Mark Leibovit was a member of the Chicago Board Options Exchange, a former “Elf ” on Louis Rukeyser’s Wall Street Week television program, and a frequent guest on PBS Market Monitor’s The Nightly Business Report. He developed the Volume Reversal Indicator and newsletter in 1979, the latter evolving into the popular Web site VRTrader.com, where he currently serves as Chief Market Strategist. Timer Digest named Leibovit the number-two Market Timer and the number-two Gold Timer for the ten-year period ending in December 2009.

THE TRADER'S BOOK OF VOLUME

The Definitive Guide to Volume Trading

The McGraw-Hill Companies, Inc.

Contents

Excerpt

CHAPTER 1

VOLUME BASICS: A TRADER'S VIEW

Is it volume which causes price changes, or do price changes causevolume—the hen or the egg, which came first?

—H. M. Gartley, Profits in the Stock Market

Back in 1934, R. W. Schabacker commented in Stock Market Profits, his300-page treatise on trading: "In our entire study of Plate V we have given noconsideration to the factor of volume of trading, though this is another highlyimportant and valuable angle of the technical approach to short-swing trading."

Having recognized the value of volume, he spent only three paragraphs discussingthis highly important and valuable tool. Why was so little consideration givento volume? One explanation is that the data required for Volume Analysis werelargely unavailable at the time and reserved only for the eyes of an elite groupof market participants, an "insiders' club" comprising floor traders, marketmakers, and institutions.

Today, with the development of sophisticated desktop trading interfaces alongwith more readily available market data, traders can access information that waspreviously in the exclusive realm of insiders. This more accessible data flowhas opened the door into the realm of Volume Analysis and the strategicdeployment of volume-based indicators, oscillators, and overlays to enhancetrading performance.

In this chapter, we challenge you to rethink any preconceived notions of priceand volume as they relate to your trading strategy and offer you a short primeron the basics of volume.

The Case for Volume

Volume Analysis provides a trader with a clear and focused view of thecollective behavior of financial market participants. Overwhelmingly, we tradershave been indoctrinated with price-based indicators, but what if what is lyingunder the hood staring us in the face has eluded us? What if, at the end of theday, the behavior revealed by volume is the high-octane fuel that creates,accelerates, or decelerates market conditions?

We've been told that market trends are created by market participants agreeingin aggregate that a fair price for a stock or commodity can be found and thatprice moves accordingly to higher or lower levels. In Volume Analysis, we viewthe development of market trends as a dynamic process that cannot simply beexplained based upon price movement alone. Our standard for identifying andpredicting trend changes incorporates the volume action accompanying these pricemovements. Throughout our exploration of volume, our guiding principle willremain arguably simple.

Volume Action Is Linked to Price Movement

Most traders have a minimal understanding that a price move accompanied bystrong or heavy volume is likely to continue in its current direction, and,conversely, if volume is lighter than "normal," the trend may be suspect. Theseconcepts are about as in-depth an understanding as most traders will everdevelop about volume. So what of the behavior of volume in technical chartpatterns, in trend continuation and reversals, and in volume overlays?

It is our belief that volume is an essential component of every price move andpattern. If a trader is unable to read or translate volume information, if hisunderstanding of it remains limited, then he is forced into the tradingstrategies and routine guidance more commonly serving the interests of theinstitutional crowd. By taking our trading off-road and examining thecomplexities of volume, we are taking a detour from trading based on price-drivendata alone. It is our hope that as you explore the pages of this book onvolume, you will gain predictive insight into trend direction and reversals andultimately develop your own set of defensive tactical strategies.

A Dynamic Volume Analogy

There are many analogies to describe the dynamic effects of volume on pricetrends. Most commonly, it is compared to fuel in a car engine. If the tank islow on gas (i.e., weak volume), the car engine eventually will falter and stall.Had the tank been full (i.e., strong volume), the car would have just cruised ondown the road. Just as too much fuel can flood an engine, too much volume, inthe form of spikes and surges (indicates an emotionally charged tradingenvironment), can signal that the "engine" might stop heading in its currentdirection (i.e., a change in trend is near).

In The Trader's Book of Volume, our focus will be to translate themeaning of volume information into trading strategies and ultimately intotactical volume overlays. How to begin to do this is to understand somevolume basics; the coordinates we are measuring will act as our guide.We begin by understanding what information is embedded within and represented byvolume.

Volume as a Measure of Supply and Demand

On any given day, both volume and price in the markets are constantlyreadjusting to accurately reflect the current market environment. If there is animbalance of buyers in the market, price may adjust to higher levels to enticeexisting holders to sell their positions to offset demand or buying pressure. Ifthere is an imbalance of sellers, price may adjust to lower levels to entice newbuying to offset supply or selling pressure.

As more traders line up and execute their intentions on either the buy side orthe sell side, the increased activity shows up in the form of volume. How volumeinteracts with price on any trading day reveals the level of supply and demandin the market for that security or commodity. The behavior of volume during thetrading day represents hard evidence that the imbalance between buyers andsellers is being resolved. Ultimately, it is the volume action, not theprice action, as most of us have been taught, that signals the first indicationof the direction of that resolution.

Volume as a Gauge of Trader Sentiment and Interest

When we look at a fuel gauge, we get a sense of our ability to go the distance.Similarly, we can take a volume measurement to represent how much bullish orbearish sentiment there is in trading a particular market, index, or issue.Elevated interest in the form of higher-than-normal volume gives clarity as towhen and at what level the next potential price move may occur. "Normal"volume will depend on our trading time frame and the unique volumecharacteristics of the index or issue being traded, but once normal isdetermined, any departure from that is significant.

A case in point: Using a volume moving average, a trader can identify higher-than-normal volume with small price swings, which may indicate that shares arebeing either accumulated or distributed in a sideways market.Below-normal volume on larger price swings, especially in trending markets, maysignal to a trader that a shift in trend is imminent. Volume Analysis thusserves to improve a trader's predictive ability as to the timing and directionof trends and reversals.

Using Volume to Track the Major Market Players

A major strength of Volume Analysis is its ability to track the trading activityof the largest market participants: that is, mutual funds, large hedge funds,and institutional players. These elite players often intentionally camouflagetheir positions. By using Volume Analysis, a trader has the ability to recognizetheir volume patterns and uncover their tracks. Traders with volume expertiseare in the enviable position of being able to take the lead or tailgate theirpositions.

Measuring and Charting Volume Data

Much as drivers assess coordinates before taking their vehicles off-road, wewill be taking a preliminary look at how volume data are measured and charted.

Volume is very versatile in that it can be used in its "raw" form (which isexpressed and read simply as volume bars plotted at the bottom of a chart) or in"smoothed" form (which uses a calculated overlay such as a moving average).These pure volume measurements can in turn be used alone, as components of othervolume indicators, and in combinations, ultimately allowing us to gauge ourtrading terrain.

Volume has been defined for charting purposes as the number of unitstraded during a given period of time. These units are typically represented byeither shares or contracts. Volume is plotted with price to determine thestrength or conviction behind price movement. There are several variations inthe way this volume information can be displayed on stock and commoditiescharts. These different methods of display have their own strengths andweaknesses. Our trading time frame generally dictates our display preferences.This section explores some of the more common ways to exhibit and interpretvolume information on common stock or other security charts.

Bar Plots

The most common method for plotting volume is the standard bar plot. Thebar plot allows for quick analysis between price points to measure the strengthor conviction behind a move. Chart 1.1 shows a simple bar plot ofvolume.

Bar plots of volume can be either zero-based or based on the lowest volume totalin a data or time series. In either case, a good bar plot gives the bars aconsistent, uniform starting point, which makes comparisons between valueseasier. For instance, in Chart 1.1, notice how volume spikes higher atprice lows on the chart. Later in the book, we will examine the meaning of thesespikes and their implications for future price movements.

Although the example in Chart 1.1 shows the trading of an exchangetradedfund (ETF) in the form of shares, we should note that such volume depictionsalso work for futures, which are sold as contracts, not shares. Chart1.2 shows an example of volume expressed in contracts traded.

Colored Bar Plots

One preferred way to enhance the display of volume is to color the volume bars.Many charting packages allow for the coloring of volume bars, making it easierto distinguish between days in which price closed higher and days in which priceclosed lower. Chart 1.3 has volume bars colored in black on days whenprice closed higher than the previous day, while days that closed lower than theprevious day are colored in gray. Although our color choices in this book arelimited to shades of black and white, other colors, most commonly red and green,can be used in most charting software. These color differentiations allow forquicker identification of positive versus negative volume.

Simple Line Plot

The simple line plot is another method that is less commonly used for displayingvolume. Rather than displaying volume bars, volume is shown as a line. Chart1.4 shows a simple line plot for volume. Showing volume in this way canallow for a quick analysis of volume spikes and surge patterns. It will not workon more thinly traded (lower-volume) securities, as the line plot can be veryerratic. Unlike the bar plot, smaller-scale shorter-term volume comparisons aremore difficult to measure.

Volume Moving Averages

The selection of a volume plotting methodology increases in importance whenadding overlays to volume. One of the most widely used methods of analyzingvolume data is with a calculated volume moving average, more commonly known as a"VMA."

A volume moving average shows the average number of shares or contracts thathave been traded over a set period of time. In the Nasdaq 100 Trust ETF (QQQQ),Chart 1.5, a bar plot of volume also contains a 9-period moving averageof volume, a common volume moving average setting for shorter-term traders.(We'll discuss time frames in more detail in Chapter 7.) Note how thevolume moving average plots make it easy to spot the days where the daily volumejumped above the average.

We've examined some of the different ways that volume data, the basic buildingblocks of Volume Analysis, can be displayed to accommodate a trader's chartingpreferences. Placing pure volume (bars) below price on a trading chartestablishes that first reference point for Volume Analysis. In the remainder ofthis book, we will be taking a new perspective on the volume window and focusingon translating these volume bars, indicators, oscillators, and overlays intoprofitable trading signals and strategies.

Summary

• Volume has the ability to uncover the movements of larger market participantsand track their "footprints in the sand."

• Volume serves as a gauge of supply and demand and overall trading conviction,and is inextricably linked with price movement. Volume can be used to predictthe direction, strength, and timing of those trends.

• Volume data, in conjunction with price information, may be charted in avariety of ways. The basic volume bar plot with a volume moving average (VMA)overlay is one of the most effective ways to chart the volume/pricerelationship.

CHAPTER 2

THE TRADER'S MANTRA: VOLUME PRECEDES PRICE

The mantra that volume precedes price has served many a trader well and remainsas much a fundamental truth today as it was when I first heard it more than 35years ago. Price movements occur daily in the financial markets. Using VolumeAnalysis, we turn our focus on the volume action behind these movements and lookfor insight into the strength and intensity of the crowd that fueled the move.Although not all market participants are equivalent, the volume numberscontinually reveal their collective sentiment.

Market price trends do not happen in a vacuum; rather, it is the behavioral orprogrammed responses of traders and managers that result in the volume shiftsthat precede a price move. As the crowd mobilizes, as reflected in the volumenumbers, its size and conviction will determine the direction and strength ofthe price movement. As the conviction of the crowd falters and the volumenumbers pull back and diminish, so too will this impact the timing and directionof the trend. This chapter displays some visual examples of this truth at work.

Viewing the Market in Three Dimensions

One of the major reasons for using Volume Analysis is to capture volume'sability to signal changes in trading sentiment to traders, whichultimately cause changes in trend or price direction. It helps to think ofVolume Analysis as a multidimensional map of the trading environment. Whileprice action looks at two dimensions, the inclusion of volume gives a visuallook behind price movement, providing greater detail as to what the drivingforces are and how they can be anticipated to behave.

One way to think of this combination is to consider the situation of a mountainbiker traveling through rugged terrain. Our biker can pack a simple flat map orone showing topographical features. A biker with a map of the technical featuresof the course will have considerably more information and be able to makequalitatively different decisions from a rider using a flat map. Our bikerrelying on a topographical map will be able to gauge the level of difficulty ofthe incline, the ruggedness of the course, and ultimately the time frame forcompletion. He will be able to access the amount of energy he needs to reservefor certain portions of the course. Sure, our biker might get from point A topoint B with a flat map, but lacking information about the technical terraincould be both costly and life threatening.

Volume as a Third Dimension: A Brief Example

The incorporation of a volume component into your trading strategy can beillustrated by a simple exercise. While sitting down, focus your eyes on a pointin front of you in the room. Now cover one of your eyes. You should notice twothings. First, your field of vision is cut in half, as the peripheral vision onone side is completely gone. Second, covering one eye compromises depthperception. You've just seen how adding volume gives you a broader read onmarket activity (peripheral vision) while also allowing you to see intensity andconviction behind price movements (depth perception). Now let's consider theexample of the iShares Dow Jones Real Estate Trust ETF (IYR) shown in Chart2.1. The top frame shows a flat, two-dimensional price momentum analysis.The bottom frame shows the Relative Strength Index, or RSI, a price-basedmomentum oscillator that is essentially a calculated figure representing thecumulative number of incrementally higher and lower closes in a given period.Even though the RSI is quite a sophisticated tool, the only input for itscalculation is price data.

Notice how, as price moves into the vicinity of its previous low, the 14-periodRSI breaks down to a new low, which could be interpreted as an indication thatthe downside price action will continue.

(Continues...)
(Continues...)Excerpted from THE TRADER'S BOOK OF VOLUME by Mark Leibovit. Copyright © 2011 by Mark Leibovit. Excerpted by permission of The McGraw-Hill Companies, Inc..
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