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Volume-The Overlooked One

Volume-The Overlooked One
February 02
17:38 2011

With so much concentration on the price charts, sometimes it’s easy to forget that technical analysis is the study of market action, which includes not only price changes over time but also the trading volumes. Yet without considering volume, you do not know what relevance to place on the price movements.

Take for example the well-known head-and-shoulders reversal pattern. Just spotting this pattern on a price chart is only part of the analysis, as the pattern has a great likelihood of failing unless the moves are accompanied by the appropriate increases and decreases in trading volume. For the head-and-shoulders pattern to be effective, it should demonstrate a lessening volume on each successive rise, and an increase in volume on the retracements, even though volume is not so significant for downward moves.

The basic premise is that volume increases in the direction of the trend, if the trend is to be sustained. Certainly with an upward trend, you would look for strong and strengthening volume to prove that the trend is sound. If the price is going downwards, sometimes the volume will not be very strong, as prices tend to fall under their own weight – the reason that short positions tend to profit more rapidly than long – but this means that a strong volume in a downtrend is very significant.

Price and volume are two different views of the buying and selling pressure on a security, and each has a place in analysis. Volume shows us the urgency of the pressure by showing how much has been resolved in sales; price reflects the latent pressure which may or may not have been determined in trading. It is often said that volume precedes price, and that a lessening in volume reveals that a trend is weakening before there is any sign in the price curve. This is a very good reason for keeping as good an eye on volume variations as you do on price variations, as anticipating future moves is one of the keys to being ready to make profitable trades.

There are a couple of useful indicators based on volume. First, the On Balance Volume (OBV), which has been around nearly fifty years but is much more easily calculated nowadays with computers. If the price is higher, the volume for the day is added to a running total, and if the price is lower, the volume is taken away. The total as such is not important, because it depends on where you start calculating, but any time there is a divergence in direction between the price and the OBV it means that there is trouble ahead.

Another indicator is called the Demand Index (DI). This uses two values, the Buying Pressure and the Selling Pressure, and calculates the DI from these. If the Buying Pressure is greater than the Selling Pressure the DI is greater than zero, and this suggests that the price should be rising. When the DI is calcualted to be negative, it is a sign that there should be a downtrend. Any time that the price is going in the opposite direction to the indication of the DI it may portend a reversal.

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