Volume

Alexander Elder - Trading For A Living

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VOLUME
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Volume represents the activity of traders and investors. Each unit of volume in the market reflects the action of two persons: One trader sells a share and another buys a share, or one buys a contract and another sells a contract. Daily volume is the number of contracts or shares traded in one day.

Traders usually plot volume as a histogram—vertical bars whose height reflects each day's volume (Figure 32-1). They usually draw it underneath prices. Changes in volume show how bulls and bears react to price swings. Changes in volume provide clues as to whether trends are likely to continue or to reverse.

Some traders ignore volume. They think that prices already reflect all information known to the market. They say, "You get paid on price and not on volume." Professionals, on the other hand, know that analyzing volume can help them understand markets deeper and trade better.

There are three ways to measure volume:

• The actual number of shares or contracts traded. For example, the
New York Stock Exchange reports volume this way. This is the most
objective way of measuring volume.

• The number of trades that took place. For example, the London Stock
Exchange reports volume this way. This method is less objective
because it does not distinguish between a 100-share trade and a 5000-
share trade.

Tick volume is the number of price changes during a selected time, such as 10 minutes or an hour. It is called tick volume because most changes equal 1 tick. Most futures exchanges in the United States do not report intraday volume, and day-traders use tick volume as its proxy.

Volume reflects the activity of buyers and sellers. If you compare volume between two markets, it will show which one is more active or liquid. You are likely to suffer less slippage in liquid markets than in thin, low-volume markets.

Crowd Psychology

Volume reflects the degree of financial and emotional involvement, as well as pain, of market participants. A trade begins with a financial commitment by two persons. The decision to buy or sell may be rational, but the act of buying or selling creates an emotional commitment in most people. Buyers and sellers crave to be right. They scream at the market, pray, or use lucky talismans. Volume reflects the degree of emotional involvement among traders.

Each tick takes money away from losers and gives it to winners. When prices rise, longs make money and shorts lose. When prices fall, shorts gain and longs lose. Winners feel happy and elated, while losers feel depressed and angry. Whenever prices move, about half the traders are hurting. When prices rise, bears are in pain, and when prices fall, bulls suffer. The greater the increase in volume, the more pain in the market.

Traders react to losses like frogs to hot water. If you throw a frog into a boiling kettle, it will jump in response to sudden pain, but if you put a frog into cool water and heat it slowly, you can boil it alive. If a sudden price change hits traders, they jump from pain and liquidate losing positions. The same losers can be very patient if their losses increase gradually.

You can lose a great deal of money in a sleepy market, such as corn, where a one-cent move costs only $50. If corn goes against you just a few cents a day, the pain is easy to tolerate. If you hang on, those pennies can add up to thousands of dollars in losses. Sharp moves, on the other hand, make losers cut their losses in a panic. Once weak hands get shaken out, the market is ready to reverse. Trends can last for a long time on moderate volume but can expire after a burst of volume.

Who buys from a trader who sells his losing long position? It may be a short seller taking profits and covering shorts. It may be a bargain hunter who steps in because prices are "too low." That bottom-picker assumes the position of a loser who washed out—and he either catches the bottom or becomes the new loser.

Who sells to a trader who buys to cover his losing short position? It may

be a savvy investor who takes profits on his long position. It also may be a top-picker who sells short because he thinks that prices are "too high." He assumes the position of a loser who covered his shorts, and only the future will tell whether he is right or wrong.

When shorts give up during a rally, they buy to cover and push the market higher. Prices rise, flush out even more shorts, and the rally feeds on itself. When longs give up during a decline, they sell and push the market lower. Falling prices flush out even more longs, and the decline feeds on itself. Losers who give up propel trends. A trend that moves on steady volume is likely to continue. Steady volume shows that new losers replace those who wash out. Trends need a fresh supply of losers the way builders of the ancient pyramids needed a fresh supply of slaves.

Falling volume shows that the supply of losers is running low and a trend is ready to reverse. It happens after enough losers catch on to how wrong they are. Old losers keep bailing out, but fewer new losers come in. Falling volume gives a sign that the trend is about to reverse.

A burst of extremely high volume also gives a signal that a trend is nearing its end. It shows that masses of losers are bailing out. You can probably recall holding a losing trade longer than you should have. Once the pain becomes intolerable and you get out, the trend reverses and the market goes the way you expected, but without you! This happens time and again because most amateurs react to stress similarly and bail out at about the same time. Professionals do not hang in while the market beats them up. They close out losing trades fast and reverse or wait on the sidelines, ready to re-enter.

Volume usually stays low in trading ranges because there is relatively little pain. People feel comfortable with small price changes, and trendless markets seem to drag on forever. A breakout is often marked by a dramatic increase in volume because losers run for the exits. A breakout on low volume shows little emotional commitment to a new trend. It indicates that prices are likely to return into their trading range.

Rising volume during a rally shows that more buyers and short sellers are pouring in. Buyers are eager to buy even if they have to pay up, and shorts are eager to sell to them. Rising volume shows that losers who leave are being replaced by a new crop of losers.

When volume shrinks during a rally, it shows that bulls are becoming less eager, while bears are no longer running for cover. The intelligent bears have left long ago, followed by weak bears who could not take the pain. Falling volume shows that fuel is being removed from the uptrend and it is ready to reverse.

When volume dries up during a decline, it shows that bears are less eager to sell short, while bulls are no longer running for the exits. The intelligent bulls have sold long ago, and the weak bulls have been shaken out. Falling volume shows that the remaining bulls have a higher level of pain tolerance. Perhaps they have deeper pockets or bought later in the decline, or both. Falling volume identifies an area in which a downtrend is likely to reverse.

This reasoning applies to long and short timeframes. As a rule of thumb, if today's volume is higher than yesterday's volume, then today's trend is likely to continue.

Trading Rules

The terms "high volume" and "low volume" are relative. What is low for IBM is high for Apple Computer, while what is low for gold is high for platinum, and so on. As a rule of thumb, "high volume" for any given market is at least 25 percent above average for the past two weeks, and "low volume" is at least 25 percent below average.

• High volume confirms trends. If prices rise to a new peak and volume
reaches a new high, then prices are likely to retest or exceed that peak.

• If the market falls to a new low and the volume reaches a new high,
that bottom is likely to be retested or exceeded. A "climax bottom" is
almost always retested on low volume, offering an excellent buying
opportunity.

• If volume shrinks while a trend continues, that trend is ripe for a rever
sal. When a market rises to a new peak on lower volume than its pre
vious peak, look for a shorting opportunity. This technique does not
work as well at market bottoms because a decline can persist on low
volume. There is a saying on Wall Street: "It takes buying to put
stocks up, but they can fall of their own weight."

• Watch volume during reactions against the trend. When an uptrend is
punctuated by a decline, volume often picks up in a flurry of profit
taking. When the dip continues but volume shrinks, it shows that bulls
are no longer running or that selling pressure is spent. When volume
dries up, it shows that the reaction is nearing an end and the uptrend is
ready to resume. This identifies a good buying opportunity. Major
downtrends are often punctuated by rallies which begin on heavy vol-

ume. Once weak bears have been flushed out, volume shrinks and gives a signal to sell short.