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There are no more crucial elements to the practice of technical analysis than price and volume. Having addressed the basics of price in previous articles, today we look at volume.
The chartist uses trading volume in different ways, but predominantly as a litmus test for confirming support and resistance levels, breakouts and reversals in trend.
Below, we address precisely how this is done, but first some volume basics.
Volume Equals Credibility
Generally speaking, a trend possesses authority and force when it’s underpinned by volume – and the more, the better. A move higher or lower may or may not continue in the face of weak volume figures, but in the eyes of the technician it certainly lacks conviction and should be traded (or left untraded) as such. All too often, weak trading numbers presage a turn in the direction of a security, and technicians prefer to see robust activity before trusting that an existing move will continue.
We saw the importance of using volume surges to recognize long-term accumulation and distribution patterns here, and the same principles apply on a shorter time scale.
The following chart, for example, shows petroleum company Sunoco (NYSE: SUN) for the better part of a year:
And here the lesson is made clear.
After several efforts early in the year to punch above resistance at $53 (in red), Sunoco finally manages to break the barrier in May. Unfortunately, the move comes on the back of average volume (blue arrow), and that proves fatal for the breakout.
Anyone who bought the stock on the strength of the brief action above $53 would have faced very stiff losses only a short time later.
Within a month the stock had lost 20% of its value. By mid-summer, spiking volumes were offering a true indication of the stock’s trend (in black).
Trading Volume Takeaways
The Sunoco example shows the importance of basing trading decisions on genuine surges in volume. No break through support or resistance should be considered trustworthy, and no trend verified, unless accompanied by a sound rise in volume.
Look now at the opposite example.
This is a chart of woodlot manager Weyerhaeuser Co. (NYSE: WY) for a span of nine months:
The company was in a nice uptrend for over a year, but saw some difficult days through March and April (in red).
Considering the lack of selling volume through April and half of May, a clever technical analyst might consider jumping back on board as the stock pulled off its lows in the $28-$29 range. After all, the flat trading volumes (red arrow) were a testament to the lack of commitment on the part of sellers.
Right?
Not exactly.
Wait for it!
A genuinely disciplined chartist would have waited until new volumes indicated that buyers were in control, as happened through late May and June (in black).
A break above the last retracement high at $30 had already occurred several weeks earlier, so a dollar or two would have been lost. But the added insurance behind the move – courtesy of the volume surge – would have been worth the wait, as the stock tacked on another 20% in the next six months.
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