** This trading lesson originally published on April 4, 2011 on MarketGauge's MG Prime titled "Volume and Price Patterns- Valuable Predictive Indicators." We'd like to thank MarketGauge for allowing us to republish this valuable lesson here for MarketHEIST readers.
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The importance of volume depends on its location within the overall pattern. For example, heavy volume through a broken trend line suggests the start of a new trend, while the same activity after a long rally or decline predicts a reversal. This counterintuitive logic confuses traders and inhibits their ability to decipher volume at key turning points.
Volume is used for two major purposes:
- To confirm price changes: if the start of a trend is not accompanied by an increase in volume it is considered to be weak and lacking commitment.
- To anticipate changes in price: increases in volume often precede changes in price.
A series of up or down volume patters are defined as Accumulation and Distribution days. Both indicate who is in control of the market and often signal a reversal. Accumulation is when the market is controlled by buyers so if a downtrend stalls and accumulation in volume takes place, sellers have lost control and a reversal is likely. Conversely, distribution is when the market is controlled by sellers so if an uptrend stalls on high volume, buyers have lost control to sellers and a reversal is probable.
Trend Climaxes are yet another way to predict if a down or up trend is coming to a halt. In the case of a Volume Spike, we are looking for unusually high volume (at least 2 times the average) measured by the average daily volume of over the course of about 50 days.
Today, we are going to look at a Volume Spike that happened recently in SPY and compare that to a similar one that happened in July 2010. In both cases, there is a significant spike in volume at the end of its trend.
The Chart, Price, and Volume Analysis
What causes volume spikes? Anything and everything. Good news. Bad News. Lower-than-expected consensus earnings. Higher-than-expected sales. Analyst upgrades or downgrades. In the case of the SPY-the volume spike came after the Earthquake in Japan and the tensions in Libya. On a selling climax, there is likely to be a panicked volume spike due to heightened investor fears. Our first clue.
The chart represents 2 totally different periods of time for the same ETF with incredibly similar volume and price patterns. The chart on the left is from July 2010. After the “flash crash” last April, the volume spiked as the prices dropped to new recent lows, although not at the required two times the average, rather, after a long period of below average volume, it spiked to above average and two times the amount it had been registering daily at that point. The chart on the right, shows a dramatic drop in price in line with a classic spike in volume or the required two times the average daily volume. For the sake of this comparison, the volume pattern is different but the price pattern is similar.
After 5 Distribution days in SPY, March 16th 2011 began to look a blow off selloff, especially since it broke beneath a key support area of 126 but managed to close right on it. Comparing it to the action in July, the ultimate low was made on July 1 at 101.13 which was also the a spike in volume although not in the classic sense. Therefore, after the close of March 16th, we were looking for 126 to hold up and an open unchanged or higher because if the pattern was to prove repeatable, we saw that on July 2 there was an inside day followed by a progression of higher closes and finally the first Accumulation day on July 7 after a long holiday weekend.
On March 17th, the pattern does indeed repeat as there was an inside day with a higher close. Following the inside day in July, the preceding day had a higher closing price and an Accumulation day in volume. The following day in March, there was a higher closing price without an Accumulation Day in volume, so the signal suggested a possible bottoming action from the 16th, but not necessarily a buy opportunity or confirmation. Therefore, at that point, one would not necessarily go short but should certainly be extremely protective of any longs, especially ones that are not in the money. Plus, since we try to examine other indicators, notice the slope of the 50 day moving average (blue line). It was positive even as the market was going lower, which was a decent confirmation that the spike volume on March 16th might have been the blow off sell off we had hoped for. Then, on Monday, March 21st, after the prior Friday’s second higher close, albeit with volume continuing on the light side, the price gapped and closed higher. Once again, volume remained light. Therefore, even though the price action indicated a bottom along with a confirmed upward slope in the 50 day moving average, the anticipated Accumulation Day in volume-or a signal that buyers were back in control still eluded the market.
On March 22nd, the action was more of a drift than a selloff by the mere fact that the volume in SPY was even less than on March 21st. It couldn't quite manage an inside day nor did it fill the gap that was left when it gapped higher the day before, which with low volume, was a positive. There is an adage that “One should never sell a dull market.”
Then, the moment we had been waiting for-an Accumulation day in volume in SPY on March 23rd. Going back to the analogy between July2010 and now, after the Accumulation day happened then, the price remained firm, the volume decreased as the week ended, and finally the following week it gapped higher and had its second Accumulation day. Now, a gap higher or stronger price action day the next day is a reliable and tradable indication that indeed, a potential bottom is in place.
On March 24th, there was a further departure in the analogy from July 2010 to March 2011, as SPY closed back above the 50 day moving average or back into a bullish phase. In July, the phase was still Bearish. Plus, it posted yet another Accumulation day in volume. Friday, March 25th was a perfect confirmation that the Volume Spike day from the March 16th was good. Even the most conservative traders should have been buying SPY above the 50 day moving average at 131.00 with a full ATR of risk. Fast forward to April 4th and SPY closed at 133.26.
For experienced swing traders a volume spike after significant price appreciation should be questioned. The swing trader should ask,
"Does the peak in volume also signal a short-term peak in price up or down?"
The answer is likely "yes" if price subsequently stalls and volume decreases. Such was the case the 4 days following the volume spike. But since the phase was still in warning, one might have waited for more confirmation. However, seasoned volume watchers might have bought at around 129 and risked to under 127. Regardless if you waited for a phase change or bought on mainly volume patterns, here is the bottom line:
MISH'S TIP: After spotting a volume spike, you should pay careful attention to the price and volume pattern over the next several days.
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