"Use of volume to confirm trends"

Volume tends to be an underestimated part of trading systems. Looking for abnormal volume levels is a reliable way to identify trend reversals. Volume analysis can play more than just a supporting role in your investing system, it can prepare you for the breakout or breakdown of a trend.

First, we should look what exactly is volume.

The market is composed of buyers and sellers. A buyer is a (bullish) trader who is in the cash position to purchase. The buyer does not have to be active at the moment, but is intending to invest. The seller (bearish trader) owns stock and is intending to sell the stock at some point in the future. When a buyer makes their decision to purchase, and meets a seller to purchase from, the buyer and the seller switch their position in the market. Now the original buyer becomes a seller, and the seller who now is in a position to re-invest becomes a buyer. This transaction of moving a seller (bearish trader) to a buyer (bullish trader) and a buyer to a seller is recorded as volume. The relationship between how many buyers there are in the market to sellers gives us the idea of a bullish or bearish market. If there are more buyers than sellers, we have a bullish market and when there are more sellers you have a bearish market.

When large amounts of buyers (bullish) or sellers (bearish) switch positions, the price of the security inevitably moves with that relationship. When the majority of traders move from a buying position to a selling position the price drops. When the price begins to drop, more buyers switch positions to avoid losses, and the ensuing wave of transactions can be seen as a volume spike as the trend reversal is confirmed by other technical indicators.

Trend reversals offer some of the most important opportunities for profit potential. They represent fundamental changes in the underlying characteristics of a particular market/issue. However, identifying major trend reversals is the real trick to trading, and since no system or indicator is perfect watching the volume will help you not be left behind the major move.

What to look for

The volume spike is not about picking off the exact top or bottom, but identifying the trend reversal. Volume spike can be characterized as a "larger than normal volume over a short period of time." Volume also tends to confirm the trend (see DOW theory).

As seen in this chart above, extreme volume days also have huge price movements. In general, these events are considered a little too volatile (unless you are day trading, but that means predicting the volume spike the day before). In our case, we want to generally avoid the extreme volume days. In the case of this particular stock, these super large volume days are generated around the ex-dividend dates which gives a reason to the frequency of these spikes.

In the center of the graphic is the volume pattern which is what we are more interested in. This pattern shows a clear example of a trend reversal during a larger than normal volume period. The characteristics of this volume spike are that there are many days with higher than average volume rather than one or two huge days. The volume during this trend reversal remains rather high for several weeks.

The other aspect of this stock is that it is also a dividend stock and typically held over a longer period of time. In a market this large there is always an income stock moving up and one moving down. For the trend trader (or for that matter any trader), we want to be continuously in the up trending issues.

Even in the case of MSO (charted above), without looking at the outside circumstances, we can see that with each change in trend, a larger than average volume can be seen.

Putting ChartFilter into context:

Watching for volume fluctuations is a good indicator for trading systems. It will help warn you of impending price changes. This indicator works best as a supplemental indicator. It also works well as a stock screener criteria.

When I use the StockScreener to find abnormal volume stocks, I use the volume ratio's found in the fundamentals pull down list.

A good screen to find stocks that have a potential breakout from a sideways pattern is use a search based on the following signals & criteria.

1. Choose exchange

2. No technicals

3. Fundamentals

Fundamental 1) Average Colume - 30 day greater than or equal to 50
Fundamental 2) Volume Ratio 20 day greater than or equal to 1.5
Fundamental 3) Close greater than or equal to 5
Fundamental 4) Price ratio 100 day less than 1
Fundamental 5) Price ratio 20 day greater than 1
Fundamental 6) 52 week low within the last month or so

Sample Results (StockScreener)

The results listed here are stocks that have recently hit a 52 week low, and there are no confirming indicators in the screen. This is, however, a good list for potentials to watch. In each case volume is increasing as well as the 20 day price average.

Sample Charts (Stock Tools)

As seen in our sample results: when the volume is exceedingly large - the price movement is equally as impressive. Also, in both bases, when larger than average periods of volume occur the major price trend tends to shift.