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Volume Analysis

Most traders know that volume data can be used to asses the prevailing market sentiment and that that the advance/decline volume ratio is an excellent indicator for “overbought/oversold” market conditions. But why study volume? Why is it that the market frequently reverses course after one (or several) large volume spikes?

Let us revisit the definition of "volume":

Volume is the number of shares, traded during a given period, for a security or an entire index or exchange. Volume is also called "trading volume".

Volume data simply shows how many shares were transferred from one group of investors to another – sometimes this data is available broken down by market price, so one can study how much trading activity took place at specific price intervals.

Volume simply shows what happened in the past, it does not directly indicate whether the demand for stock (by willing buyers) outweighs the supply (offered by willing sellers). However, the proper analysis of an index’s past volume action allows analysts to anticipate its likely future trends.

Let us analyze Chart 1 below. This is an example of a trend lasting up to several months, which we define as a “mid-term trend”. Mid-term moves are principally dictated by the sentiment of mid-term players. Long-term players are usually not too concerned about mid-term fluctuations, as long as they don’t upset a prevailing long-term trend. Long-term players are thus likely to wait out mid-term fluctuations before making buy or sell decisions. Similarly, the same principle can applied to short-term traders, who concern themselves primarily with short-term market moves rather than mid- and long-term timeframes.

Chart 1. S&P 500 60-day intraday (one bar = 1 hour)
Advance/Decline Volume Ratio with a 2-Day Moving Average

In our example above, we are studying market action in a mid-term timeframe. In this context, we can say that point "B" marks the critical point from where on the market is in danger of becoming “overbought”. We call the time between points "B" and "C" a "distribution phase". Using the example above, we define and characterize a distribution phase as:

• A period of trading usually initiated by a volume surge that is sufficient to stop and reverse an ongoing trend within the near future. This volume surge is indicative of a pronounced change in market sentiment and marks the critical point from where on the market is in danger of becoming "overbought";
   
• The duration of a distribution phase is extended enough to allow a sufficient number of high-priced shares (in our example, following a prolonged up-trend) to change hands from one group of mid-term traders to another. While our particular example uses a mid-term timeframe, the same principle applies to any other timeframe. This transfer of shares brings the market to the point where it becomes “overbought” in the mid-term;
   
• The distribution phase is also prolonged enough to allow market sentiment changes to take place, which (in our example above) slowly but surely shift the supply / demand balance from the buy side to the sell side. A sentiment shift takes place for the mid-term players involved: some are glad they sold, while they were in a profit zone, others who recently bought in are starting to realize that their timing was off and are now confronted with mounting losses.

Please Note: In the chart above, the values for the May 19 and June 7 peaks in the advance/decline ratio appear to be almost identical; however, the reading on May 19 was only 6.55, whereas the value on June 7 peaked at 9.11 (i.e., almost 40% higher). The visual distortion in the chart is caused by the use of a logarithmic scale.