The Missing Link Of Technical Analysis

All disciplines have that one key feature that brings everything together.  Without this item, the process just doesn’t seem to work correctly.

This fact is particularly true for technical analysis.  The indicators and charts just don’t appear to work right without this often overlooked feature of technical analysis.   While it is often talked about among traders and even in mainstream financial media, it is often disregarded by traders and investors.

This feature of technical analysis is so critical for your success that I refer to it as the “missing link”.

The reason many traders and investors ignore this missing link is because they don’t understand how to use it.  Everyone knows about it, but only the top performing investors know how to use it.

volume

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If you haven’t already guessed it, I am referencing VOLUME as the missing link in technical analysis.   While most traders think they know what it is and how to apply it, very few do.

This article will show you in an easy to understand way how to use technical analysis’s missing link of volume.

First let’s define volume as it applies to the financial markets.

Volume is defined as the number of shares or contracts traded in a security or market over a particular time frame.  It can be measured from a minute by minute basis to an infinite amount of time.  A good way to look at is if you purchase 1000 shares of stock, the volume in that stock increases by 1000.

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Volume is used in conjunction with technical analysis to gauge the strength or weakness of a move. 

The key to determining whether or not to buy into an uptrend or selling into a down trend is volume.  If price is rapidly increasing along with volume, it is a strong signal that the uptrend will continue.  Also, if the price is skyrocketing higher, but the volume is low or decreasing, it is a clear signal that the uptrend will soon end.

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The reason this is true is because stocks need buyers to keep moving higher.  The more buying, the higher the volume of the stock.  As the stock moves higher it should attract more and more buyers which in turn lift the volume.

For example, you are patiently waiting your stock to break above a triple top resistance pattern on the chart.  Finally, price breaks above your “go long” line on the graph at the triple top.  You enter the trade, but price immediately retreats down hitting your stop loss.

These false breakouts are a common occurrence for chart based traders. 

Adding volume to your analysis can help prevent this unfortunate but common happening.  Making sure that the breakout is accompanied by increasing the volume can drastically improve the odds of success.

breakout

Now, it is critical to keep in mind that a fast increase in volume can signal the end of a move in both up and down trends.  These moves are known as exhaustion moves or blow off tops during a bull market.

What happens is all the traders who are late to the party pile into the stock at once.  When all the remaining buyers all buy at once, there is no one left to purchase the shares.  Therefore price plunges lower rather than continuing to move higher.

The key is to look for steadily increasing volume over time to confirm the continuation of a trend in either direction.  Volume spikes can be signaling an exhaustion move.

Now that we understand the basics of using volume let’s take it one step further and talk about volume indicators.

There are two conventional technical analysis indicators that are used to measure volume changes.  These indicators are used in conjunction with the traditional technical analysis tools

The two primary volume tools are On Balance Volume OBV and the Accumulation, Distribution Line.

Both of these indicators work to help quantify volume so that better trading decisions can be made.  One is not superior to the other, but each can have their diverse circumstances to help you gain a better understanding of volume.

Here Are Two Volume Indicators:

  On Balance Volume or OBV:

On Balance Volume or OBV is the most widely used volume tool among traders

Its purpose is to clarify if funds are rolling into or out of stock or contract.

obv manny

The basic idea is tremendously simple.  A single period of volume is added if the close is higher and a unit of volume is subtracted if the close is lower.

The corresponding numbers are charted creating the OBV line that is related and compared to the price to identify confirmations and divergences.

An advancing OBV line and increasing prices confirms a definite trend. At the same time, a decreasing OBV line and climbing prices reveals a feeble or soon to flop price move.

.Accumulation/Distribution Line:

Technical analysis researcher Marc Chaikin created this indicator to measure volume.

The A/D line differs from OBV it includes opening and closing prices into the design (  also known as the price range).

The A/D line is calculated by the following formula (close-low) – (high-close)/(high-low) X volume in the period.

This resulting number is plotted in line graph form, similar to the OBV indicator.  The primary use of this indicator is as a divergence indicator.

accumulation line

A bearish indication is assumed when the A/D line is moving downward, yet the price is traveling higher. The bullish sign would be upward trending of the A/D line combined with a declining price.

The downside of the A/D line is it doesn’t take into account price gaps. A stock that jumps higher then closes within the range will not be revealed in the A/D line. Even a sequence of price gaps will not be specified with this volume indicator.

This is why it’s a must to use volume indicators in combination with price and other indicators.  Any attempt to use the volume indicators as standalone tools is a formula for catastrophe.

day trader

The proper and skilled use of volume can only come with hands-on practice an observation.  Observing price, volume and the volume indicators on real-time charts is highly recommended to learn quickly how everything fits together.

The good news is that most all technical analysis software and broker trading platforms have the OBV and Advance/Decline Line indicators built into them.  This means there is no need to understand the formula behind the indicators for most traders.

The Key Takeaway

Volume is the missing link of technical analysis.  If you wonder why technical analysis is not working for you the way it is suppose to, be certain to consider volume.  Volume is the key to correctly interpreting technical signals.

During upward price trends and break outs look for steadily increasing volume.  If volume is decreasing during a price increase, avoid buying the stock at that time.

Be cautious of volume spikes as they may be signaling an exhaustion or blow off top end of a price trend.

The two primary tools to measure volume are the OBV and the Advance/Decline Line.  Fortunately, both of these tools are built into the majority of broker trading platforms and technical analysis software.

The proper use of volume when investing takes hands on practice that can only be gleaned by watching price charts in real time.