A Short Guide to Using Volume

When looking at a chart, it’s striking how little information we have about a stock. A chart shows the price action and volume, and many chartists turn volume off, eliminating 50% of the information that’s available to them. Volume can be ignored most of the time but the rare signals provided by this information can be important. The chart below shows an example of when volume can be useful, just two days in six months.

1

In August 2015, fears of a bear market grew quickly as the S&P 500 fell 13% in a week. Although many traders ignored the information, volume was telling us not to worry. In the chart, you can see a volume spike as price bottomed in August. A volume spike is a day when the volume is significantly higher than the previous day. It’s a signal that something important happened because a volume spike shows that a large number of traders took action on that day. In this case, traders were acting because they seemed to believe prices had fallen too much and they wanted to own stocks after the selloff. In late September, prices tested the August low and another volume spike developed. By now, traders should have been buying aggressively. But few really understood the volume signal. The next chart highlights those signals.

2

In the second chart, we’ve transformed volume into an unusually useful indicator. This indicator is the ratio of up volume to down volume. So few people follow it that it doesn’t even have a special name. It’s usually called the up-down volume ratio. Up volume is the sum of the volume of all stocks that closed higher that day. Down volume sums the volume of all stocks closing lower. The ratio is usually under 3 as most days aren’t providing us with significant information. When the ratio spikes above 9, indicating that volume in stocks closing up was at least 9 times greater than volume in down stocks, we have a buy signal. In the chart, ratios above 9 to 1 are highlighted with green bars.

Notice we don’t get many signals from this indicator. History shows we can go years at a time without a signal from this indicator. Signals are so rare few people follow the indicator and that’s why it’s valuable. Many years ago, the head of technical research at Merrill Lynch told his analysts “to know what everyone knows about the markets is to know nothing.” He wanted them to find indicators no one else had and he wanted insights that weren’t available anywhere else. The up-down volume ratio can help you find information few traders have.

3

You don’t need to check the indicator every day. It’s only going to be important after prices drop. After a 10% decline, you could check Yahoo’s market data center for the numbers you need to calculate the indicator. In this example, up volume was 62% of the day’s action and down volume was 37%. Ignore the unchanged volume in your calculation. The up-down volume ratio was 1.7 (67%/32%), well below the level of 9 that indicates we should be buyers.

The up-down volume ratio is one indicator you should know, but there are other volume indicators that some analysts claim can provide useful information at times. We will look at a few of those.

One of the oldest volume indicators is on-balance volume (OBV), an indicator popularized by Joe Granville in the 1960s but originally developed in the 1930s. OBV is a running total of volume. To get today’s OBV, you start with yesterday’s OBV and add today’s volume to it if the price closed up, and subtract today’s volume if the price closed lower. OBV also provides signals only occasionally, as the next chart shows. Divergences are usually considered to be the only signals OBV offers.

4

OBV is overlaid on the price action to make it easier to interpret. Most of the time, OBV moves in line with the price action. Occasionally, as in January of this year, OBV diverges from prices. In this case, OBV moved higher while prices did not. We expect volume indicators to tell us which way prices will move when there’s a divergence. In this case, OBV moved up so we expect prices to move up. There was a quick down move followed by a strong rally. Many traders ignored volume and became bearish when prices fell, missing the subsequent gains.

This chart shows the standard method of interpreting OBV, using visual analysis to spot divergences. We can program divergences and learn whether or not they are actually predictive. This is, of course, preferable to visual analysis since our eyes are prone to making errors. We can test OBV divergences using the same technique we used when we put MACD divergences to the test in an earlier article. The results are predictable – OBV divergences do not provide information that can be used to generate consistent profits. Divergences work about a third of the time and taking all of the signals would lead to more losses than wins.

Other analysts have noted OBV doesn’t work very well so they have tweaked the indicator in various ways. The tweaks all modify the calculation in a similar way, changing the value of the most recent day’s volume based on the price action. For example, the Money Flow Index (MFI) uses the typical price instead of the close and changes the formula so the indicator is calculated in the same way RSI is. The typical price is the average of the high, low and close.  The next chart adds MFI along with OBV and we can see there isn’t much difference between the two, despite the added complexity of calculating MFI. Testing confirms each performs in a similar manner.

5

The Volume Accumulator (VA) takes a percentage of each day’s volume and adds it to the previous day’s VA. To obtain the new value of VA, the percentage of volume to use is found by calculating where the close is relative to the low. If the stock closes at the day’s high, 100% of the day’s volume is used in the VA. If the stock closes exactly on the low, none of the day’s volume is used and VA is unchanged. If the close is exactly in the middle of the range, 50% of the volume is used. The range is equal to the high minus the low.

Intraday Intensity uses a process similar to the VA except the percentage of volume to use is equal to the value of the stochastic indicator for that day. We could go on but testing shows all perform about the same. Rather than continuing to look at indicators that don’t work, there is one variant that tests well, Dr. Alexander Elder’s Force Index (FI). The formula is below:

FI = (Close – Close.1) * Volume where close.1 = yesterday’s close

This indicator was developed to be part of a trading strategy. The rules are simple. For short-term traders, buy when the 2-day exponential moving average (EMA) of FI is less than 0 and sell when the 2-day EMA is above 0.  This is a standard short-term mean reversion strategy. In back testing, it wins about 60% of the time and delivers an average annual return of about 18% a year.

Traders focused on the longer term can also use the FI. In this case, the rules are to buy when the 13-day EMA is greater than 0 and sell when the 13-day EMA falls below 0. This is a standard long-term trend following strategy. In back testing, about 35% of trades are winners which is typical of a trend following strategy. The average win is about 3 times as large as the average loss and the strategy is profitable in the long term with an average annual return of about 18.8%.

In conclusion, volume is useful but from a trader’s perspective you should keep it simple. Remember the up-down volume ratio is one of the best bottom-timing indicators available. You should always check this indicator after a big down day. You can safely ignore OBV and its many variations because they don’t provide winning information often enough to bother following them. If you want to trade with a volume-based strategy, you should consider the Force Index as a strategy. The results justify the effort required to follow the indicator.