Effective Volume Restores Market Visibility

The evolution of the trading environment during the last few years has put stock traders in an extremely dangerous position: they are at the mercy of computer trading programs, without the benefit of the market visibility that was available before decimalization.

Decimalization occurred in April 2001 and before that date, prices were quoted in sixteenths of a dollar. The change to one-cent increments made it easier for market participants to read the tape, but it caused two important changes:

1. Before decimalization, the spread cost was 1/16th of a dollar, while it is now one cent. This means that many participants placed their orders in the book, waiting for prices to come to them. Those who urgently needed to buy stocks had to bid the price up at a "steep" one-sixteenth of a dollar. After decimalization, the cost to bid up the price became so low that it was no longer advantageous to put orders ahead of time in the order book. This drained the visible supply and demand from the order book. Because it is impossible to see the real supply/demand balance in the order book, it is difficult to gain market visibility without looking at the price changes.
2. The second consequence is found precisely in this lack of visibility: institutional investors need to place large orders, but when the book size is thin, it becomes very dangerous to place such orders. New computer programs were developed to monitor the available liquidity and partition large orders into smaller orders that are released into the market. All the institutions now use these computer-controlled, order-processing algorithms. If we add to that the 20% of orders that come from automatic trading programs (black boxes), we can see that the individual trader is no match against powerful institutions that use exceedingly complex tools.

There are only two ways out of this: either we come back to "value investing" à la Warren Buffet, where earnings and cash flows are the rules, or we restore visibility in the system.

How to restore visibility in the equity markets

There is a rather simple way to detect institutional players' fingerprints as they accumulate or distribute shares: since there are only 390 trading minutes in one trading session, a large player needs to buy—or sell—a large enough number of shares on a regular basis for him to have his fill at the end of the day. If an institution wants to buy 500,000 shares of a stock that trades about 1,000,000 shares per day, it will have to purchase 10% of the average volume per day for five consecutive days.

Even if the institution sends strings of small orders when the corresponding liquidity is available, this action will have a direct impact on the supply/demand equilibrium: small disequilibrium will appear as small price changes from one trading minute to the next (I call these changes "price inflections" and "Effective Volume" refers to the minute volume that is responsible for a price inflection). Many of these inflections are undetectable to the naked eye, but if we separate the price inflections produced by large minute-volume bars from those produced by smaller minute-volume bars and construct an Effective Volume flow chart such as in the examples below, we can then see what institutions are doing: buying or selling shares.

In other words, the idea is to make a statistical analysis of all the volume bars that provoked a price inflection during a trading day, separate the institutional players from the retail players, get rid of the noise made by retail players, and then reconstruct the original large orders of the institutions before they were sliced into small orders.

The method and its formulae are published in my book Value in Time (Wiley).

Effective Volume for safer stock trading

Since Effective Volume shows what institutional players are doing, it can often confirm some traditional technical pattern. Experience shows how it worked out for communications equipment manufacturer CommScope, (CTV | Quote | Chart | News | PowerRating) while a different type of pattern shows for the biotechnology company Medivation (MDVN | Quote | Chart | News | PowerRating).

For CommScope, during the three phases of consolidation (A, B, and C), large players were in constant stock accumulation, while the general price trend was positive. After the positive earnings of April 29, the stock jumped while attracting profit-taking by those who had accumulated large positions. Of course, nobody knows if this sort of accumulation prior to an earnings release is related to insider trading or privileged information, but following large Effective Volume at key points in the life of a stock can be rewarding.

Figure 1: Large Effective Volume analysis for Commscope

This is also true for the biotechnology company Medivation, which I traded during the very volatile market periods of April 7 to 9. In this case, the large Effective Volume helped me to find the bottom of April 7. Indeed, the stock pushed sharply down during A and B trends, while large players were quietly accumulating. Then, the small trading range C formed, while there was renewed buying. This type of pattern is rather safe: the previous accumulation shows that there is not much selling pressure and the current accumulation during the C trading range shows that the supply/balance is probably changing. Given such a condition, I would place a stop loss below the 11.5 support level and wait for the break-out. In the very volatile markets that we have experienced since January, the Effective Volume method allowed for about an 18% trading profit on mainly short-term long plays.

Figure 2: Large Effective Volume analysis for Medivation

Using Effective Volume for market monitoring

Figure 4 shows the Effective Volume method applied to the S&P 500. By contrast, the Effective Volume method applied to the futures and to the S&P 500 gave very strong warning signs days before the May 15 collapse, this allowed me, on April 29, to buy long-term puts on the market index.

Figure 3: Large Effective Volume analysis applied to the DOW E-mini contracts

Because each stock carries a different share price, I multiplied the Effective Volume by the share price for each stock and then applied the weight used for the S&P 500. I then obtained what I called the "Large Effective Money Flow," which is a statistical image of the waves of money moving in or out of the stocks that make up the S&P 500, using a 20-day rolling window—note that was constructed using about one billion computer calculations. The results are very interesting: the Effective Money Flow method shows that big market corrections occurred after institutional players had been net sellers—sometimes for months—while the share price was still increasing (see the red lines A, C, and E, where the stock price made a new high while the Money Flow made a lower high). The green lines (B, D, and F) also show when the price made a lower low while the Money Flow made a higher low, often a sign that the market is ready for a new up-leg.

Figure 4: The Large Effective Money Flow applied to the S&P 500

I am sure that trading activity using standard tools can be greatly improved just by trade confirmations from this Effective Volume method. While the method is explained in my book, the code is also available on this web site, in exchange for a small donation to charity: www.effectivevolume.eu.

Traders have been the victims of computer-generated volatility for too long. We need to put visibility back into the trading ecosystem. More visibility will reduce volatility and help traders to focus on profitable long-term price swings instead of being forced to react to bursts of unpredictable waves of computer-generated orders.

Pascal Willain is a Belgian entrepreneur with a background in mathematics and software engineering. He was a featured trader in Dr. Alexander Elder's book, Entries & Exits (Wiley). More about the Effective Volume tools can be found on his web sites at www.willain.com and www.effectivevolume.eu.