Using Volume Indicators in Technical Analysis

Posted by Bigtrends on January 20, 2012 8:33 AM

Basics of Volume Indicators

Let's begin this discussion with a basic definition of Volume, specifically stock volume -- option volume is another interesting indicator and topic for another time.

Simply put, volume is the number of trades made on a stock in a specific period of time.  To complicate matters just a bit, the NYSE and the Nasdaq historically measure volume differently.  For every buyer there is a seller, so for every purchased share there is a sold share.  The NYSE would take this equation and count it as one trade with one share of volume.  The Nasdaq would count it as two shares of volume, counting both the bought and the sold shares.

For those who have looked at charts and wondered what the histogram below a chart was, wonder no more.  This is most often a representation of the stock's volume.

Average volume is exactly what it sounds like.  It is the number of shares traded per day averaged over a time period.  Often the time period is a year (52 week).  For liquidity purposes you may look at stocks with over 1 million daily average volume, for example.

There are many volume-related indicators, one of the longest-lasting is On Balance Volume (OBV), which was introduced in 1963 by Joe Granville in his book, Granville's New Key to Stock Market Profits.  Granville's indicator was one of the first to measure positive and negative volume.  Granville stated that volume precedes price, and OBV adds the volume from the sessions where a stock finishes lower.  This sum is then subtracted from the sum of sessions when a stock finished higher.  If a stock closed higher today than yesterday, the new OBV is (Yesterday's OBV + Today's volume).  If the stock closes lower, the OBV is (Yesterday's OBV - Today's volume).  Finally, a close at the same price means yesterday's OBV is today's OBV.

It is believed that changes in the OBV will occur before price changes.  Some believe that rising volume indicates the presence of "smart money" flowing into a security.  Once the general investing public follows the example, the stock's price should rise.

NFLX Daily Chart with Volume and OBV

The chart above certainly shows a big turnover in Netflix (NFLX) shares during its steep decline and in the subsequent rebound.  OBV has also turned higher during the recent rally.  Comparing volume to the actual float (# of shares outstanding for trading) can also be useful as an indicator of share ownership changeover.

A Volume Breakout takes place when a stock performs an immediate about face in volume thanks to a news event.  More often than not, volume breakouts will follow earnings surprises, revised forecasts, contracts, or potential takeovers.  Of course, the news itself doesn't really matter to us; it is what the news means for the company's future and for sentiment & technical analysis. 

Should a volume breakout accompany the breach of a major resistance (or support) level, it could be an indication that the stock is readying for a continued run higher (or lower).  On the chart of Johnson Controls (JCI) below, we have overlaid the volume and you can see a massive spike just occurred on news.  The volume breakout was accompanied by a gap lower -- this one will be an interesting one to follow in terms of how the subsequent price performance will be affected by the big volume spike.

JCI Daily Chart

New indicators based on various volume readings have been created by Pascal Willain in his book Value In Time:  Better Trading Through Effective Volume.  Willain has created a variety of techniques based on what he calls "Effective Volume" that appear fairly novel and innovative -- worth checking into and researching more in order to find more practical trading applications from them.

In sum, volume can be a very valuable tool for an investor, with a myriad of techniques and methods that can implemented into your trading arsenal.  Bottom line is that the amount of shares trading hands in a day can be an important part of figuring out which direction a stock is headed.  Some think a move higher on low volume is not usually sustainable, while heavy volume on a down move is significant -- there are a variety of strategies that can be implemented, tested, and incorporated by active traders.

Trade Well.