rule, I would be remiss in not pointing that just a week ago we had a key reversal day in the rising price of oil that proved to be a trap, as after a one day price decline was followed the very next day by another reversal right back to the upside that lasted another week. Remember, this is why you create a stop loss.) When large market volume fails to move prices to new highs or new lows we can begin to consider the idea that stocks are being distributed or accumulated before the next change in trend. Towards the end of each phase of a bull market, when volume surges and price fails to move up, it can be said that stocks are generally being distributed. These new buyers are generally believed to be the "Dumb Money", since in a healthy market, price advances with growing volume. When high volume fails to advance price it is believed that the brightest minds on the street can't see future business conditions clear enough to warrant holding stock, so they begin selling to the retail buyer. On the other hand, during the third phase of a bear market, after precipitous declines have shaken the faith of investors, volume surges will be unable to pressure prices lower. Upon the failure of high relative volume forcing prices lower, the astute practitioner will begin to acquire stock believing that the brightest minds on the street are now able to see clearly that conditions of business are at their nastiest, and that from here business will begin improving. Again, it is important to understand that when large volume cannot move price, one can be fairly certain that lighter volume will fail as well. A trend change is likely close at hand.
Surging Volume As A One Day Occurrence
Surging volume as a one-day occurrence is an alarm clock. Nothing more. It simply tells us to wake up and look at the potential for action ahead. Ask - did the volume create higher prices, lower prices, was it a key reversal day? Did it break prices out of a channel or push prices back into a channel after what appeared to be a change in trend? Our job is to ask questions of this action and look to see if the theme continues in the days ahead. In the end one-day volume surges are like one-day price surges or declines - deceptive and they should be watched closely.
Surging Volume That Follows Through
The most important volume to watch is follow through volume. A first date can be amazing, but without a good second or third date, the relationship is doomed. There is no need for every date to be perfect, but don't wait to long before turning on the charm or away he or she will go. Same thing for musicians and volume! One hit wonders are incredibly forgettable, but string a few hit records together and before you know it your Brittany Spears. Um, yeah - bad example, moving on. Volume tracks the same way. High volume follow-through (Usually within seven trading days of the first surge) shows conviction and a desire of market participants to be in play. Put a few high volume days together -people will begin to take notice and be willing to jump in if the volume is moving prices as well. In fact, that is really what is important here. Follow-through volume must be accompanied by similar price behavior. Surging daily volume should move the major indexes 1 ½ to 2% or I would become cynical of the action. Investor's Business Daily has based their entire investing philosophy on follow-through volume and price action. You can read about it by researching CANSLIM investing online. Surging volume that follows on the heels of a previous high volume price advance or decline suggests that the indexes are going to continue in the same direction for a fair amount of time. You need to be aware of market conditions to judge if the move is of primary or secondary importance. Follow-through volume occurs in bull and bear market conditions, in both trend continuation and countertrend movements.
Each of the volume explanations must work in conjunction with price action at the proper price points. Mindlessly considering volume in the middle of a trend or trading range is useless. Knowing the market condition prior to judging volume will help to create conditions that will allow for an inside look into what volume means to the future price structure of the markets.