19. Volume : Volume Analysis

Definition of Volume Analysis

The examination of the number of shares or contracts of a security that have been traded in a given time period.
Volume analysis is used by technical analysts as one of many factors that inform their trading decisions. By analyzing trends in volume in conjunction with price movements, investors can determine the significance of changes in a security's price.

Volume typically increases as price increases and vice versa; when the opposite occurs, it's called divergence.

Volume is one of the most important technical analysis tools to learn and understand how to apply to price movements. Volume increases every time a buyer and seller transact their stock or futures contract. If a buyer buys one share of stock from a seller, then that one share is added to the total volume of that particular stock. Volume has two major premises:

When prices rise or fall, an increase in volume is strong confirmation that the rise or fall in price is real and that the price movement had strength.
When prices rise or fall and there is a decrease in volume, then this is interpreted as being a weak price move, because the price move had very little strength and interest from traders.

Volumes indicate how many shares are bought and sold over a given period of time. The more active the share, higher would be its volume. For example, you decide to buy 100 shares of Amara Raja Batteries at 485, and I decide to sell 100 shares of Amara Raja Batteries at 485. There is a price and quantity match, which results in a trade. You and I together have created a volume of 100 shares. Many people tend to assume volume count as 200 (100 buy + 100 sell) which is not the right way to look at volumes.

The following fictional example should help you understand how volumes add up on a typical trading day:

At 9:30 AM there were 400 shares exchanged at the price of 62.20. An hour later, 500 shares were traded at 62.75. So at 10:30 AM if you were to check the total volume for the day, it would be 900 (400 + 500). Likewise 350 shares at 63.10 were traded at 11:30 AM, and upto 11:30 AM, the volume was 1,250 (400+500+350). So on, and so forth.
Here is a screen shot from the live market highlighting the volumes for some of the shares. The screen shot was taken around 2:55 PM on 5^th of August 2014.

If you notice, the volume on Cummins India Limited is 12,72,737 shares, likewise the volume on Naukri (Info Edge India Limited) is 85,427 shares.
The volume information that you see here is the cumulative volume. Meaning, at 2:55 PM, a total of 12,72,737 shares of Cummins were traded at various price points ranging from 634.90 (low) and 689.85 (high).
With 35 minutes left for the markets to close, it is only logical to expect the volumes to increase (of course assuming traders continue to trade the stock for the rest of the day). In fact here is another screen shot taken at 3:30 PM for the same set of stocks with volume highlighted.

As you can see, the volume for Cummins India Limited has increased from 12,72,737 to 13,49,736. Therefore, for Cummins India the volume for the day is 13,49,736 shares. The volume for Naukri has increased from 85,427 to 86,712, making 86,712 shares as the volume for the day. It is important for you to note that the volumes shown here are cumulative.

The volume trend table

Volume information on its own is quite useless. For example, we know that the volumes on Cummins India is 13,49,736 shares. So how useful is this information when read in isolation? If you think about it, it has no merit and hence would actually mean nothing. However when you associate today’s volume information with the preceding price and volume trend, then volume information becomes lot more meaningful.
In the table below you will find a summary of how to use volume information:

The first line in the table above says, when the price increases along with an increase in volume, the expectation is bullish.
Before we understand the table above in detail, think about this – we are talking about an ‘increase in volume’. What does this actually mean? What is the reference point? Should it be an increase over the previous day’s volume number or the previous week’s aggregate volume?
As a practice, traders usually compare today’s volume over the average of the last 10 days volume. Generally the rule of thumb is as follows:
High Volume = Today’s volume > last 10 days average volume
Low Volume = Today’s volume < last 10 days average volume
Average Volume = Today’s volume = last 10 days average volume
To get the last 10 day average, all you need to do is draw a moving average line on the volume bars and the job is done. Of course.

Thought process behind the volume trend table

When institutional investors buy or sell they obviously do not transact in small chunks. For example, think about LIC of India, they are one of the biggest domestic institutional investors in India. If they would buy shares of Cummins India, would you think they would buy 500 shares? Obviously not, they would probably buy 500,000 shares or even more. Now, if they were to buy 500,000 shares from the open market, it will start reflecting in volumes. Besides, because they are buying a large chunk of shares, the share price also tends to go up. Usually institutional money is referred to as the “smart money”. It is perceived that ‘smart money’ always makes wiser moves in the market compared to retail traders. Hence following the smart money seems like a wise idea.
If both the price and the volume are increasing this only means one thing – a big player is showing interest in the stock. Going by the assumption that smart money always makes smart choices the expectation turns bullish and hence one should look at buying opportunity in the stock.
Or as a corollary, whenever you decide to buy, ensure that the volumes are substantial. This means that you are buying along with the smart money.
This is exactly what the 1st row in the volume trend table indicates – expectation turns bullish when both the price and volume increases.
What do you think happens when the price increases but the volume decreases as indicated in the 2^nd row?
Think about it on the following terms:

Why is the price increasing?
1. Because market participants are buying
Are there any institutional buyers associated with the price increase?
1. Not likely
How would you know that there are no meaningful purchase by institutional investors
1. Simple, if they were buying then the volumes would have increased and not decrease
So what does an increase in price, associated by decreasing volumes indicate?
1. It means the price is increasing because of a small retail participation and not really influential buying. Hence you need to be cautious as this could be a possible bull trap

Going forward, the 3rd row says, a decrease in price along with an increase in volume sets a bearish expectation. Why do you think so?
A decrease in price indicates that market participants are selling the stock. Increase in volumes indicates the presence of smart money. Both events occurring together (decrease in price + increase in volumes) should imply that smart money is selling stocks. Going by the assumption that the smart money always makes smart choices, the expectation is bearish and hence one should look at selling opportunity in the stock.
Or as a corollary, whenever you decide to sell, ensure that the volumes are good. This means that you too are selling, along with the smart money.
Moving forward, what do you think happens when both volume and price decrease as indicated in the 4^th row?
Think about it in on following terms:

Why is the price decreasing?
1. Because market participants are selling.
Are there any institutional sellers associated with the price decrease?
1. Not likely
How would you know that there are no meaningful sell orders by institutional investors
1. Simple, if they were selling then the volume would increase and not decrease
So how would you infer a decline in price and a decline in volume?
1. It means the price is decreasing because of small retail participation, and not really influential (read as smart money) selling. Hence you need to be cautions as this could be a possible bear trap.

Revisiting the checklist

Let us revisit the checklist and revaluate from the volumes perspective. Imagine this hypothetical technical situation in a stock:

Occurrence of a bullish engulfing pattern – this suggests a long trade for reasons discussed previously
A support level around the low of bullish engulfing – support indicates demand. Therefore the occurrence of a bullish engulfing pattern near the support area suggests there is indeed a strong demand for the stock and hence the trader can look at buying the stock.
1. With a recognizable candlestick pattern and support near the stoploss, the trader gets a double confirmation to go long

Now along with support near the low, imagine high volumes on the 2^nd day of the bullish engulfing pattern i.e on P2 (blue candle). What can you infer from this?
The inference is quite clear – high volumes plus increase in price confirms to us that large influential market participants are positioning themselves to buy the stock.
With all three independent variables i.e candlesticks, S&R, and volumes suggest to take the same action i.e to go long. If you realize this is a triple confirmation!
The point that I want to drive across is the fact that volumes are very powerful as it helps the trader in confirming a trade. For this reason it is an important factor and therefore must be included in the checklist.
Here is how the updated checklist now stands:

The stock should form a recognizable candlestick pattern
S&R should confirm the trade. The stoploss price should be around S&R
1. For a long trade, the low of the pattern should be around the support
2. For a short trade, the high of the pattern should be around the resistance
Volumes should confirm to the trade
1. Presence of above average volumes on both buy and sell day
2. Low volumes are not encouraging and hence do feel free to hesitate taking a trade where the volumes are low

The chart below of Gold futures shows a strong trend being confirmed by a strong increase in volume

The chart above of Gold shows that when prices began making new highs, volume increased. As the price of Gold increased, more and more buyers (buying pressure) jumped on board.

Likewise, if prices are heading downward and are making new lows and volume increases, the sellers are becoming more and more interested as price falls (increased selling pressure).

Importance of Volume when Analyzing Price Movements

The following is an extreme illustration of the importance of volume:

A buyer places a market buy order after hours for 10 shares of stock. The transaction occurs one dollar above the closing price. Therefore, the one dollar price move had 10 shares worth of interest from a buyer.
A buyer places a buy order for 100,000 shares of stock. This transaction takes place at a price that is one dollar above the current price.

Which example is more bullish? They both increase the last transaction price by one dollar. If a trader didn't use volume, he/she would think that the move was identical from a price chart perspective. Of course, the second example is more bullish because the one dollar more the buyer of the 100,000 shares is willing to pay is significant (the buyer is bullish and is taking a large bet to prove it); whereas, in the second example, 10 shares is insignificant.

Increases or decreases in price along with increased volume isn't always confirming of trend.

Volume Spikes & Blow-offs

Extreme increases in volume along with extreme rises or falls in price can sometimes be interpeted opposite to regular volume analysis:

Sharp increases in price and sharp increases in volume can mean bulls have been exhausted, all buyers have bought and there is no one else but sellers; the result is bearish.
Sharp decreases in price and sharp increases in volume can mean that everyone that wanted to get out of the stock or future has; therefore, there are only buyers left - bullish sign.

The chart below of eBay (EBAY) stock illustrates a volume spike, defined as at least two times the average volume:

Volume extremes occur at bottoms as well, which is shown below in the chart

A strong understanding of volume is an absolute necessary addition to price analysis. Knowing when price increases or decreases have firm support or knowing when either buyers or sellers have been exhausted is extremely useful when trading. Another way of visualizing volume is Volume Rate of Change and the Volume Oscillator.

Volume Rate of Change

The Volume Rate of Change indicator measures the percentage change of current volume as compared to the volume a certain number of periods ago. The Volume Rate of Change indicator can be used to confirm price moves or detect divergences. The formula for Volume Rate of Change is expressed below:

[(Current Volume / Volume n periods ago) - 1] x 100

Generally, the Volume Rate of Change is calculated based on 14-periods for input n, but of course can be modified to any trader preferred period. A chart of the 100 ounce Gold futures is shown below with the 14-day Volume Rate of Change indicator:

As the price of Gold was increasing, the Volume Rate of Change indicator was increasing as well, indicating that there was buying interest as prices were rising. When Gold broke above trendline resistance, the Volume Rate of Change indicator surged higher, showing that buyers were extremely interested in buying Gold.
Using volume to confirm price analysis can help a trader make better trading decisions. The section discussing how to interpret Volume would be an excellent addition to this Volume Rate of Change section (see: Volume).

Volume Oscillator

The Volume Oscillator consists of two moving averages of volume, one fast and one slow. The fast volume moving average is then subtracted from the slow moving average. The Volume Oscillator is interpreted using the same principles as volume analysis:

An increase or decrease in price accompanied by an increase in volume is considered a sign of strength in the prevailing trend. Therefore, when the fast volume moving average (default 14-period) is above the slow volume moving average (default 28-period), the Volume Oscillator is above the zero line and is confirming price direction, whether it be up or down.
An increase or decrease in price accompanied by a decrease in volume is considered a sign of weakness in the prevailing trend. Therefore, when the fast volume moving average is below the slow volume moving average, the Volume Oscillator is below the zero line and is warning that the price direction is lacking strength and conviction.

An example of the Volume Oscillator is presented next in the chart of the E-mini Russell 2000 Futures contract-

The fact that price is making higher highs and higher lows is a bullish sign. When the price increases in the Russell 2000 e-mini is combined with the Volume Oscillator making higher highs and higher lows, a double bullish sign is given.
The Volume Oscillator can be used as a confirmation indicator, as it was above with the Russell 2000 e-mini future, or it can be used to detect divergences.

Volume Oscillator Divergences

Volume Oscillator divergences occur when there is an increase or decrease in price which is accompanied by a decrease in volume. When this divergence occurs, the fast volume moving average (default 14-period) is below the slow volume moving average (default 28-period) and the Volume Oscillator is below the zero line. These divergences are warnings that the current price direction is lacking strength and there is potential for a trend reverse.
An example of a Volume Oscillator divergence is presented below in the chart of the E-mini Russell 2000 Futures contract:

When the price was increasing in the Russell 2000 e-mini, the Volume Oscillator was not confirming the price movement because it was decreasing making repeated lower highs and lower lows. This bearish divergence indicated that the recent price increases were not being made with volume strength. The bearish divergence was confirmed when the e-mini future's upward trendline support was broken. However, when the Russell 2000 e-mini futures contract made its downturn, the Volume Oscillator confirmed the price downtrend by making higher highs and lower lows, a signal that volume was increasing and thus indicating that the trend downward had strength. The Volume Oscillator is a helpful addition to any technical trader's toolbox. Analyzing volume gives traders another viewpoint for analyzing potential trades.

Volume Accumulation

The Volume Accumulation indicator combines volume and a price-weighting that shows the strength of conviction behind a trend; the Volume Accumulation indicator is a helpful tool in uncovering divergences. The formula for the Volume Accumulation formula is shown below:

Volume x [Close - (High + Low)/2]

The formula only gives positive volume to the day if the close is higher than the midpoint of the high and low. If the close is towards the lower half of the range of the price action, then volume is negative for the day. A chart compares the Volume Accumulation indicator with the On Balance Volume indicator that adds positive volume if the close is higher than the previous close, even if the close is only a penny higher, is given next of the stock:

As can be seen in the chart above, Volume Accumulation was giving a more realistic representation of what the stock of Citigroup was doing - going downward. The logic behind the Volume Accumulation technical analysis indicator is follows:

An up day on high volume is considered bullish, because volume is being transacted at higher prices; for example, there is an imbalance of supply and demand, demand is more than supply, therefore price increases. The fact that there is much volume shows that the size of the supply and demand imbalance is large.
A down day on high volume is considered bearish, because volume is being transacted at lower prices. With an imbalance of supply and demand, there being more supply than demand, then prices will go down. Since their is high volume, this is a bearish signal because there were many more stock traders and investors trying to get out of their position and willing to do that by asking a lesser price.

An important use of the Volume Accumulation indicator is to confirm price movements and show divergences between the indicator and prices, signaling a potential reversal in trend.

Volume Accumulation Divergences

Any increase or decrease in price with little volume is to be looked upon with skepticism. The Volume Accumulation indicator helps show instances where price is making new highs or lows, but the indicator is failing to confirm those price moves. Also, the Volume Accumulation technical indicator can confirm price movements.
The chart below of the contract shows examples of these divergences, both bearish and bullish:

High #1 to High #2

The E-mini Russell 2000 future made a lower high; this move lower was confirmed by the Volume Accumulation indicator which made a lower high as well.

Low #1 to Low #2

The emini futures contract made a lower low; however, the Volume Accumulation indicator did not confirm this move. Instead, the indicator made a higher low, a bullish divergence suggesting that the bottom had arrived in the price of the futures contract. This bullish divergence was a strong indication for traders to lessen the size of their short positions or even buy to cover all their short positions.

Low #3 to Low #4

The Volume Accumulation indicator confirmed the price increase in the e-mini future by making a higher low. During periods of confirmation like this, traders feel much stronger about stock or futures positions that are held in the direction of the major market trend.

The Volume Accumulation is a very useful technical analysis tool that combines both price and volume. Other similar technical indicators include Chaikin Oscillator and Money Flow Index.

Key takeaways

Volumes are used to confirm a trend
100 share buy and 100 shares sell makes the total volume 100, not 200
The end of day volumes indicates the cumulative volume across trades executed throughout the day
High volumes indicates the presence of smart money
Low volumes indicate retail participation
When you initiate a trade to either go long or short always make sure if volumes confirm
Avoid trading on low volume days