Today's Trading Lesson From TradingMarkets

Using Volume: The Key To Price & Liquidity
By Loren Fleckenstein

TradingMarkets.com
 

As an intermediate-term momentum trader, I use volume in two basic ways: to assess liquidity and to interpret price.

Thinly traded stocks can produce explosive price moves. When major demand hits such stocks, available supply is quickly overwhelmed, producing extreme price gains. I know traders who seek out such stocks and do well trading them.

However, these are very risky waters to fish in. Thinly traded stocks lend themselves easily to manipulation. The volatility can become extremely violent and adverse. And if you trade large positions, you can get caught in a liquidity trap. The stock can move explosively against your position while you're stuck without sufficient volume to sell your buy or cover your short. Light-speed order execution and real-time alerts are useless if the market doesn't provide timely inventory to fulfill your order.

Liquidity Filters

For these reasons, I recommend most traders filter for stocks with minimum average daily volumes of 300,000 shares. A 50-day moving average works well. If an interesting stock falls just short of the 50-day minimum, I'll check the 30-day. If the 30-day moving average hits 300,000 shares, I might consider the stock sufficiently liquid to trade.

Furthermore, stocks with healthy minimum volume aims toward favorites of the institutions like mutual funds, what Kevin Haggerty calls "the Generals." Their powerful buying and selling decides the direction of share price moves over the intermediate term. 

The TradingMarkets StockScanner allows you to screen for average daily volume using a 50-day average. Kevin Haggerty's Index Screens, which are powerful tools for spotting potential trades in the S&P 500 and Nasdaq 100 stocks, use a 30-day average. For more on how to use those screens, see Kevin's lesson, Trade Selection Using Four New TradingMarkets.com Screens. 

Here's a simple StockScanner screen that an intermediate-term momentum trader might run. It incorporates a minimum average daily volume of 300,000 shares. Remember that the StockScanner denominates volume by hundreds of shares. So lop off the last two zeros of your minimum volume requirement. For example, you would enter a minimum volume screen for stocks trading 300,000 shares as 3000 in the StockScanner. 

There is probably a sweet spot when it comes to liquidity. All things being equal, I prefer stocks that trade 300,000 to 600,000 shares on an average day. I don't want so much average daily volume that that a stock cannot move sharply without extraordinary demand or supply coming to market. There are exceptions. For example, extreme contractions in recent trading volume and price volatility can set up any stock for a big move once strong demand returns to the market.

Supply and Demand

The second key aspect of volume is that it enables the trader to interpret price action. In a free market, price is a function of supply and demand. By judging price change in the light of volume change, the trader can ascertain whether the force of demand (buying) is overwhelming supply (selling), setting up the long trade, or supply is overwhelming demand, signaling time to sell or short. 

Here are some rules of thumb that guide me in my interpretation of price and volume.

1. A close up on an increase in volume over prior-day volume represents an accumulation day; net institutional buying appears to be occurring. That's bullish.

2. The accumulation day gains greater authority the higher the stock closes in its daily range. On a wide daily range, if the stock gives up most of the its intraday gains and closes near the bottom of the range, distribution has occurred, negating the session as an accumulation day.    

3. A close down on an increase in volume over prior-day volume represents a distribution day; net institutional selling appears to be occurring. That's bearish.

4. The distribution day gains greater authority the lower the stock closes in its daily range. On a wide daily range, if the stock recovers most of the its intraday losses to closes near the top the range, accumulation has occurred, negating the session as a distribution day.    

5. The greater the volume relative to average daily volume, the more likely the coincident price change will auto-correlate. In other words, the more likely the stock will move in the same direction. The weaker the volume, the less authoritative the price move. So for instance, if you're holding a long position, you want to see your stock move ahead strong volume, pull backs on light volume. Gains on light volume, pullbacks on heavy volume are bearish.

6. A contraction of volume, combined with a contraction in price volatility, can provide a superb setup for entering high relative strength stocks in certain cases, such as the completion of a cup-with-handle.

7. Heavy volume with little net price change after an extended run or near new highs represents churning and could signal a top, particularly if this occurs over a number of sessions. 

Anyone who trades must become a student of supply and demand, the most fundamental aspect of any market. This is just an introduction. For more along these lines, I strongly recommend that you read Kevin Haggerty's lesson, Selection Of Trades By Identifying Buying and Selling Pressure.

Putting It Together

Some of these principles are incorporated in a number of the TradingMarkets indicators. You also can use these ideas in your own StockScanner screens. However, as I said, these are rules of thumb. Indicators and customer screens only give you a cast of suspects. You still have to use your own eye and mind to investigate and find the highest probability trades. Spotting an accumulation day, for instance, does not guarantee that a stock is headed higher. A series of distribution days does not guarantee that a stock is headed lower. I am a discretionary trader. It's the cumulative effect of many price and volume clues, combined with pattern recognition, which enables me to make decisions about entering or exiting trades. 

Let's examine the volume signals as shares in SunGard Data Systems (SDS) traced a cup-with-handle pattern over 25 weeks, then broke out.

After peaking on March 24, 2000 at 40 a share, the stock entered a correction. It tried to reverse off its May 24 low. On May 30, the share price closed up 8.2% on a noticeable range expansion and closed near the top of the day's range. Volume increased over the prior session. All things being equal, those would be bullish signs. However, volume came in at 416,400 shares, 32% below the stock's average daily volume of 619,298. (See Point A in the following chart.) That's anemic. There's no reason to think that the move will extend into a sustainable advance. 

Sure enough, the stock peaked on June 2. Notice how volume spiked that session. (See Point B.) That adds more authority to the idea that the stock will encounter resistance if it retraces to that level. The more volume, the more shareholders who bought at that point. Some of those weak holders will be tempted to bail at their break even point. Plus bears might find this a tempting level to short. We'll call this area an "intermediate peak" within the pattern.

SunGard shares tried to hold up, then caved, taking out the prior low. On July 7 (Point C), the shareholders panic, driving the stock down to an intraday low of 26 1/2, a decline of 11.9% from the prior close. Then the stock rallied sharply to close just shy of the top of the range. Volume swelled to 2.7 million shares, more than five times the stock's usual trade. That represents a massive turnover of weak holders in favor of new strong holders.

From this point, strong or rising volume often accompanies price progress. On July 21 (Point D), the stock gaps up on strong volume. Two days later, on July 25, SunGard follows through to the upside on 784,900 shares, about 62% above the norm. 

Notice that the subsequent pullback occurred on light volume. Then the stock resumed its recovery. Note the three accumulation days (see green arrows) up through the break above the intermediate peak (Point E). Volume on these days was not overwhelming, but it exceeded the 50-day moving average as well as the prior-day volume. That indicated institutional money flowing into the stock.

SunGard shares formed a characteristic cup-with-handle with a volatility contraction following a shakeout on Aug. 23. Notice the tightening range. The distance between the Aug. 18 high (Point F) and Aug. 23 low (Point G ) spans 3 3/4 points. The distance between the Aug. 20 high (Point H) and Sept. 19 (Point J) spans 1 7/8 points -- a volatility contraction of 50%.

What does this mean? We need volume to complete the picture. Heavy volume with little net price change after an advance is churning and raises the odds of a price decline. Light volume with little price change suggests that shareholders are content to sit tight at the current market price. That condition primes the share price to spring higher if heavy demand comes to market.

SunGard's chart shows the latter scenario. Observe how trading activity dried up under the tightening handle. On Sept. 14, monster-sized volume hit the stock, triggering the breakout on Sept. 14 (Point J).

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