Once relegated to the backwaters of finance, technical analysis has become the go-to method for making real-time decisions in the stock market.
Most traders understand how to use price bar charts to determine the direction of share price and use this information as a tool to make investing choices.
However, there is far more to the proper use of technical analysis than watching price charts for decision making. Technical analysis is defined as the study of price and volume with the goal of making profitable investing decisions. The volume metric in the definition is often ignored by investors when using technical analysis.
Volume is not considered because the majority of traders do not understand the proper ways to utilize it. Frankly, many investors consider the study of volume boring and not near as exciting a study of price. This is why it is ignored by all but the very top performing decile of investors and traders.
Believe it or not, this lack of understanding is why many traders are not successful when using technical analysis.
The proper use of volume analysis is what separates winning stock traders from the vast majority who lose or just break even over time.
Let’s take a closer look at the three primary volume analysis tools.
The first thing is to define volume.
Stock market volume is defined as the total number of shares traded within a specified timeframe.
Liquidity and volume are joined at the hip. Volatility is also part of the liquidity/volume equation.
The greater the volume, the greater the liquidity.
Generally, the higher the liquidity the lower the volatility, with volatility being the size of price moves.
The higher the volatility, the less the liquidity in most situations.
Understanding this volume, volatility, and liquidity connection is the key to successful trading and investing.
The ideal situation for investors is to like to see volume slowly increasing in the direction of a trend.
However, it is critical to understand that a spike in volume can indicate the end of a trend and declining volume can reflect a soon to die move.
The three primary volume analysis tools are, On Balance Volume, Accumulation/Distribution Line, and Ease of Movement. Fortunately, most online broker platforms have these analysis tools built into them. Understanding how they are designed will provide you an edge when using the tools.
Here’s a closer look at these tools.
1. On Balance Volume or OBV
Invented by market prognosticator Joseph Granville in his 1963 book. “New Key To Stock Market Profits”.
It remains one of the most popular volume indicators to this day and is commonly cited by the financial media.
Its function is to measure positive and negative volume, displaying it in graph form so that the trader can determine if capital is flowing into or out of a stock. Understanding this capital flow can assist in making decisions in the stock market.
The indicator is built on an extremely easy to understand idea. It adds a period’s volume when the close is up and subtracts a period’s volume when the close is down. These numbers are charted to create the OBV line which is compared and contrasted to price to find confirmations and divergences.
The way it works is that volume changes will lead the way for price changes.
A climbing OBV line and increasing prices confirms a strong trend. However, a falling OBV line and rising prices reveals a weak or soon to fail trend.
Here is an example of OBV in action. The stock is Citigroup C, you can see how price trended down in March, up in April and then down in May/June. Note how the OBV line follows price in both rising and falling markets.
2. Accumulation/Distribution Line
This indicator is credited to technical analyst Marc Chaiken.
It attempts to measure money flow into and out of stocks/contracts.
The difference between OBV and the A/D line is it takes opening and closing prices into the calculation (range).
The calculation is (close – low) – ( high-close) / ( high – low) X volume in the period.
The resulting number is then plotted in line graph form, similar to the OBV indicator.
It’s often used as a divergence indicator. A bearish signal is given when the A/D line is moving downward, yet price is moving up. Bullish indication would be an upward movement of the A/D line combined with a declining price.
The primary issue with the A/D line is it doesn’t reflect price gaps.
A stock that gaps then closes within the range will not be shown in the A/D line.
Even a series of price gaps will not be shown with this volume indicator. Many times you can see the A/D line trending downward, yet price is moving up. This is a bearish signal, and traders who follow this indicator would consider shorting here.
3. Ease of Movement EOM
This indicator determines the amount of volume that is required to move price.
It was developed by Richard Arms to chart the relationship between volume and price change.
Arms is more widely recognized as the creator of the Arms index or TRIN.
EOM is plotted on a graph with a midpoint of zero. It is graphed in line format and normally smoothed with a 14 day moving average. When price is moving up on light volume, Ease of Movement indicator shows high values above zero. Low values are shown when price is moving downward on light volume. If it takes lots of volume to move price, the indicator stays near zero. Signals are given to go long when the EOM line crosses above zero and short when it crosses below zero.
It is critical to note that none of this indicators should be used as a standalone trading tool. Volume analysis techniques must be utilized in conjunction with both technical and fundamental analysis for maximum success.
A strong bullish signal exists when volume, bullish price factors and support from the fundamental picture converge. The same thing can be said for a bearish view when all three metrics are signaling negative sentiment.
Unfortunately, all three of these metrics are rarely in synch with each other. The successful investor works to detect positive or negative changes starting to occur in the three factors to make educated buy or sell decisions.
The Key Takeaways
Volume is the missing link when it comes to the successful use of technical analysis. It is part of the three prong investing system of fundamentals, volume, and price. The three major volume analysis tools are On Balance Volume, Ease of Movement, and the Accumulation/Distribution Line. Each of these tools can be used to help make decisions concerning the direction of volume.
It is critical to remember that spikes in volume can be signaling buyer or seller exhaustion, therefore a change in trend. In order to identify spikes, the investor needs to know the average volume to locate excessive volume that may be signaling a trend change.
The ideal situation is to see volume slowly increasing in the direction of the trend. This increase in volume is indicating that investors are accumulating shares or selling shares in the case of a downtrend. Using this key in conjunction with one or more of the three volume analysis tools can provide a very clear picture on the likely duration of the price move.