Using Volume: The Key To Price & Liquidity

• December 30, 2000
• Loren Fleckenstein

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 |
Quote |
Chart |
News |
PowerRating) 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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