The “Voices of Volume”

Virtually all technical indicators are a mathematical derivative of price action. Volume analysis opens a completely separate dimension, which addresses the question “To what extent does participation confirm the move underway?” Here are some principles that help guide our thinking as we listen to “The Voices of Volume.”

1. Volume can Lead Price

Similar to a momentum divergence, a new high in price needs to be confirmed by at least relative increases in volume, if not new (relative) volume highs as well. If new price highs are clearly not confirmed by new (relative) volume highs, then this is a warning signal that the new price highs might not last long. The On-Balance Volume (OBV) indicator is essential for some traders due to its potential to lead price.

2. Massively Rising Prices with Massive Increases in Volume are often Unsustainable

This goes back to the principle “Trends End in Climaxes” where a sudden rush of euphoria causes all who want to join to be ‘all in’ and thus unable to push prices higher. As we know, most people are bullish at the top and bearish at the bottom, and when there’s a ‘last ditch effort’ to get into (or out of) a stock, the classic sign is some sort of price blow-off which usually is marked by a stratospheric rise in volume - don’t get caught up.

3. Price Consolidation after a long Downtrend with Increasing Volume is Bullish

This scenario represents accumulation, in that funds are meeting any selling pressure buy accumulating all available shares, and thus “they know something the mass public doesn’t” or otherwise will catch onto later which could lead to the birth of a new trend.

4. Price Consolidation after a long Uptrend with Increasing Volume is Bearish

For the opposite reason, after a long rise in price, if price consolidates for a long period of time, yet volume increases, this means that funds are distributing their shares to the numerous buyers who can’t push prices higher, and when the buying pressure eases off, the price would be more likely to fall (or start a new downtrend) than continue rising.

5. Massive Volume on a New Significant Price Low is Bullish

This signal could represent a capitulation from buyers which is being met by aggressive accumulation by funds or traders, but most likely simply represents a ‘throwing in the towel’ on the part of the buyers who can’t take the pain of lower prices any longer. Strangely enough, when volume spikes massively on a large volatility down-move in price, this often signals bottoms, especially if the price closes higher on the day or at least closes in the upper range (such as the surge on January 22, 2008).

Comparison Chart

Open Interest information is only provided by the Futures and Options Market, though they can assist volume decisions as well.

For an explanation on how to interpret this chart, visit the blog article, “Insights from Volume and Open Interest.“

It is a good idea to display volume bars or other volume indicators on your charts to allow you to go beyond the price dimension and assess participation using the principles of confirmation and non-confirmation.

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The Basics of Trendlines

Trendlines are among the most basic tools of Technical Analysis, yet are quite powerful in their interpretation.

A trendline requires at least two “touches” or price points to be drawn, similar to a ray or line in geometry. However, there are a few factors that cause some trendlines to be more “valid” than others.

1. Times Touched

A trendline that has been “tested” or touched multiple times is more valid (or significant) than one that has been tested fewer times. Trendlines gain validity each time they are successfully “tested.”

2. Angle or Slope

A trendline with a lower slope, particularly around 45 degrees, will be more valid (or significant) than one with a steeper angle. A steeper trendline will require more force to continue and is more likely to reverse.

3. Time Period

A trendline that has lasted many years is more valid than one that has lasted a few weeks or months.

Commonly Asked Questions:

“Should I trendline connect all valid points or do you allow for some points to penetrate the trendline in its construction?”

This question has inspired much debate among analysts, each having compelling arguments for both sides.

Generally, it is better to allow some “wiggle room” when drawing trendlines, particuarly using candlestick charts, and allow for intrabar penetration. Be guided by the rule “Trendlines are more valid when they are connected by more rather than fewer points.” This might mean having to draw lines that pass through some bars in favor of picking up support or resistance via other bars. Use trial and error in your analysis.

“Can I use trendlines on oscillators or other indicators?”

Absolutely! In fact, you can see signals sometimes ahead of price when you use trendlines on the RSI, On-Balance Volume, MACD, and other technical indicators. Trendlines are particularly important when looking at “Relative Strength” charts which compares one security to another.

“What is the ideal trendline?”

The ideal trendline is one which has transpired over a decent length of time, touches many price points, is not too ’steep,’ and accurately reflects support or resistance via the developing price structure.

“What happens when a trendline is broken?”

These can serve as early warning signals of a possible trend reversal ahead. At a minimum, they should give you pause that the prevailing trend might be in danger of reversing soon, though you’ll generally need further confirmation that the trend has officially reversed. The significance of the expected move depends on the above factors related to the validity of trendlines.

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The Basics of Support and Resistance

The concepts of “Support” and “Resistance” in the marketplace are as common as bread and water - scarcely a trading day goes by when you don’t encounter these concepts in some form or another. How do we accurately define these terms?

Support is known as an area where price is expected to cease declining and form a reversal, inflecting back to the upside.
Resistance is known as an area where price is expected to cease rising and form a reversal, inflecting back to the downside.

It is generally better to refer to these concepts as “price areas” rather than exact price points, and allow wiggle-room should price violate expected support by a fraction.

There are a variety of methods one can use to determine expected areas of support or resistance, from moving averages, to trendlines, pivot points, previous market highs or lows, Fibonacci levels, or chart patterns.

Ultimately, you will likely place stops and targets or enter trades at areas you believe will hold as support or resistance. If you are correct in your assessment, you will have identified a low-risk trade set-up.

Support and Resistance adhere to the hierarchy of timeframes, meaning support levels on a monthly or weekly chart will be more valid (or significant) than those on a daily or intraday timeframe.

Also, Support and Resistance adheres to the “Polarity Principle,” wherein old support levels, once broken “change polarity” and are expected to become new resistance should they be tested again (and vice versa).

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The Basics of Charting a Stock

You’re looking at a stock chart for the first time - where do you start?! What do all those lines mean?

Price data is often plotted on the vertical or Y-Axis while time data (minutes, days, weeks, months) is often plotted on the horizontal or X-Axis. The goal of reading a chart is to determine where price has traveled over a given period of time and determine potentially where it might be going through studying past and present price data.

There are a few popular methods of representing price action on a chart, including the following:

1. Line Charts often reflect the period’s close only, operating under the notion that the close is the most important piece of information, as it reflects the sentiment of all market participants willing to hold positions overnight. A line chart “connects the dots” of each period’s close and is well-suited for trendline or price trend analysis. Line charts eliminate the period’s open, high, and low and allow you to focus on how price is moving from close to close.

2. Bar Charts reflect the open, high, low, and close of the period and are drawn as vertical lines with small hash marks to reflect the open and close. Sometimes a bar chart will only show the high, low, and close. Traders find bar charts represent the data simply, yet provides more information than Line Charts. Bar charts can compress the data, which allows you to see more bars at a time and thus ascertain the trend or applicable price patterns more clearly.

3. Candle Charts emphasize the price difference between the open and the close, while also showing the period’s high and low similar to Bar Charts. Some traders believe Candle Charts have advantages over Bar Charts because the period’s action is easier to visualize, and many believe “candlestick patterns” hold a major key to seeing the balance between buyers and sellers play out over time.

There are other types of charts, including Kagi Charts, Gann Swing Charts, Point and Figure Charts, and Renko Charts - it is generally advised to begin with Line, Bar, and Candle Charts before moving on to these other forms of charting, although some traders utilize Point and Figure charts exclusively.

Indicators on Charts

Most traders want to see more information on a chart than just the period’s open, high, low, and close. They want to use indicators to help them see insights into price behavior that may be developing.

It is quite common to see Volume Bars on charts, which reflect trading activity over a given period. Generally, volume is displayed at the bottom of a price chart.

Moving Averages are usually overlaid with price data and are also scaled on the Y-Axis. These can be helpful in determining a price trend or to find possible support or resistance levels.

Oscillators and other indicators are often displayed either above or below the price data, depending on the trader’s preference. These can include simple or complex indicators which can reflect volatility, price swings, momentum, rate of change, or other derivations of price or volume.

Sometimes a chart may show more complex, hand-drawn annotations such as Elliott Wave Counts, Fibonacci Retracements, Cycle notations, or Gann angles. Generally, these are placed on a chart by the trader, and not automatically by a computer program.

I advise you to play around with the chart settings that you understand and feel adds value, but once you settle on a workable set of parameters, you need to “train your eye” to recognize these settings and not adjust them too frequently.

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Bull Flags and Bear Flags

Bull and Bear Flags are one of the simplest and potentially profitable patterns in chart analysis. Generally, this is because one can achieve a “Dual Edge” in trading the pattern, meaning the pattern tends to ‘work’ more times than not, and when the target is achieved, it yields more profit (up to two or three times as much) as the stop-loss that is incurred when the pattern ‘fails.’
Let’s look at the idealized representation of this pattern:

One cannot predict the initial impulse - known as the “flag pole” - that creates the patern, nor can one accurately predict the retracement that constitutes the “Flag” portion. The pattern derives its edge and opportunity from a price break-out above the upper trendline that forms the “Flag” portion of the move. We expect a “Measured Move” to occur which gives us a potential price projection, and location to place our stop (beneath the lower trendline of the flag) if we are incorrect.

Here are two examples of the pattern in action:



The first chart is Corn Futures on the Weekly Chart while the second example is the DIA (Dow Jones ETF) on a 5-minute chart - both selected to demonstrate the applicability of this pattern on all timeframes.

The following summary is specific trading instructions for the pattern:

Why do I like this pattern?

It is relatively simple to identify, only uses price (no complex indicators), and the stop-loss along with profit target projections are clear.

What does it look like?

Graphically, the pattern is comprised of a large volatility upward impulse move (which resembles a ‘flag pole’) which is then followed by a retracement that occurs downward in a near 45 degree angle. After this retracement is complete, a ‘measured move’ component breaks back to the upside which is roughly equal to the original flag pole portion.

The first component is the ‘pole,’ which you often can’t detect as it forms. It is the second component that creates the ‘trade.’

Once you see a clean retracement against a large, near vertical price move, this is your clue to begin looking for this trade. If the retracement is bound by near parallel channels which form a 45 degree angle, then this increases your confidence that a flag pattern is occurring.

If the retracement pulls back to the 20 period (or some other) moving average, or some other area of perceived support, this adds confidence to this pattern.

Entry

Generally, once you see price retrace about 50% of the initial ‘pole’ or price comes into a support zone, this would be your entry. If you are an aggressive trader, you can enter as price continues downward in the retracement in anticipation of a reversal. Generally, you’ll fall victim to less slippage and will get a better position if the measured move occurs.

If you are more conservative, you can actually wait for the price to break out of the upper channel and enter at that point. You’ll sacrifice initial trade location, but will put the odds a little more in your favor.

Stop and Target

Where do you place your stop and where do I play for a target? It depends on your style of trading.

The stop should go a ‘comfortable’ distance beneath the lower trend channel of the flag portion. Again, if you are conservative, you can place it just beneath the support zone or bottom trend channel.

If you’re more aggressive, you can place the stop lower than this zone, or even beneath the initial pole (of the impulse).

Keep in mind that you have a clear target once you establish your trade, and so you can easily cut that target in half to establish a clean 2 to 1 reward to risk ratio.

The target is an equal distance of the pole which is added to the bottom of the lower trend channel in the flag.

Example: If the ‘pole’ impulse is $5.00 (taking price from $40 to $45), and the retracement takes price down $2.50 to $42.50, then the ‘measured move’ target would be $42.50 + $5.00 or $47.50. Your stop could be placed where you are comfortable beneath $42.00.

Where does it occur?

This pattern occurs on any of the intraday time frames and the daily timeframe of ETFs, indexes, and futures contracts. Unfortunately, this pattern occurs less frequently on the weekly charts (though the targets are larger) and especially the monthly charts. Classic technical analysis books say that a ‘flag’ portion of the daily chart must unfold in 4 weeks time.

For a detailed explanation on how to use TradeStation specifically to project the target for a flag, visit the post “How to Project a Measured Move of a Bull Flag.“

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