How volume prefigures market trends

Every shade in the paintbox helps to flesh out a clearer picture. By blending the two disciplines of fundamental and technical analysis, investors achieve a more competitive edge. The two approaches complement one another. Traditional fundamental research analysis sets a price for financial assets, based on data such as earnings, dividends and sales. Technical analysis, on the other hand, studies market action primarily through prices and volumes of transactions. Using charts, technicians interpret investors’ collective mindsets and behaviour as buyers.

Good technicians employ a wide spectrum of indicators, and volume is one of the most important inputs. It depicts the battle between supply and demand, serving as a concrete expression of investor conviction or lack thereof. As a stock price moves up, increased turnover gives a clue that financial institutions are keen on accumulating an asset for their portfolios, whereas tepid volume would suggest less enthusiasm.

Speak volumes

As an asset’s price climbs, volume plays a key role. Its significance is slightly less important on a descending course. Technicians often remark how a stock can fall from its own weight, particularly after a parabolic move up in a short time frame. The psychological explanation is that owners may be looking to take profits off the table. Perhaps they had believed the stock was zooming to the moon, but suddenly they realise it has actually landed there. If their wave of sell orders meets with few bidders, the stock can plummet if volume is light. “It keeps dropping, because no one is there to catch the ball,” says Guy Ortmann, senior technical analyst at HFP Capital Markets.

Moreover, heavy selling during a final “washout” can even be highly positive. Imagine a stock that has already fallen over a number of weeks from 80 to 50. Then suppose it opens up at 50, and the sellers panic as they throw in the towel, itching to get out at any price. Yet in spite of a sharp intraday move lower, the stock actually closes well off its lows, amid intense activity. The last holdouts exit in exhaustion, clearing the way for a new wave of buyers. The S&P 500 index, for instance, painted such a scenario in the early summer of 2010.

Nonetheless, volume still remains secondary to price as an indicator, and works best as a confirmation of a trend. “Even with intense trading activity, supply and demand might be neutralising each other,” Mr Ortmann says. Another question is how to define “heavy” or “light,” which often changes over time. For instance, extraordinary volume held sway in 2009, whereas three years later investors are trading less frenetically. Which is the correct benchmark to use, to create an apples-to-apples comparison for a normal level? Ari Wald, an equity strategist at Brown Brothers Harriman, recommends on balance volume (OBV) as a useful graphic tool. That indicator measures a cumulative total of volume on up days minus a total on down days. To illustrate, from February through May in 2011, the price of the S&P 500 kept trucking higher, but OBV was sending warnings with lower lows. Although investors were still brimming with optimism, on June 30, Mr Wald himself noted that weakening OBV “keeps us sceptical about the current rally”. Evidence mounted, keeping technicians cautious months ahead of the precipitous August 2011 chute.